European debt crisis

The New York Times: A Power Vacuum Is Killing the Euro Zone

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This article originally appeared in The New York Times

As problems mount in the euro zone, it’s increasingly evident that we’ve been witnessing an institutional failure of monumental proportions.

What is to be done about Greece? Simply keeping it in the euro zone won’t help much, even if it’s possible.  The continuing crisis has sapped confidence in banks not only in Greece, but also in Spain, Italy, Portugal and Ireland, though to varying degrees.  Unless there are explicit guarantees to these banks soon, the market will likely take a further turn for the worse.

An absence of guarantees could prompt a broader chain reaction of capital flight and bank collapses across several countries.

The basic problem is that many people won’t keep their euros in a Greek bank, and perhaps not in a Spanish bank, either, when those euros can be moved to Germany or some other haven.

Yet German citizens do not appear ready to guarantee Spanish banks or, by extension, the whole credit system of Spain and the other periphery nations. Guarantees of that scope are probably impossible and may also require constitutional changes in some nations.

We thus face the danger that the euro, the world’s No. 2 reserve currency, could implode.  Such an event wouldn’t be just another depreciation or collapse of a currency peg; instead, it would mean that one of the world’s major economic units doesn’t work as currently constituted.

We are realizing just how much international economic order depends on the role of a dominant country — sometimes known as a hegemon — that sets clear rules and accepts some responsibility for the consequences.  For historical reasons, Germany isn’t up to playing the role formerly held by Britain and, to some extent, still held today by the United States.  (But when it comes to the euro zone, the United States is on the sidelines.)

There appears to be a power vacuum, and the implications are alarming. We may be entering a new world where international cooperative arrangements, in environmental areas as well as finance, are commonly recognized as impossible.  If the core European nations cannot coordinate effectively, what can we expect in dealings with China, Russia and other countries that have less of a common background and understanding?

In the euro zone, we are seeing two refusals to cooperate: Germany won’t renew financial pledges to Greece without Greek compliance on previous agreements, and Greece doesn’t want Germany to control its national budget.  Both seem reasonable positions, and maybe they are, but reasonable positions can apparently destroy an international agreement rather easily.

Is there a way out?  To seek a binge of pro-growth government spending, in the hope of stimulating economies, is to assume what already stands in doubt. The crisis has reached a head partly because the market already lacks trust in the periphery governments to invest money for sustainable economic growth.

There is also talk of forming a true fiscal union, but that seems to be doubling down on a bad idea.  If the euro zone cannot summon enough cooperation now, how is any union requiring tighter cooperation supposed to work?  How would national budgets be set and approved?  A credit collapse remains a real possibility.

Is it too late for monetary policy to make a difference?  The other euro-zone nations might allow Greece to leave, while guaranteeing payments for food and fuel, both of which Greece imports, for a reasonable period.  Higher price inflation might then depreciate the euro, limit the need for difficult downward wage adjustments, and help Spain and Italy improve their competitiveness.  The inflation could come through central bank bond purchases from the troubled nations, thus easing their debt problems.  That may be the only useful option still on the table.

But that’s also not easy.  First, economically healthier nations may be reluctant to accept the inflation, which would represent a rather direct, continuing redistribution of wealth to the troubled debtor countries.

The second problem is that some of the banking systems in the periphery nations may be too broken for monetary policy to take hold.  Imagine the European Central Bank trying to infuse new money and credit into Spain, while bank deposits move quickly to Germany, Switzerland and other safer places.  Again, why would anyone want to keep money in the bank of a fiscally troubled nation?  That loss of confidence will not be easily repaired.

Since December, the European Central Bank has lent more than a trillion euros to euro-zone banks, but that has bought no more than a few months of peace.  It isn’t clear how much more can be done.  It probably is about time to judge the euro zone as a failed idea — and rarely is it wise to double down on failed ideas.

What is most disturbing is that the euro-zone nations are democratic, protective of basic liberties, and have advanced intellectual and research communities. The final lesson of this debacle is that smart nations with noble motives can make very big mistakes.  And that should concern us all.

New York Times: Democracy Is Having Its Say

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Tyler Cowenwrote this column for The New York Times’ Room for Debate on April 23, 2012.

Today, very few countries in the euro zone are capable of making credible commitments or binding agreements with the others.

Quite simply, democracy is having its say. The French soon may elect a left-wing candidate who, in essence, wants to exempt France from fiscal rules and place more fiscal risk on Germany. The Dutch can no longer form a governmental consensus on the budget. The Irish will be putting the fiscal compact up for a referendum, and the Greeks are holding an election in May. Even in Germany there could be problems holding together the ruling coalition.

In general, voters are unwilling to give up their say over policy, or to regard the European Union or euro zone as necessarily superior to national interests. When it comes to the specifics, it appears increasingly likely that at least one national electorate will pull the plug on the entire set of bailouts and austerity programs.

There is no way to pull off the required cross-national agreements. Resources are being drained from euro zone banks, which are contracting their lending to business. This will make the current recession worse, which in turn will necessitate further unpopular policies, including cuts in government spending. Euro zone countries will become more nationalistic in hard times, and more likely to vote against incumbent governments, no matter what the specific issue at stake. It is hard to see a stabilizing outcome, so the best bet is on a crack-up of some of Europe’s major economies, including Spain and Italy.

There is an old saying in economics, namely “no monetary union without a corresponding fiscal union.” It could be added “no fiscal union without a corresponding electoral union.” In the longer run, we will probably end up with none of these institutions.

The euro zone probably was unworkable from the beginning, and now we are seeing why.

From the Fed, a Shield Against Europe

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This article was originally published in The New York Times

As the euro zone mess unfolds, another financial crisis may be coming our way. The conduit could be some spillover effect from across the Atlantic — whether in derivatives or money markets — or maybe some under-the-radar surprise.

With such dangers at hand, it’s time for a spot-check on whether financial regulation in the United States has left us prepared. So far — with one notable exception — it’s not looking good.

A core problem in finance is that banks and other intermediaries can take on too much risk, not caring enough that their potential failures may throw people out of work, burden taxpayers and damage the broader economy. The solution — if it can be managed — is to ensure that banks have enough safe, liquid capital so that A) they are betting a lot of their own money, thereby inducing some caution, and that B) they have a large-enough cushion to limit the risk of failure. “Lots of capital, not too much leverage” is the basic formula for a safe financial system.

Such a general approach is needed because it’s again become clear that regulators can’t predict the specifics of the next crisis. Less than two years ago, our government enacted the Dodd-Frank law, the most complex financial regulation bill of all time, based on the work of hundreds of economic and legal experts, all hyper-aware of the issues of risk. Neither this bill nor our government, however, foresaw that we were already living in the onset of the next potential financial crisis, namely the spillover from the euro zone.

Dodd-Frank left questions of capital and leverage largely to the Basel III international banking agreements, the second piece of the new financial regulatory architecture. Basel III, like its predecessors Basel I and Basel II, encourages banks to hold sovereign debt. This has been revealed as a mistake, just as it was wrong for the earlier Basel regulations to encourage banks to hold mortgage securities.

Most fundamentally, Basel III seems obsolete even before it can formally take effect over the next few years. Its standards imply that European banks will have to raise more capital, possibly in the hundreds of billions of dollars. At this point, that’s like wishing a poor man were a millionaire. The question will sooner be one of survival. In lieu of raising new capital, many European banks will stretch the capital they already have and meet minimum capital standards by shrinking, thereby cutting back on lending and damaging economic growth.

The standards may eventually be tossed out or revised, even though they looked good on paper not that long ago. If nothing else, after recent downgrades, there are no longer enough triple-A securities to carry out the requirements.

Despite these problems, the United States may oddly enough be facing this new financial turmoil in a relatively safe position, though whether it’s safe enough remains to be seen. The Federal Reserve took the lead on future capital requirements just last week, but for the shorter run there is a more important Fed policy move. Starting in late 2008, as a response to our financial crisis, the Fed bought government and mortgage securities from banks on a very large scale.

Bank reserves at the Fed rose from virtually nothing to more than $1.6 trillion. Then the Fed paid interest on those reserves to help keep them on bank balance sheets.

It is estimated by Moody’s that America’s biggest banks now have liquid assets that are 3 to 11 times their short-term borrowings. In other words, it’s the cushion we’ve been seeking. Furthermore, a lot of those reserves sit in the American subsidiaries of large foreign-owned banks, protecting the European system, too.

This new safety comes not from regulatory micromanagement but rather from the creation of additional safe interest-bearing assets. While European economies have been losing safe assets through debt downgrades, the United States financial system has been gaining them.

The Fed’s stockpiled liquid reserves have met some heavy criticism. Hard-money advocates contend that they are a prelude to hyperinflation — although market forecasts and bond yields don’t bear this out — while proponents of monetary expansion have wished that banks would more actively lend out those reserves to stimulate the economy. That second view assumes that the financial crisis is essentially over, but maybe it’s not. As the euro zone crisis continues, it seems that Ben S. Bernanke has been a smarter central banker than we had realized.

The final lessons are scary, but also powerful.

First, don’t assume that the first wave of a financial crisis is the final act. Circa 1931, many people thought that the global economy was recovering, until an additional wave of financial crises caught fire in Europe and later damaged the United States. Mr. Bernanke is a scholar of exactly this period.

Second, no matter what laws are written, good central banking is the most powerful and most influential financial regulator, if only through the broad management of liquidity and safety. The euro zone has put too much responsibility on national governments and too little on its central bank.

Third, good regulation should take account of our rather extreme ignorance. That means emphasizing the more general protections, as embodied in a ready supply of safe liquid assets, rather than obsessing over the regulatory micromanagement of particular bank activities.

On the whole, we still haven’t learned that last lesson. Nonetheless, this time around we may just squeak by, largely because of the prudence of our central bank.

Choices for Greece, All of Them Daunting

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This article was originally published in The New York Times

Without outside help, Greece is probably insolvent right now. In evaluating the country’s prospects, it’s worth asking what it would take for Greece to pay all of its bills and what kind of damage we might expect along the way.

The answers are to be found not only in statistics — like the debt-to-G.D.P. ratio, now running at more than 140 percent for Greece, and headed higher — but also in human sentiments and solidarities. A considerable amount of Greek patience and German flexibility and sacrifice are minimum prerequisites for turning back a major disaster in the making.

To put matters in perspective, the Greek economy is less than 2 percent of the overall economy of the European Union. That seems a manageable size for an aid-based solution; estimates in the neighborhood of 200 billion euros in aid (close to $300 billion) are common. The real difficulty is in maintaining global financial confidence while the losses are distributed in an orderly manner.

That isn’t as easy as it may sound. About 30 percent of the Greek debt is held by Greek sources, including the banks and the Greek government, in its social security funds. A default on the latter assets would mean that the Greek government was defaulting on itself. It would still have to come up with much of that money or face a total political and economic meltdown.

The private sector can be persuaded to realize some losses on Greek debt, but there is a risk of setting off a Lehman Brothers-like financial panic, especially if there is a judgment of complete or selective default from the credit agencies. Standard & Poor’s warned of such a judgment last week. Big penalties for private creditors may also have weighty implications, because of the potential for a chain reaction — in which credit dries up for Ireland and for Portugal, which ran into fresh trouble when Moody’s downgraded its debt last week. Furthermore, the private sector holds only about a third of the Greek debt total — and that involvement is falling rapidly — so bondholders cannot be the only fall guys.

Then there is the European Central Bank, which holds about 18 percent of the debt. The wealthier European Union nations could transfer funds to Greece and the central bank as permanent debt relief, rather than continuing with debt rollovers that may look similar to Ponzi schemes. As it stands, vulnerable countries are being pushed into ever-higher debt levels. Yet the central bank has strict rules, including a no-bailout clause and price stability as the sole goal of monetary policy, while the European Union often requires member unanimity for major changes.

In other words, these rules were written to prevent what is now the only coherent response to Greece’s troubles — namely, a timely recognition of the losses and an agreement that they will be shared jointly in some way.

And don’t forget that more than 40 percent of the European Union’s budget is taken up by subsidies to farmers, leaving little room for subsidies required in an emergency like this. The union was not designed to turn on the proverbial dime.

The closer you look, the worse it gets. German politicians promised their voters that the euro would never lead to fiscal union or tax increases, yet aid to Greece would put those issues on the table. Political support for costly transfers also seems weak in the Netherlands, Finland and other northern European nations.

Furthermore, for Greece, such a bailout would not count as a long-term solution. Paying back one’s creditors is not the same as resuming economic growth, and the country would still face the fallout not only from its spending cuts and tax increases, but also from sharing a monetary policy and exchange rate that for it is deflationary. Relative to the size of its economy, the total Greek spending cuts now being contemplated are proportional to the United States government cutting $1.75 trillion. (Even if you believe government needs to shrink, it would be hard to pull off such a big change on short notice.) Right, now Greece’s gross domestic product is falling at a rate of more than 3 percent a year.

Even if a Greek default didn’t wreck broader markets, it wouldn’t cure Greece’s problems. The Greeks are still borrowing, so a default would dry up some of their funds and force the government to make even bigger spending cuts.

If it left the euro zone, Greece could reap the substantial benefits of a currency depreciation, but doing so would also set off huge runs on banks. And the country has no alternative paper currency ready for use.

If you are a euro optimist, you might believe that the day of reckoning for Greece will be stalled long enough for Portugal, Ireland, Spain and possibly Italy and Belgium to recapitalize their banks and trim their government budgets. You might believe that of the Greeks will eventually default, but that by the time the contagion effects are checked, the Greeks will have pulled in some aid, and the global impact will be a mere hiccup instead of a new financial crisis. But that still will leave Greece with no clear economic path forward. For a best-case scenario, that’s not very good.

If you are a pessimist, you might see such a response as an unworkable plan of naïve technocrats. Here’s your line of reasoning: At some point along the way, democracy is likely to intervene: either Greek voters will refuse further austerity and foreign domination, or voters from northern Europe will send a clear electoral message that they don’t support bailouts. And there’s a good chance one or both of those events will happen before a broader European bank recapitalization can be achieved. In the meantime, who wants to put extra capital into those ailing Irish, Portuguese, and Spanish banks anyway?

In an even bleaker scenario, bank recapitalization won’t be realized anytime soon and those same economies will show few signs of growing out of their debts. A broader financial crash will result, and it won’t be contained by an easily affordable bailout.

Those are the choices playing out now, in the streets of Athens and in the halls of power centers like Washington, Brussels, Paris, Frankfurt and Berlin. Stay tuned. There’s a lot of news on the way, but probably very little of it will be good.

How Will Greece Get Off the Dole?

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This article was originally published in The New York Times

Greece is a relatively wealthy country, or so the numbers seem to show. Per-capita income is more than $30,000 — about three-quarters of the level of Germany.

What the income figures fail to capture is the relative weakness of Greece’s economic institutions. They are not remotely comparable to those of Germany and some of the other better-governed European Union nations, which is why the current crisis will prove so difficult to solve.

The European Union and the International Monetary Fund have arranged an enormous bailout package. But it’s not just a question of supplying funds to get Greece through a short-term debt crisis, or of cutting the Greek government budget, but of whether the country will see much future economic growth.

Consider the World Bank’s Doing Business index, which ranks countries according to the quality of their regulatory environment for commerce. The index places Greece at No. 109, just behind Egypt, Ethiopia and Lebanon. For the category of “high-income countries,” the Greek ranking is next to last, ahead of only Equatorial Guinea, which has oil wealth.

Greece has a malfunctioning fiscal system in which the shadow economy is estimated to be roughly 20 to 30 percent of the reported economy and tax evasion may run at $30 billion a year. Simply collecting taxes that are legally due would help bring Greece’s books into balance, yet even this simple remedy does not appear imminent.

As the World Bank index suggests, government funds are often spent hindering production rather than supporting it. This gives one clue as to why the numbers make Greece appear richer than it really is. Public expenditures are valued at cost when measuring gross domestic product, yet arguably the quality of Greek public services, per dollar spent, is less than that of many wealthy countries. Nonetheless Greece plunged ahead and joined the euro zone in 2001, with some unfortunate consequences.

Greece’s currency, the euro, is stronger than that of its neighbor Turkey, so a holiday in Greece is more expensive. Yet Greece has not built enough luxury hotels, golf clubs and resorts to justify the cost difference. Over all, the greater expense of Greek goods and services, which are paid for in euros, lowers the country’s international competitiveness. Ideally, they should be priced in a weaker currency, which would be appropriate for a poorer country.

Over time this problem will worsen if productivity in Germany and France grows at consistently higher rates and the value of the euro puts Greek exports increasingly out of sync with market realities. One painful way out of this dilemma would be for Greece to engineer a continuing deflation of wages and prices, but Greek voters have already taken to the streets to pressure their government to preserve salaries and benefits, and planned deflation is difficult to sustain in any case.

The Germans and the French have been complicit in treating Greece as a wealthier country than it really is. The strong euro keeps exports from the poorer euro zone nations noncompetitive and also makes it easier for Greece and other lower-income euro zone nations to buy German and French exports; both tendencies benefited German and French commercial interests.

To make matters worse, following its accession to the euro zone, Greece began spending and borrowing as if its future productivity would be high. The European Central Banktreated Greece as a fiscally responsible nation by buying some Greek bonds, which were then highly rated. Many European banks followed suit, and this meant an unjustified credit boom for the Greek state. Greece was able to pursue unsustainable policies; for instance, many Greeks retire before age 60 with benefits at three-quarters salary. Such a luxury is uncommon even in far wealthier countries like the United States.

At this stage, it’s a moot point whether Greece is a poor country masquerading as a wealthy country or vice versa. The announced bailout requires that an ailing Greek economy borrow and repay even greater sums of money. If the old illusion was that Greece was a wealthy country, the new illusion is that Greece will, in short order, become wealthy enough to pay back ever-growing sums of debt.

Since the Greek economy accounts for only about 2 percent of the euro zone gross domestic product, in theory it could be made a permanent recipient of largess. Yet that’s hardly an appealing solution, both because Portugal, Spain and others might want the same deal and because Europe doesn’t have much social solidarity across national boundaries.

The United States has rich and poor regions, but the 50 states are forced to run balanced budgets, and there is greater mobility within the nation, based on a shared language and culture. Major national policies, like President Obama’s health care plan, are not judged primarily in terms of which states win and lose; in fact the largely opposed “red states” get a lot of the benefits through higher Medicaid subsidies.

Greece is not the only country that suddenly feels poorer. Britain faces budget deficits at about 12 percent of G.D.P., and Italy has a debt-to-G.D.P. ratio of 110 percent. In the United States, the housing and job markets are recovering only in fits and starts and we face significant future Medicare liabilities. This is the era of the rude economic awakening, and Greece is simply an extreme manifestation. The new European bailout plan is a denial of this truth rather than recognition of the new reality that a lot of countries, most of all Greece, aren’t as rich as we used to think.

Euro vs. Invasion of the Zombie Banks

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This article was originally published in The New York Times

Is a euro held in an Irish bank in Dublin, or in a Portuguese bank in Lisbon, as sound and secure as a euro in a German bank in Berlin? That apparently simple question holds the key to understanding why the euro zone may splinter and bring a new financial crisis.

In Ireland, there has been a “silent bank run” on financial institutions for much of the last year. In February, for instance, Irish private sector deposits dropped at an annual rate of 9.8 percent. That’s largely because some depositors doubt the commitment of the Irish government to the euro. They fear that they will wake up one morning to frozen bank accounts, followed by the conversion of their euro deposits into a lesser-valued new Irish currency. Pre-emptively, the depositors send their money outside Ireland, where it still represents safe euros or perhaps sterling, accessible by bank transfers and A.T.M. cards.

This flight of capital reflects a centuries-old economic principle known as Gresham’s Law, sometimes expressed casually as “bad money drives out good money.” In this context, if two assets — euros inside and outside Ireland — are not equal in value in the eyes of the marketplace, sooner or later the legally fixed price parity will fall apart.

If enough depositors fear frozen accounts, the banks will be emptied out, and they also will require additional government bailouts, on top of the bailouts for the bad real estate loans. The banks come to resemble empty shells, conduits for public aid but shrinking and unprofitable as businesses — and, to a large extent, that is already the case in Ireland. Portugal is moving in this same direction, toward being a land inhabited by zombie banks.

It’s the zombie banks that doom the current European bailout plans. On any single day, or even for a year or two, an economy can survive with zombie banks, but over time functional domestic banks are needed to allocate credit.

As it stands, European Union emergency facilities are marking time by lending more money to the fiscally troubled nations in the currency union. But these loans do not reverse the logic of Gresham’s Law. For instance on its longer-term notes, Portugal is already paying yields in the range of 8 to 10 percent, and yet the Portuguese economy is shrinking. The Portuguese are digging deeper into debt, and confidence in the banking system and the fortitude of the Portuguese government is dwindling.

At this late point there’s probably no way to escape the mess by cutting government spending in the troubled countries. This year Ireland has a budget deficit of more than 30 percent of G.D.P., whereas in Portugal it is 8.6 percent. Even the best economic reforms can take many years to pay off with concrete results, and with zombie banks a turnaround is even harder and perhaps impossible. Most important, immense government spending cuts are often unpopular and so investors wonder whether an ailing country’s political system will see it through. The confidence problem remains.

A second option is a giant write-down of current debts, combined with national bailouts to the creditor banks. For instance, taking this approach, the Merkel government in Germany might acknowledge the status quo isn’t working and speedily recapitalize the German banking system, while letting Ireland, Portugal and others off the hook for some of the money. It’s easy to see why this policy isn’t popular in Germany, and indeed, for years German politicians promised to their voters that such an outcome would never happen.

Another dramatic way out is for Ireland, Portugal or some other country to break from the euro and create a new and lesser-valued domestic currency, while also defaulting on some debts. Any such breakaway country would incur the wrath of the European Union and also might have trouble borrowing on international capital markets. There will be no easy exit path from the euro. Still, taking this approach, a resolution of some kind would be in place, no subsequent devaluation of bank deposits would be expected and the new lower-valued currency would improve growth. Also, the troubled countries already cannot borrow at workable interest rates.

There would be an associated problem, however: if any one euro zone country were to start exiting the euro, there would be bank runs on the other fiscally ailing countries. The richer European Union nations know this, and so they are toiling to keep everyone on board. But that conciliatory approach creates a new set of problems because any nation with an exit strategy suddenly has enormous leverage. Ireland or Portugal need only imply that without more aid it will be forced to leave the euro zone and bring down the proverbial house of cards. In both countries, aid agreements already are seen as a “work in progress,” and it’s not clear that the subsequent renegotiations have any end in sight, because an ailing country can always ask for a better deal the following year.

All of the ways forward look ugly but, sooner or later, some variation of at least one of them is likely. Unfortunately, they all share the property of lowering European bank values, whipsawing currencies, hurting business confidence and possibly ending the European Union as an effective institution for collective decisions. That’s all because the euro, in retrospect, appears to have been a misguided attempt to equalize the values for some very unequal assets, namely the bank deposits of strong countries and those of weak countries.

To track the risk of a new financial crisis, focus on whether the troubled euro zone economies are seeing bank runs and capital flight. Then comes a fundamental question about human nature, namely: Why do we so often postpone admitting that short-run patches simply aren’t going to work?