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By David Howden, on 4 May 12
In the past year we have witnessed the growing influence and clout of the Occupy Wall Street movement in the States, the St. Paul’s protestors, or any other of the numerous regional protests spreading around the developed world. Although at times difficult to pinpoint exactly what has gotten these groups so upset – whether lack of jobs, austerity cuts, or the like – there does appear to be one common concern. The growing divide between the “rich” and the “poor” seems to be increasing, and this is causing alarm.
In most cases of economic advance we have seen a growing divide between the haves and the have-nots. This makes sense for many reasons. In a market economy one ends up having much by providing others with much. It is only by ensuring that others’ needs are best met that the businessman can attract clients. On another level, we should not forget that just because there is a growing divide between two tiers in society, that does not imply that both are not better off as a result. We can think back to Margaret Thatcher’s final speech in parliament when the Right Honourable Gentleman opposite chastised her government for just such a growing divide. Thatcher’s response was fitting as an end to her terms as Prime Minister, but also to the Britons whose lives were made better under it – even though several British citizens had gotten wealthy (even fabulously so) under her tenure, the average Briton had also seen their quality of life improve immensely. Indeed, it was probably those at the lowest echelon of society – the destitute with no jobs in the 1970s – that benefited the most as their lives gained new meaning in the booming 1980s.
Today’s divide is different, however. The rich are getting richer and there is no discernible improvement in the life of the average Briton. Indeed, inflation adjusted salaries are lower than they have been in a decade. Instead of the rich spending their largess on investment that improves the lives of the rest, they are spending it on what many see as superfluous luxuries.
In 2010, Sotheby’s London set a new auction record with the £65m sale of Giacometti’s “L’Homme qui Marche 1”. While many housing markets remain in tatters, mega-mansions are doing fine. During the peak of the boom in 2007, the highest price paid for a home outside of London was outside of Henley-on-Thames. The selling price was £40m. Last autumn the same house sold for £140m. The Knight Frank Wealth Report reports that 25 percent more high net worth individuals are expressing an interest in fine art in 2011 than the previous year.
These ostentatious displays of wealth are sure to evoke feelings of insecurity and ire from the have-nots. They are purchases that only a small fraction of the population can afford, and benefit from.
The difference in the wealth divide that exists today compared to its 1980s has a simple explanation. They are caused by different conditions.
Take a sustainable economic advancement. The business setting improves, taxes are lowered and regulations done away with (or made more sensible) and conditions of low price inflation allow for easy monetary calculation. Businessmen follow their natural urge to serve wants better than others in hopes of earning a monetary gain. If they do this well and customers demand their products, these businessmen hire additional workers. Everyone wins – the business leaders get remunerated for their foresight and hard work with wealth, workers get jobs, and customers gain access to new goods. Each worker sees his wealth increase due to a new or better job. The businessman gains even more – he earns additional money from each and every one of these additional workers he hires (or else he would not have hired them in the first place). A wealth divide emerges, but all involved are better off than they otherwise would be.
That story more or less explains the growing wealth divide that defined Britain’s 1980s.
Today’s wealth divide is different. Business conditions are not improving. Taxes are not being lowered, a condition that would incentivize more entrepreneurs to start enterprises. Regulations are not easing to remove barriers to entry for smaller firms – those typically lacking the legal budgets to navigate such difficult waters. Price inflation is not exactly low, and is also highly uncertain. None of the criteria for a booming economy, one capable of causing a beneficial wealth divide, are apparent. Yet a growing wealth divide we have.
One explanation is the final criteria above – the lack of low and stable price inflation. When new money enters the economy, it does not affect all participants equally. It enters at a specific point where someone spends it. At that moment, the constellation of prices reflects an old quantity of money and spending patterns. Once this new money enters the economy, price pressure increases. The first person to spend this money benefits as they spend money which then causes prices to adjust – they can take advantage of the situation by being part of the cause of the price increase, instead of an innocent bystander.
Price inflation is not something that drives business growth. It aids some (those who first receive the money), but it complicates life for the rest of us. Each year that passes we see prices increase. They do not all do so evenly. We need to decide how best to allocate our money among the new array of prices. Those who first spend any new money are not encumbered in the same way – they are the ones that make prices increase.
Since this crisis has began, the Bank of England has embarked on a highly inflationary policy aimed at rescuing insolvent banks and aiding those nearly so. This policy has evidently not promoted economic growth in the economy. It has also advantaged those few that have early access to the funds created and have the liberty to spend them at the old pre-inflation prices. Investment managers, developers, bankers and the like – those closely involved in the process of injecting new money into the economy – have been spending the increased supply of pound notes on art, real estate and fine wines. While this gives an impression of wealth to some, it is all an illusion. It is a monetary manipulation enriching some at the expense of others.
For the rest of us – those feeling as though we are falling behind the Joneses – the object of our ire should not be those that are getting wealthy at our expense. I would do the same thing if I was in a position to receive new pounds that Mervyn King is gifting around. I would direct my ire at the root cause instead. The Bank of England’s inflationary policies since 2007 (and before) have created a special class within Britain. Members of this class get to use money to fund their consumption at old pre-inflation prices. For the rest of us, well, we get the feeling that we’re left behind.
By David Howden, on 10 February 12
European countries offer a variety of pension schemes. For our purposes here, I want to draw attention to the variety of public participation rates in the total pensioned assets among EU member states. Consider the following chart, courtesy of Lans Bovenberg and Caspar van Ewijk:
The UK stands out as the country that has, far and away, the highest portion of its pensioned assets in private plans. Some of the usual suspects, like Greece and Italy, round out the bottom of the list with almost all of their pensions in public hands.
Private pensions have many advantages over their public counterparts. These advantages are notable now more than ever. They help diversify risks for investors. With public pensions proving to be less safe than in the past, this is a welcome benefit. Private schemes don’t leave investors exposed to the credit risk of their own governments. Private schemes deepen the capital markets, and allow for better allocation of funds than public (and government debt-centric) pensions. In sum, private pensions promote financial stability.
But there is one advantage that hasn’t been getting much press. Countries with large private pensions make some unfortunate policy choices a little less difficult.
The sovereign debt crisis illustrates the need for European governments to scale back on their expenditures. Lacking an easy way to enhance their revenues, cutting back on services is the only way to stay solvent. Greece is the most evident case of this problem, but it exists in all EU countries to some extent. Voters don’t generally get excited by the prospect of reducing public services. Or more correctly, they don’t get excited by this prospect in a positive way.
Several governments are to the point where significant fiscal reform is now necessary in the quite immediate future to stave off a worse fate. The problem that past reform inaction now breeds is that there are few areas of the public sector that can generate cuts large enough to meaningfully scale back the respective budgets.
Public pensions comprise large swaths of the public budgets of all European states. Large cuts to pensions are not welcome, but they are one of the few areas where significant and timely cost savings can be made. Countries that have made changes to their public pensions in the past have seen much resistance. Violent riots erupted in Greece, and even France had its share of unfortunate reprisals.
This is largely to be expected. With few private alternatives, citizens of these states are left with an almost exclusive reliance on their public pension plans. It could have been a mistake for these people to believe that their public pensions would pay out their full benefits, but that is largely beside the point now. For a 50 year old Frenchman facing a future of pension cuts, there are now few prospects to augment his retirement income.
It should come as no surprise that citizens are hesitant to accept cuts to their pensions. Even those that accept that cuts must be made aren’t thrilled by the cuts having to be made in a way that directly affects them.
Some countries, like the UK, should take notice of these developments and be optimistic. With the public pension scheme proportionately the smallest in Europe, it may face considerably less backlash in reforming than we have seen in other countries.
Of course, the British might look to the recent student protests over tuition and fee increases for university as the opening act for the reaction to the cuts to come. Yet, significant differences exist. Students privately fund only a very small portion of the total cost of their university studies. Going from a situation where one pays a small portion of the total cost to a larger portion is a significant increase in the total cost that they must bear. Any increase in private university fees shifts a comparatively large burden of payment onto students’ pocketbooks.
As a thought experiment, imagine the student riots if the same education cuts occurred. Except instead of the current proportion of public and private expenses for University, imagine that only 25% of costs were publicly provided for, with the remaining 75% privately funded. Could anyone seriously imagine the riots being anywhere near the same magnitude if this funding balance was in place to begin with?
Rioting pensioners in Greece are no different than the students in Britain. They are both part of an entitlement system that promises to pay for large portions of expenses. One should not expect to see the same backlash when a system is changed that isn’t publicly funded to the same extent, such as the public pension scheme in Britain.
People don’t object to paying their own way. They do object to being lied to, or having promises reneged on. The public pension scheme in Britain provides one advantage to reform that its European neighbours don’t have.
By David Howden, on 7 February 12
Credit ratings agencies have come under fire for not being proactive enough in recognizing bad sovereign risks. Even if the ratings agencies were a little quicker with the downgrades, the result would not be significantly different for investors. This is because there are two paths to default.
Credit ratings agencies exist to measure one thing – the risk that an entity will explicitly default on its obligations. In this regard, ratings agencies by-and-large do fairly well. What they do not do well (nor is it their job), is to assess the risk of the other default, the one by inflation.
Charles Goodhart argues that we can see the distinction if we compare the plights of two countries. England has high debt to GDP levels, yet has retained its rating through the recent downward revisions. France, by comparison, has lower debt levels and was recently downgraded. What gives?
Some would argue, as the ratings agencies do, that France is threatened because she cannot inflate her worries away. The Euro blocks this option, as Paris must succumb to Frankfurt on monetary affairs. England faces no such constraint, or at least, not an insurmountable one. The Bank of England might be nominally independent from Her Majesty’s Government. Yet what the crown gives it can take away. The BoE can be a direct policy arm of parliament if need be. When faced with insolvency, such a course of action is foreseeable.
Inflation (both measured and expected) is already higher in the UK than in France. While the investor buying French debt worries about a small chance at not getting his money back, the buyer of British bonds faces the fact that the bond’s nominal value is continually eroded at a faster rate than his French counterpart.
For the investor, it makes no difference which default occurs. Whether explicitly at a moment through insolvency or slowly through inflation, the effect is the same. Long drawn out tortures can be just as effective as swift death sentences (sometimes more so).
Investors fixated on credit ratings are cognizant of only half the story. Given this, one wonders if the official ratings mean anything at all.
Take the United States, for example. Its recent downgrade brought into question Washington’s ability to pay off its national debt (among other obligations). But that was just making explicit what was already implicit for decades. As inflation ate away at the nominal value of the debt, the country was slowly defaulting by another means.
Some may look at the low interest rates on US Treasuries right now, and argue that the risk of default is low. These investors would likely be correct. One could also argue that interest rates are low because the Fed has been purchasing large quantities of them, and without this intervention rates would signal a much different story. This story is also likely correct. But the latter story is just removing the explicit default risk from the Treasury and giving it to the Fed. The Fed will just buy more bonds from the Treasury to finance the payoff of the existing ones if the threat of default nears. This amounts to default not at the hands of Treasury, not explicitly anyhow. This becomes a Fed-orchestrated default, through the process of inflation.
Rating agencies do investors a great favour by pointing out the explicit default risk of different debt securities. Investors would do well to recognize the limited relevance of these ratings, especially in light of the continual implicit defaults we are exposed to through inflation.
By David Howden, on 12 December 11
During the current crisis, it is difficult to see the benefits of the euro. While it is increasingly seen as the cause of most countries’ malaise, its benefits are generally limited to the increased trade between European countries.
One additional benefit that requires review is that the euro currently fiscally restrains European governments, analogous to how the gold standard used to work. Eurozone governments lack the ability to directly monetize their debts. As a consequence, inflationary pressures have been subdued during the present recession. If each country controlled its own monetary future, it is difficult to say whether inflation would still be held at bay.
Sovereign countries have a natural incentive to inflate their liabilities away when finances get tight. It is for this reason that independence of the central bank is granted. By being separate from the government, the central bank’s conflict of interest is reduced, or hopefully eliminated. Southern European countries historically granted only weak independence to their central banks. This was evident over the thirty years prior to the formation of the euro as Europe’s south frequently found itself in periods of high inflation.
The European Central Bank was formed to guarantee and institutionalize this independence. No longer would a member state be able to inflate its worries away, and hence an era of stability ensued. Without fear of inflation, foreign investors found southern European countries increasingly attractive.
If the euro, and especially the ECB, did not exist today, one would expect that the current budget crises of the PIIGS would be cured with the usual medicine. Strong doses of inflation would reduce the real value of these liabilities, staving off insolvency.
While the euro is increasingly seen as a net “bad” for at least some Eurozone economics, there is at least this silver lining: it has promoted monetary responsibility.
Yet this assessment looks only at the visible effects of the recession, and not at the counterfactual of how things could have been. Let’s partake in some revisionist history.
As I have outlined previously, by joining the monetary union, member states effectively guaranteed investors lending them money that there would be no inflation risk. As a consequence, borrowing rates decreased substantially throughout the Eurozone. This effect was particularly pronounced in the previously high inflation countries of southern Europe. What this translated to was reduced borrowing costs through associated risk reductions. Credit expansion was fostered as southern European governments could raise ample funds at rates far lower than they had ever seen.
The counterfactual is what the last decade would look like without the euro. Investors lending money to southern European countries would not have had the same confidence that their investment would not be inflated away. As a consequence, borrowing rates would have been higher, and the propensity of these European countries to borrow would have been tamed.
To partake in a small amount of speculation, I hazard to guess that with this reduction in borrowing, PIIGS countries would not be in the solvency crisis now gripping them (or at least the magnitude would be diminished). If they did not find themselves in the current malaise, there would be little reason to inflate their troubles away. Or, at the very least, if the size of the problem was tempered by higher borrowing costs, there would be less of a need to inflate the problem away today.
Despite working as type of “fiat gold standard” that alleviates inflation, the euro has actually been the mechanism bringing forth the perceived need among so many European countries to pursue inflationary policies. Pursuing such policies will eliminate one of the few beneficial aspects of the common currency, and will do little to change one simple fact: the euro fostered the conditions that made such excess borrowing possible in the first place.
By David Howden, on 5 December 11
Everyone seems to be searching for a roadmap for the Euro-crisis. A precedent to guide policymaking and financial decisions would give some assurance that feasible outcomes are available. I have argued elsewhere (here, here and here) that there are examples for individual countries to follow. But what of the eurozone as a whole?
With luck, precedent for the precarious situation the 17 members of the euro-club face is available. Across the pond, the United States of America once faced a similar challenge.
After the revolutionary War, the US was faced with a band of individual member states (emphasis placed on the “States” aspect of the USA). The Articles of Confederation allowed each state the exclusive right to tax its population. The Continental Congress was given the right to issue paper money – “Continentals”, as they were known.
Individual states refused to give the Continental Congress the ability to tax, nor did they consent to sharing their tax revenue with it. With no ability to raise funds through taxation, the Continental Congress turned to the only fund-raising means available – issuing new Continentals. The phrase “Not worth a Continental” predictably resulted, as hyperinflation set in.
This course of events prompted Alexander Hamilton and his Federalists to argue for a stronger central government, with the ability to both tax and issue debt. The ratification of the U.S. Constitution in 1789 was the culmination of this drive.
This is the situation roughly analogous to what the eurozone faces today.
Each of the 17 member states has the ability to tax but not to issue currency. The European Central Bank has the ability to issue currency, but not to tax. Some countries can no longer remain solvent through increasing taxes alone. Two solutions result:
- Allow individual states the right to issue money.
- Allow for a centralized fiscal agency to collect taxes for redistribution within the eurozone.
Option 1 amounts to a breakup of the currency union. Option 2 is currently the more popular option. By having a fiscal union with one tax-collecting agency, transfer payments can solve country specific insolvencies. (Of course, longer-term issues remain, but that is for another article.)
Is such a solution as efficient, or equitable, as we are led to believe?
The longevity of the United States suggests that fiscal union is not such a bad idea for a currency union. But important differences exist between the eurozone’s future and the US.
First, with no central fiscal agent for the eurozone there is no central spending required, unlike with the Continental Congress. Each eurozone member state funds its own activities. For example, there is no joint military that requires funding, as is the case with the United States. Hence, there is no threat that the ECB would hyperinflate the euro to fund its fiscal activities (as it has none). This was decidedly not the case with the Continental Congress.
Second, has the centralization of fiscal power been beneficial to the US? The longevity argument is not as strong as one might think. America has, after all, defaulted explicitly on its debt four times in its history. It has evaded insolvency numerous times by inflating its liabilities away. But such an action is default by another means. It has taken from the citizens in the form of an inflation tax to pay for its excesses.
Third, with a central fiscal agency, the US Congress has continually seen a strengthening of its role and scope. New agencies to displace the rights of the individual states have become the norm. The bill to fund the increase in federal activities has risen commensurately. The cost of a centralized fiscal agency in the US has been paid with increasing taxes – whether explicitly through the income tax, or implicitly through the inflation tax.
If the eurozone finds itself amidst a crisis set off by too much government spending (an insolvency crisis) does anyone seriously think the solution is a centralized fiscal agency with the incentive to increase its own indebtedness?
As the United States’ own history demonstrates, calls for a centralized fiscal agency to complete a currency union are misplaced at best and damaging at worst. If history is any guide, fiscal consolidation will result in increased indebtedness on a supranational level. This indebtedness is solved in one of two ways: increased taxes on the member states, or increased inflation. Neither of these seems like a welcome option.
By David Howden, on 28 November 11
Talks of contagion risk, despite having a brief respite earlier this year, are back stronger than ever. With Italy dominating the news, the new risk is that a new European domino is threatening to topple the others over.
Paolo Manasse and Giulio Trigilia give a particularly insightful look into what these contagion fears actually look like.
The authors find that over 80 percent of the total variance in the Eurozone CDS market can be explained by general Eurozone risk. This is a sharp increase from less than 60 percent at the beginning of the year. Their conclusion: “once again markets are bundling EZ members as one in terms of risk.”
Despite an earlier uncoupling of country-specific risks – especially those of Greece, Portugal and Ireland – the markets are once again pricing in a convergence of these countries´ risks relative to general CDS spreads. Stated differently, over the summer months these countries accounted for only small statistical portions of total CDS spreads. The tides have turned of late, with the result that these countries are increasingly affecting the general risk of the Eurozone market. Their conclusion: the risk of systemic contagion is increasing.
Finally, the two authors look at the correlation between the new contagion culprit de jour – Italy – and other Eurozone member states. The bilateral correlation between Italy and all countries (save Germany) is between 0.99 and 1. In other words, 5-year CDS spreads are moving in almost perfect lockstep between the affected European countries. The authors’ conclusion: little diversification can be achieved by investing in different Eurozone countries.
By all three measures the authors make the claim or allude to the conclusion that because markets are moving with high degrees of correlation, the risk of contagion is high. Such an analysis ignores the definition of what “contagion” means.
As I pointed out previously, contagion in the general sense (and also the financial sense) only occurs when one event affects an otherwise innocent bystander. Two questions arise. How do we know that the innocent bystander was actually affected by the “contagious” party? What would it take to be considered fully “innocent”?
The two authors in question actually answer the first question, at least as it pertains to Italy, claiming “Italy’s problems are homemade – contagion is a sideshow.” Indeed, Italy’s problems are more the result of unsustainable domestic policies coupled with weak growth then they have to do with contagion from Greece (or elsewhere). This in part explains why markets gave only the weakest rally with the exit of Berlusconi. The problems are largely already sunk, and it is now difficult to quickly revive growth or limit promised expenditures.
On the other hand, what does it take for one to be innocent, and thus susceptible to contagion. If I walk down the street, and someone with a contagious disease sneezes on me, I am surely the object of contagion. I had no connection to the individual prior to the event. Indeed, there was no way that I could have known that they were to sneeze on me (perhaps they did so only accidentally, but it would make no difference). But what if my friend with a communicable disease is bed-ridden at home, and so I decide to pay him a visit. By entering his sickly house I knowingly place myself at risk. When I return home and get sick there is no use in blaming my sick friend for my unfortunate health. I did it to myself.
The countries of Europe are sick, and the Eurozone as a whole is highly contagious. But there is no way that we can say that those parties inside the system are innocent. Holding Greek debt, or Italian debt, or bonds of a bank that holds these debts, these are all acts that remove your supposed ¨innocence¨. These are all activities that put you at risk because of the connection between the risky activity that you are undertaking, and the party that you are undertaking it with.
If I don’t want to get sick, I don’t enter my sick friend’s house. If I don’t want to be affected by the Eurozone’s sickness, I don’t invest in the guilty parties’ bonds. I also don’t associate with people who do so – banks, insurance companies, or investment funds.
By labeling the crisis as one of contagion, attention is drawn away from the real causes. Highly risky financing activities fueled by an easy-money credit policy over the last decade are now bearing their rotten fruits. Profligate European governments now find their revenues unable to cover their promised expenditures. There are specific causes to this crisis, and specific culpable parties. Chalking market misfortunes up to “contagion” risk obfuscates the true causes, and hinders meaningful analysis of workable solutions.
By David Howden, on 24 November 11
I recently wrote about the inconsistency of the economic arguments for the formation of the Eurozone. The conclusion that the euro was oversold at inception leads us to conclude that calls to save it are also oversold. If the economic considerations for the Eurozone are misguided at best, let’s see if the political arguments fare any better.
The European monetary system existed in various forms for decades prior to the euro. It bred its own instabilities across the continent throughout these decades. Existing as a complex web of fixed exchange rates, continual readjustments caused an uncertainty as to what values one could expect their cross-border costs and benefits to be worth in the future. Germany, the largest and most fiscally conservative country in Europe, was long seen as overemphasized under these conditions – smaller and less fiscally and monetarily responsible countries were under constant subordination to a highly valued Deutschmark.
The creation of the Eurozone would serve four political ends:
- The single currency would offer greater integration.
- The increased mobility of capital removed most of the gains from pegging exchange rates (and that brought about many losses if these pegs were abandoned).
- The Maastricht Treaty, that key Treaty governing debts and deficits, would promote political stability
- Germany would no longer be overemphasized as an economy, and political rivalries of the past would be diminished.
It is difficult to see any of these political goals being achieved.
While the single currency may have promoted greater integration among goods transfers within Europe, there is no real evidence that this has resulted in greater integration where it really matters for most Europeans – in the labour market. Further goods market integration does not transfer immediately to labour market integration, and as this recession makes clear, the labour market is what the unemployed masses are most concerned with. (Indeed, as I made clear in my last article, labour market integration is a criterion for forming a currency union, not an expected result thereof.)
The Maastricht Treaty originally set limits on debts and deficits that European governments could incur – 60% of GDP for the former, and 3% of GDP for the latter. It also set strict inflation and exchange rate criteria for potential member countries to maintain prior to admission to the Eurozone. While these rules create political stability in the sense that they constrain the fiscal policies of the member countries, they have famously been abandoned. Indeed, Germany – the role model for European financial conservatism – was the first country to break the Maastricht Treaty. It has since become laughable. Ireland ran a budget deficit of over 30% of GDP last year. Several member states run public debt-to-GDP ratios of more than 100%. Only Finland continues to abide by these rules (with the Netherlands coming very close).
When rules are thrown out the window, discretion reigns. When discretion reigns – especially 17 different types of discretion, one for each country using the euro – the uncertainty inherent for the euro-using community soars. In a similar application, Bob Higgs famously argued that “regime uncertainty” prolonged America’s Great Depression. Many entrepreneurs and investors sat on the sidelines, unsure of the future state of the regulatory and tax environment of Depression-era America.
A similar atmosphere exists in the Eurozone today, except in a more extreme form. It is not only the business community that is hesitant to undertake new ventures; it is anyone using the euro as a currency. This includes not only European entrepreneurs, but also European consumers and interested foreign parties. Instead of providing the political stability promised by the euro promoters, we are now witnessing one of the most extreme periods of instability and uncertainty of the modern era.
Finally, the shift from the Exchange Rate Mechanism to the euro was supposed to end a period of German dominance. European countries – especially Southern European countries – were continually constrained in their fiscal and monetary policies under the ERM. As the continent was linked via a complex of fixed exchange rates, disparate inflation rates vis-à-vis the largest economy – Germany – resulted in continual strain on the individual central banks. Readjustments, commonly in the form of devaluations, became the norm. Germany implicitly set the interest rate and fiscal policy for Europe. If a European country veered from these norms, its exchange rate would come under pressure, and would have to be reset when the central bank was unable to defend it.
The European Central Bank was set up as an attempt to remove this German dominance. Now instead of being subordinate to the Bundesbank, European governments would have an equal say in how monetary affairs were to be run. For a period this was true. Indeed, one could argue that Germany became subordinate to the rest of Europe under the monetary regime of the ECB (as Philipp Bagus argues in his book The Tragedy of the Euro).
It is increasingly becoming clear that few member states are equals to Germany in the Eurozone. No good deed goes unpunished. The heavily German-funded bailouts of several Eurozone economies to date have been met with indignation. As the saying goes in Ireland, “We serve neither King nor Kaiser.”
To briefly recap, none of the four pre-euro arguments for the common currency stand the test of time. Two of them (greater capital and labour mobility, and increased integration) were actually criteria to be met prior to forming a currency union, not results to expect after. The other two – increased political stability and decreased German dominance – are being reversed with every passing day.
The great European experiment of currency integration has failed to meet any of the economic and political goals set prior to its formation. Perhaps it is time to admit the error, and stop trying to salvage a broken system.
By David Howden, on 22 November 11
European monetary integration relies on the theory of the optimal currency area (OCA). Successful currency unions generally meet four criteria:
- A high degree of economic integration exists within the region
- Prices (and wages) are sufficiently flexible
- Places within the region are exposed to symmetric shocks
- There exists a risk-sharing agreement (i.e., directed fiscal policy) for the region
A region fulfilling these four criteria makes a prime candidate because one monetary policy will be able to combat the root shock affecting the economy, with factor mobility and price flexibility reallocating resources to where they can be more fully utilized. The cost of joining is the sacrifice of an independent monetary policy. Instead of the Bank of Spain or the Bundesbank directing monetary policy for Spain or Germany, the European Central Bank does so for all included countries. As long as all included countries face the same shock, or provided that factor mobility is sufficiently high to easily reallocate resources, this unique monetary policy should be (according to the theory) adequate to combat any ensuing crisis.
While the effectiveness of monetary policy in mitigating adverse shocks is certainly not without its own controversy, for our purposes we will take the theory on its own merits and judge its outcomes accordingly. Importantly, the fourth criterion becomes a caveat on the others – only in circumstances of low factor mobility, price rigidity or asymmetric shocks will fiscal agreements and transfers payments be necessary to stave off recession. Hence, OCA theory states that targeting fiscal policy will only be necessary if these criteria are not met. In other words, if a country is not an optimal currency area.
The euro was originally sold as an economic enhancement to certain European countries. The costs of trade (through direct exchange costs and uncertainties) of having multiple currencies across the continent made at least some European countries candidates for currency union inclusion. While this cost reduction would be beneficial, inclusion in the currency union would only be net beneficial if the cost of joining a currency union was lower than the resultant benefits.
Against these criteria, how does the Eurozone fare?
Cross-border trade is quite high within Europe, so capital mobility is consequently high. The Treaty of Rome was passed in 1957 to liberate the mobility of goods, services, labour and financial capital across European borders. One would consequently believe that capital flows within the European continent are high, and by and large they are.
Labour mobility is a different issue. While freedom to movement is a key principle of European integration, there are inherent features of the labour market that make it quite rigid. Language differences are the most obvious difficulty to labour reallocations, but cultural differences also abound. An unemployed Spaniard does not just move to the Netherlands to find work (an unemployed Spaniard might not even move from his home province to another region of Spain to find work, but that is another question).
Is the Eurozone exposed to similar shocks? In a broad sense one can say that today’s crisis has homogeneous roots across the continent. Yet with the Dutch economy still performing well with the PIIGS in full depression, it is difficult to say that this is the case. One significant factor is the euro itself. One currency for the zone implies one currency value for the whole zone. The euro trades for the same price in Germany as it does in Greece. This would not be problem if prices were flexible. If Greek prices (and especially wages) were sufficiently downward flexible, an overvalued euro would see real prices equilibrated with the rest of the zone through nominal Greek price declines. This is not the case.
Southern European economies famously suffer from an overvalued euro, inhibiting their abilities to create export growth to escape the crisis. Germany, in contrast, is quite possibly exposed to an undervalued euro, resulting in a large net export position. While the euro may be more or less fairly valued for the whole region – net exports for the euro zone are about zero – for any specific component country this may not be the case.
Having a risk-sharing agreement for a currency area is effectively a caveat for when asymmetric shocks occur. In the Eurozone, fiscal agreements were only loosely defined at the euro’s inception. While transfer payments from high to low income European countries were fairly noncontroversial during the boom, as budgets are strained during this recession there is considerably more animosity towards the idea. Indeed, given the perverse incentives facing transfer payment recipients, it is not clear that increased risk-sharing is a desirable alternative. Indeed, Germany pushed for the Stability and Growth Pact to diminish reliance on fiscal transfers for this very reason.
Lacking flexible prices and labor or symmetric shocks, it is difficult to make the case that Europe is an optimal currency area. While this is becoming apparent in this recession, a proper reassessment of the “optimality” of the currency union is hard to come by. In other words, maybe we should be asking if the Eurozone was oversold to us.
In response, calls for fiscal consolidation are becoming increasingly common. If Europe’s woes cannot be solved by one blanket monetary policy, and some countries lack the resources to enact appropriate fiscal responses to stave off recession, other member states should chip in to save their less-fortunate neighbours.
This approach confuses what the criteria for a currency union are with whether it should exist in its present form or not.
If the criteria for the currency union were correctly met, such targeted fiscal policy would be unnecessary. Resources would be automatically reallocated as prices adjust to make this possible. Fiscal consolidation within Europe does nothing to promote such reallocations. Indeed, it could well inhibit it. German transfer payments to Greece in the current crisis remove the incentive Greeks have to reduce their prices downward to regain competitiveness. It also removes the incentives for Greeks to migrate to other Eurozone areas to find employment.
As this current recession progresses, instead of focusing attention on how to save the existing currency union, perhaps time would be better spent reviewing the initial arguments for its formation. The Eurozone was oversold at inception, the painful economic results of which are now all too obvious.
In the next article of this two-part series, we will look at the political arguments for currency integration, and see if they have fared any better than these economic arguments.
By David Howden, on 15 November 11
One can read The Daily Mail for its coverage of the royal family, snapshots of British life, or, if you are like me, the headlines. On Saturday, guest contributor Ian Morris, Professor of History and Classics at Stanford University, served up this classic example:
The perils of the begging bowl: Exactly 100 years ago China was ‘rescued’ by European loans. The result was a century of misery. Now the boot is on the other foot.
Morris continues to explain that 100 years ago, in 1911, the last emperor of China had just been toppled. The newly formed Republic of China was penniless (yuanless?), and desperate for loans to keep it afloat. European investors, flush with cash in what was the still prosperous pre-World War I era, flocked to Beijing to make loans to keep the newborn country afloat.
Today the eastward journey continues, but it is not made by Europeans looking to invest their savings. It is instead European politicians looking to secure loans to keep their unsustainable experiments afloat for a little while longer. While this great European experiment with the welfare state is now obviously insolvent, an attitude remains that we are only in the midst of a liquidity crisis. This view is wrong. No amount of loans can save a country from a crisis of insolvency, as has proven to be the case in Greece recently.
A more important question to ask is whether Europeans should be seeking bailouts to keep the current system afloat.
The Republic of China, formed in 1912 supported by European funds gave way to The People’s Republic of China in 1949. The latter demonstrated itself to be the most despotic regime of the twentieth century. The impoverishment of citizens by other regimes, Nazi Germany or Soviet Russia, pale in comparison to the hardships endured by the hardworking Chinese over the last century.
Several centuries ago, China was the most prosperous nation on Earth, far exceeding even Europe in terms of wealth and technology. The Industrial Revolution changed this, but China still managed to maintain its competiveness, particularly by trading with the newly arriving European entrepreneurs as shipping improvements made trade between the continents increasingly possible during the 19th century.
The loss of the Emperor in 1911 set in motion the key steps that would place the nation’s future in the hands of its eventual tyrant leader, Chairman Mao. Funds provided by wealthy European investors fomented this shift, allowing freshly flailing regimes to secure a political foothold in the late teens and early 1920s.
One must ask, with the fortune of hindsight, whether such financing was beneficial. Fostering what would later become a tyrannically regime must surely be viewed with less than rose-coloured glasses today.
The European states may not seem tyrannical in comparison to China. The point is that they are examples of countries with failed policies. One must ask if searching for ways to continue these erroneous policies is beneficial for the Europeans that must live with them. Europeans with an eye for history need only look at a similar policy pursued 100 years ago for the answer.
By David Howden, on 7 November 11
One significant issue arising in the crisis has been the size of some European underground economies. Politicians seek measures to increase public revenues as public budgets come under strain. As large segments of European, and especially southern European, economies are hidden in the underground, large amounts of otherwise taxable incomes are likewise hidden.
Chapter 4 my new edited collection, Institutions in Crisis: European Perspectives on the Recession, grapples with the issue of these underground economies. With over a quarter of Greek economic activity only unofficially undertaken, we see that in some countries the issue is significant. Indeed, the average underground economy for the PIGS (the PIIGS excluding Ireland) is 21.7 percent of GDP, almost three times the size of America’s, and double that of Germany’s.
Two important questions must be answered. First, what explains the size of these underground economies? Second, how can we integrate them into the official economy?
There are two general reasons why economic activity seeks to be underground rather than official. On the one hand high, tax rates prohibit otherwise mutually beneficial economic activities from occurring. Movements into the underground try to evade these taxes and thus allow trades to be made (for those of you who can remember your first-year economics class, this is a way to reduce those triangular deadweight losses of taxation). On the other hand, regulations add a potentially complex and costly web of rules that entrepreneurs must abide by. In some cases it is only possible, or at least easier, for a firm to operate in the underground instead of the official regulation-abiding economy.
When looking at the general range of underground economies in Europe it does not take long to discern which effect is stronger. Europe is well known for its plethora of taxes, as well as its high marginal tax rates, but there is no clear relationship between taxes and the size of the underground economy. High tax Scandinavian countries, for example, seem to enjoy relatively small undergrounds. Some southern European countries, Spain for example, have relatively low tax rates and large undergrounds.
The answer lies in the distinction between different interventions that Murray Rothbard made in this economic treatise, Man, Economy and State. Binary interventions are those where one party becomes subordinate to the intervener in the transaction. Labor taxes, for example, cause a firm to hire labor at a different price than it originally would have, and under the constraints placed on it by the government imposing the tax. Triangular interventions, in distinction, are those that place both parties to a transaction subordinate to the intervener simultaneously. Testing requirements on drugs subordinate both drug producers and consumers to the government imposing the regulation – no transaction can take place regardless of the desires of the relevant parties.
Northern European countries, despite their high tax rates (a form of binary intervention) enjoy relatively low levels of triangular interventions. Low levels of simple regulations make entrepreneurial undertakings relatively pain free. Business owners can comprehend the binary interventions as an additional cost of business, and proceed cognizant of the fact that they face a minimal level of complex and uncertain regulatory burdens. Consequently, there is not much reason to operate in the unofficial section of the economy. (Keep in mind that although one can save on taxes by doing so, there are costs – the lack of a clearly defined and enforceable rule of law being the foremost.)
Southern European countries, in distinction, are well known for the bureaucratic boondoggles they are. Triangular interventions abound. Complex and uncertain labor laws make firing (and subsequently, hiring) employees a costly or impossible ordeal. Unable to navigate the regulatory burdens endemic in these economies, entrepreneurs hide in the underground. By saving on the expense of the difficulties of complying with complex regulations, entrepreneurs are able to outweigh the added costs by working in less official conditions.
As this problem is most acute in the PIGS countries, it has become an issue as politicians search for means to bolster government revenues. By reallocating economic activity to the official sector, taxes will be able to be collected and government coffers replenished. Calls for more frequent auditing and increased fines have come to the fore. Such solutions are misplaced at best, and will exacerbate the problem at worst.
Increased audits and fines for the “guilty” will doubtlessly decrease the size of the underground economies. This added risk and cost of underground business will incentivize some entrepreneurs to withdraw, or at least curtail, such economic activity. It is doubtful that this will translate into increased official economic activity. Entrepreneurs in the underground are there because the conditions in the official economy are not conducive to business. High taxes and complex regulatory structures drove them out in the first place. Without a change to either of these two facets (primarily the latter), we should not expect any increase in official economic activity.
In my book I spell out one additional reason why EU politicians should not be overly keen on minimizing the size of their underground economies. As unemployment rates have increased, the various undergrounds have been able to cushion part of the blow. Working conditions in the underground economies are certainly not as desirable as in the official one, but the unemployed have few choices. Lacking growing employment opportunities in the official economy, a lack that I stress is caused by excessive and uncertain regulatory burdens, removing the underground options available will only serve to further impoverish the burgeoning unemployed masses.
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