Don't Shoot the Messenger

What Wolfson Did Next

At around 9:00am London time this morning Lord Wolfson held a press conference to announce the five finalists in his economics prize contest. I have done a podcast discussing the prize objectives and their implications with the Spain based British blogger Matthew Bennett. You can download it here.

The first thing that needs to be said about the initiative Wolfson has taken, in offering a 250,000 pounds stirling prize using his own money to anyone able to offer practical solutions to the current Euro crisis, is bravo. Someone willing to put their money where their mouth is, to try to find policies which should be applied in the common good has to be lauded.

Naturally Lord Wolfson is not looking for just any solutions, as the initial question makes clear, he is looking for a solution in which at least one member country leaves the Euro and a procedure (or template) whereby other countries who find themselves in a similar situation might leave. The question he asked is the following one.

“If member states leave the Economic and Monetary Union, what is the best way for the economic process to be managed to provide the soundest foundation for the future growth and prosperity of the current membership?”

 Unfortunately this question begs many others, some of which have no easy answer. In particular the question assumes that someone at some point will be seeking to voluntarily leave the currency union, and that this process can be managed in an orderly fashion. I doubt that either of these assumptions are realistic, on grounds which I will explain in what follows. But first, I have to declare an interest, I submitted an essay (which you can find downloadable here), although in all honesty I have to say I never expected to be shortlisted or win. I never expected this outcome since I basically wrote trying to explain some of the theoretical background to the Euro crisis which I feel is poorly understood, and suggest that, basically speaking, they had asked the wrong question. As I wrote in the letter accompanying my submission.

Hello there,

Please find attached a Word version of the essay I would like to present to your prize. I’m sure its not exactly what you are looking for, but it is what I have to say on the subject. I fear the question is looking for a technical answer to what is inevitably a political and economic/theoretical problem. On the other hand I did not feel I could let such an important event go by without submitting something.

Anyhow, I am sure I will fare rather better than Arthur Schopenhauer did with his essay “On the Foundations of Morality” (“Über die Grundlage der Moral”) which was not honored with an award by The Royal Danish Society of the Sciences in Copenhagen, even though it was the sole submission in their essay competition. On this occasion I am confident you will recieve a wide selection of excellent and appropriate responses. With my best wishes for every success in your endeavour,

Edward Hugh

So Where’s The Snag?

Basically the intellectual world surrounding the Euro is divided into two (more or less fortified) camps – those who believe it can work, and those who don’t. Many things could be said about the assumptions being made by those who think the project can still be rescued, but I have commented on this endlessly, and here is not the place to repeat already well known arguments. The problem and the frustration is, and this is what I imagine is getting through to Wolfson, virtually no argument presented by those who fear it can never work seems to cut any ice with those who are convinced it certainly can. Either you think the Earth goes round the Sun, or you think the Sun goes round the Earth, and that’s it, there is no single empirical argument which can lead people to change their opinion. The truly worrying thing is that most participants in the debate seem unable to even identify an argument or a fact in the world which would lead them to a rethink.

But leaving aside the “Euro Too Big To Fail” camp, there is far from uniformity among those who feel the project is flawed. Certainly there is consensus on some basic core questions, such as:

a) Currency unions – like marriages – can be done and undone
b) Greece has a special problem
c) Many periphery economies have lost substantial competitiveness and need to devalue

But beyond this things get more complicated. In particular, I think the debate about why the Euro could be a problem which was held in the 1990s and the one we are in the process of having today  are very different animals. In part this is because currency unions when they divorce, just like marriages, leave offspring (in this case shared legacy debts) and what exactly to do with this offspring can and will occasion dispute between the various contracting parties. The kind of dispute which gives endless work to lawyers and makes amicable settlements very difficult. As Tim Harford put it in the FT,  “Lord Wolfson is offering a prize for turning an omelette back into its constituent parts”.

The world before the fall can never be recovered, or as the novelist Thomas Wolfe put it, “You Can Look Homeward Angel….But…You Can’t Go Home Again”.

The fact that in historical time you can only move forwards and not backwards also raises questions about just how the world has changed in the interim, questions which pose a number of key theoretical issues which need to be addressed. In many ways this is why I sent in the piece I did, to try and call attention to just these issues. The debate about just what to do with the Euro cannot be abstracted from the particular features of the world we now live in.

In particular I would highlight two key features which often seem to get ignored.

a) the impact of financial globalisation and what Carsten Valgreen calls the global financial accelerator on currency values. Virtually no one – not the USD or the UK pound sterling, or the Swedish Krona – can manage their currency valuation as they see fit, or devalue as they want. Currency parities are determined by complex interactive process which are by their very nature non linear in character.

Just look at the current valuation of the Japanese Yen and its impact on Japanese exports. It is impossible to understand much about current German policy thinking if you don’t get the fact that a principle constraint and line in the sand for Germany is not ending up being another Japan. The world of the 1990’s was not like this, and the simple rote argument of devaluation as the answer (which I myself use because while not being entirely right is not entirely wrong either)  is not as straightforward as it seems, or as it once was. Hence the resistance in Brussels, Berlin and Paris to this panacea.

b) European societies are ageing rapidly, and this has implications. You will strain hard to find any reference to this phenomenon in the  majority of commentaries offered on what to do about the Euro crisis, yet arguably the phenomenon of population ageing lies at the heart of the current debt crisis in developed economies. Impending health and pension liabilities are what makes so much sovereign debt unsustainable, and this is an issue which goes beyond the boundaries of the Euro Area, affecting countries like the US, the UK and Japan. Again, “the Euro is the root of all evil” argument fails to address this issue.

This approach is typified by Nomura economist Richard Koo, who argues  “Japan had a Great Recession, and a Great Stagnation, but it never had a Great Depression,” while adding “But recession in some eurozone countries could become a depression, just like the 1930s. This is a view which spectacularly seems to miss the point that people in Spain are not envious of where Japan finds itself now, with sovereign debt somewhere over 225% of GDP and in danger of spiralling upwards out of control. It is evident that Japan’s fight against excessively rapid population ageing and the consequent deflation has simply bought the country time, but the problem has yet to be resolved. Having your own currency and the ability to print money is all well and good, but when offered as a universal panace it merely becomes a simplistic solution to what is a very complex problem. A modern version of fools gold.

c) Finally we now have more than a decade’s experience of labour mobility from one European country to another, and in particular of migration patterns from periphery countries to the core. Among young qualified workers there is more mobility than many seem to imagine. I was in Latvia recently, which is a country not in the Euro but which is suffering population loss in such a way as to make its very continuity unsustainable in the longer run (you can find and download my presentation here). What I became convinced of during my visit there is that the fiscal union question is not only a Euro currency one. Simply having a single labour market in the context of generalised population ageing means that even non Euro countries will eventually need to participate in a common treasury due to the health and pension liabilities they are going to face.

Having said all this, let me return to my initial argument. For reasons I explain in the essay (or in this post here) it seems unlikely anyone would willingly want to leave the common currency.

a) Greece might like to leave if its debts to the IMF, the EU and the ECB could be restructured in an orderly and amicable way, but this seems unlikely, especially since others would rapidly seek similar treatment. On the other hand, if Greece left without agreement on official sector restructuring their debts to the official sector would become unpayable, so Greece is unlikely to want to leave.

b) So let’s look at another possibility – a German exit. Germany, as I argue in my essay,  has been a great beneficiary of the Euro since it has effectively had the advantage  of having an extremely undervalued currency.  Germany will not easily surrender this competitive advantage.

c) One solution could be to divide the Euro in two, as I argue in this piece I wrote last summer, but this proposal has generated little real interest, and Europe’s leaders have not demonstrated they have the political mettle to carry such a complex initiative through. Hence, despite the good intentions of Lord Wolfson and his prize participants, it seems a rationally designed solution is highly improbable, and it would be more realistic to start to prepare for the worst.

What Next Then?

So if the Euro is, as Gideon Rachman put it “the time bomb no one can defuse” (I captured some of the essence of this idea in my CNN blog post, “Dr Strangelove and the Euro Doomsday“), what is now likely to happen?

Well, the LTROs have temporarily stabilised things, and made deposit movements from one country to another a much more containable evil. But this only offers some short term relief. Credit is still gridlocked all along the periphery, where the various countries are essentially entering long term depressions, with very high levels of unemployment, low economic growth and rising non performing loans in the financial sector. This is all unsustainable, but still, what could possibly be the trigger for disorderly break up?

Well, in the short term  Greece could find itself unable to comply with the terms of its Troika programme, and as a consequence not receive its ongoing funding. This could happen at the time of the first review (roughly three months from now) or at the time of the second one (towards the end of the year). Given that the Greeks themselves are likely to be unwilling to leave, they could decide to print their own Euros using a facility known as Emergency Liquidity Assistance (ELA) whereby the local central bank effectively monetises government debt and enables civil servants to be paid (or even recieve a pay rise). It is important to remember that in the Argentina case all sorts of scrip money schemes (Patacos, Lecops) were resorted to, before finally the peg was surrendered. Even Argentina wasn’t in any rush to leave its disastrous peg. But then Argentina couldn’t print dollars. The novelty in the present case is that Greece (in theory) can print Euros.

Up to now use of ELA (in Ireland, in Greece) has only been possible with the agreement of the ECB, but desparate circumstances can produce desparate solutions. Certainly this issue is being discussed in Greece. In article entitled “Is ELA the key to keeping the Drachma at bay?” journalist Nick Malkoutzis argued:

“Greek banks have turned to ELA several times over the past couple of years. It’s not clear exactly how much they’ve borrowed in this way but some estimates put it in excess of 30 billion euros. The difference with the past few days is that Greece has essentially been in default and, despite that, the roof did not cave in on its financial system and the need for it to exit the eurozone did not come up once in the European debate. Could it be that the last few days have given us undeniable proof that Greece can default and remain in the euro?”

 “Athens University economics professor Yiannis Varoufakis is one of the experts who argue that it is up to the ECB whether Greece can default on its debt but not need to return to the drachma. “All that it would take to allow Greece to stay in the eurozone, in a better state than it is today (and less austerity for that matter), is the continuation of the present ECB policy toward Greek banks,” he wrote in a blog post last month. “As for those who argue that the ECB will take an aggressive stance, think again: The ECB will not knowingly take steps which will destroy the eurozone.””

If Greece did make this move it would effectively be initiating what Buiter has termed the “Euro as the new rouble zone”. The Euro Group (or even the entire EU) would then be faced with the much more general problem of whether or not to expel the country, risking initiating a cascade effect of contagion of totally unknown dimesions.

In the longer term, given the ongoing economic depression, we will almost certainly see growing political destabilisation along the periphery, leading to a steady process of weakening in Europe’s  democratic institutions. This is my greatest fear, and here Hungary seems to offer us an example of what might happen. Hungary it will be remembered was the first country to embark on austerity measures back in 2006, and these measures have still to yield the gains claimed for them in terms of economic growth.

The Euro was created as means of drawing Europe together politically, it would be a tremendous tragedy if instead it ended up tearing the continent apart and effectively destroying democracy in one country after another all along Europe’s periphery. I repeat what I said in my letter of submission to wolfson,  the problems with what to do about  the Euro are not by-and-large legal and technical (how to reclassify debt), they are inevitably political and economic/theoretical. The issue has shifted from that of what to do to manage an orderly exit, to one of how does the rest of the world prepare itself for a disordely one. As Lord Wolfson himself said in his recent Telegraph article:

“What seems likely to happen is that, as their public finances deteriorate, one of these countries will again be unable to refinance its debts. At this point the tsunami hits and the danger of financial contagion may dictate an urgent re-think of the euro”….”If that moment comes, the world must be prepared – with an understanding of the challenges and a plan. We will need an economic fire drill that minimises the damage caused by the euro’s disintegration and gives Europe the best chance to return to prosperity”.

 Lord Wolfson is a practical man, I am sure he will know how to appreciate the importance of the tasks and challenges that now face all of us. Those responsible for managing current Euro Area policy have the right to let the thing explode, but do they have the right to sweep the better part of the known financial world away with them in the Tsunami that will surely follow.

11 Responses to “What Wolfson Did Next”

TonyApril 3rd, 2012 at 9:16 pm

Ed, give it a rest! Do they pay you for this or you just need to write? I'm sorry, but the Anglos seem to be consumed with this issue of the Euro. I'm much more worried about the Pound and the Dollar falling apart.
Have a nice Easter!

Michael JApril 4th, 2012 at 2:11 am

leave off with the personal insults, 'do they pay you for this or you just need to write…', just say what have to say about the content.. otherwise, have a nice channukah!

Tonymc9April 3rd, 2012 at 11:24 pm

I disagree Tony, Ed has to be taken seriously. If you have followed his commentaries over the past few months, he has demonstrated a startling clarity in his analysis of Euro problems and Spain in particular. The peripherals and the politicians in Brussels represent the biggest threat to European stability. the former because none of them is too big to fail and the latter because over the past two years they have shown supreme ineptitude in tackling the problems head on. As a result we appear to have gone backwards and Spain et al are slipping as sure as night follows day into a state where they will probably be forced to leave the Euro. they won't volonteer but they can't afford to be members either.

DiranMApril 4th, 2012 at 7:01 am

Great work, Ed on trying to frame some exceptionally difficult issues that the Euroweenie politicos are doing their best to avoid. Here in Greece, we moving to elections with parties that have no conceptual or policy coherence whatsoever.

Especially I like your reference to ELA – a point that Takis Economopoulos has brought up. We even had some joint appearances on his TV show, where I discussed Greek shipping and sharply criticized 'expansionary deflation' policies in Greece.

DiranMApril 4th, 2012 at 7:02 am

Of course, Greek shipping is a US dollar-based industry with an emerging market customer base. The Greek Diaspora is also US dollar-based.

Eurozone membership is not beneficial either to Greek Shipping nor the Greek Diaspora. Remember that shipping is the premier Greek business. Also, the Greek Diaspora is as many people or more than Greeks living in Greece. You should take this into account in your analysis of Greece.

If Greece has any hope as a nation, this depends on Greek shipping and the Greek Diaspora.

DiranMApril 4th, 2012 at 7:55 am

Greece is one of the worst cases in Europe in terms of an ageing, shrinking population. The census results last year were horrible in this regard.

Take this into account on Greece, Ed!

Aegean1972April 6th, 2012 at 7:15 am

Brussels could have prevailed the unfolding depression throughout europe 2-3 years ago. Back then it would have cost them around 2 trillion ringfencing Greece and sending a good message to the markets to "stop it" right there. One bazooka back then could have stopped opening Pandoras box.

But Euro-ideologues were too proud (or uninformed) back then to admit that it was a European debt-crisis and not "a Greek one". Greece wasnt the "special needs" child. The whole euro-periphery was.

Now it will cost Brussels 5-10 trillion in the BEST CASE senario to get things under control (in the next 5 years) as the crisis unfolds everywhere (even in Holland!!). Debt restructurings and massive stimilous packages for growth all over the periphery.

Look how many trillions Obama has spent to get the US economy started and still the US economy is anemic. Imagine how much money europe will need to get things going again..

Greece is 4 years ahead than most other euro-periphery nations. Hard austerity is making people kill themselves on High Street and the virus is spreading all over europe.

Its time Brussels wakes up, because the foundations of Europe are REALLY shaking.

Aegean1972April 6th, 2012 at 7:35 am

Add to the equation China's hard landing, political instability and refusal to take action.
Also add Americas growing concerns about the exploding national debt and the high unemployment, add the high oil prices and Iran, add the political instability of the middle East and you got a really unstable senario in your hands.

leading nations can either work together to get-a-hold of this massive unfloding crisis or they can see themselves drowing in a decade of protectionism, recession/depression, arms races and major social unrest/political instability.

The time to grab the bull from the horns is now!

rodeneugenApril 9th, 2012 at 2:10 am

Definitely demography is the main factor to be blamed for the recession in Europe and in Japan as well. But it is not the whole story.
Historically Europe's or the Christendom's disaster was caused always from its division to so many independent political entities (sorry; states, kingdoms) that were stacked in their concept of political independence. This division always served only the ruling elites, as they instigated for hate and conflicts among the population of those separate states, to sustain this separation and by it also legitimizing their rule. At the end of the day what all these wars in Europe were about? From today's perspective nobody can find justification for any of these wars and mainly not for the last one, that ended less than 70 years ago. Now that Europe is slowly and surely losing its significance as economic and political power on the world stage, if it wants to defend some of its declining significance, and secure decent standard of living for its aging population, it has to create one united political structure. Any development against this direction will be unfortunate from any perspective. The Euro Zone crisis started to push the events to right direction and fortunately it happened now and not ten years from now and pity it did not happened five years ago. Just try to imagine what would be, if Greece could continue to live on deficit for another 10 years. Their debt would be by then more than trillion Euro (in today prices), add to it Spain, Portugal and Italy, and everybody can understand, that you would need ten Germanys to solve the problem. What happens now, is a lesson, that the politicians had to learn (something they tried very hard to forget) that with common currency, there has to be one coordinated fiscal policy, meaning they can't play for ever the play of economic sovereignty. We are still far from having in Europe one federal budget department, one economic legislation and one taxation. I just hope, the leadership of the net landing states will have the strength not to give up their demands to lessen the economic sovereignty of the individual states in the EU. Those who call to oppose this trend are looking for very, very short term goals. Since today it is hard even to remember the Irish rejection of the Lisbon treaty that happened at June 2008 , I am rather hopeful for EU.

GHerzogMay 2nd, 2012 at 7:17 am

Do politicians really ever learn lessons, or is that the core issue? It is just so easy to promise old age benefits to voters and then to retire from politics before the issue comes to a head. Pensions have a long history of failing to live up to their original aims.

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