Thursday, February 25, 2010


It seems pretty clear by now that we are experiencing the worst economic upheaval in global terms since the Great Depression of the 1930's. Indeed I would submit that our present problems are of a more fundamental nature that will require a major change with respect to current economic thinking before they can be solved.

It can perhaps help to provide some perspective on the present situation by briefly reviewing the nature of the changes brought about by the last crisis.

Though it is simplifying somewhat, before the Great Depression, the philosophy of free markets without intervention still held sway. The Government though still necessarily involved in the economy, played a largely passsive role attempting to balance the books with respect to its own incomes and expenditure.

Though the business cycle was well recognised as a regular occurring phenomenon, it was viewed somewhat like weather conditions. Thus when things were especially bad one simply waited for market conditions to eventually improve.

However the Great Depression - which was particularly severe and long protracted - somewhat inevitably led to new thinking with John Maynard Keynes especially questioning the prevailing consensus. One way of expressing this is with reference to the fallacy of composition.

Free market economics is firmly based on the primacy of the individual micro element (with respect to consumption, production and markets). This then led to a somewhat reduced notion of the overall macro economy as simply the aggregate of such micro elements.

However the phenomenon of the Business Cycle - which was a very regular occurence with respect to developed economies - indicated that key assumption on which free markets were based did not actually operate in practice (certainly within a short time frame).

Thursday, February 11, 2010

Greek Problems!

The present economic difficulties in Greece are pointing to serious deficiencies in the overall operation of the Eurozone.

The Eurozone now consists of 16 member countries. Whereas some of these such as Germany, France, and Italy relate to sizable economies, several others such as Greece and Portugal are relatively small (and not as developed as the largest members).

As I have stated before, EMU (Economic and Monetary Union) since its inception has contained a significant weakness. Whereas it is very impressive on the monetary side with a single currency controlled by a strong Central Bank, it is comparatively weak on the equally important fiscal side. Though a European Budget does indeed exist, it is of extremely small magnitude (just over 1% of Community GDP) and not designed in any case for economic management purposes.

Though certain fiscal guidelines (such as maximum level of permitted borrowing) are laid down in the Growth and Stability Pact, no real budgetary coordination takes place as between Eurozone members. So when Germany for example is preparing its annual budget, the focus is primarily on measures to assist the German economy. Consequent effects on other members' performance - if considered at all - are of a very peripheral nature.

While the overall policy of the European Central Bank is geared to consideration of the Eurozone (en bloc), the performance of individual member countries can vary significantly from the norm.

And this scenario is much more likely for a smaller member as its individual performance has little impact on the whole Eurozone.

So for example when Ireland (representing between 1% and 2% of total Eurozone GDP) was experiencing an inflationary boom around 2000 and 2001, the Eurozone area was showing signs of recession. Therefore the consequent action of the Central Bank in reducing interest rates to stimulate overall performance only acted to aggravate the boom in Ireland.

Now in the current economic climate several of the smaller peripheral Eurozone countries such as Ireland, Portugal and Greece have been experiencing especially harsh deflationary problems. However as the rest of the Eurozone returns to economic growth, the ECB could respond by gradually increasing interest rates, which could then make the problems of adjustment of these smaller members much more severe.

It might help to understand the nature of the current problems in Greece (and to a lesser extent in countries such as Portugal, Spain, Italy and Ireland) by referring to the previous exchange rate system that operated in the Community prior to the establishment of EMU in 1999.

In the early 90's, the European Monetary System (EMS) was in place with a key element the Exchange Rate Mechanism (ERM). Countries were still using separate national currencies but attempting to keep them relatively fixed (with only small margins of fluctuation permitted). The ultimate basis for deciding on the central rates given to each currency was with reference to a notional currency called the European Currency Unit (ECU) that was to become the eventual Euro.

From 1987 to 1992 the ERM appeared to be working very well with all member countries staying within the narrow permitted limits of deviation (just over 2%) from the central value of the ECU without resorting to revaluation of national currencies.

Indeed the ability to preserve such discipline was considered at the time as a necessary prerequisite for eventual introduction of a common currency, where effectively no exchange rate deviations would be possible.

However this apparent stability was to prove something of a mirage when in late '92 and early '93 a number of currencies in the system came under speculative attack forcing eventual devaluation.

Then in order to preserve the Exchange Rate Mechanism the permitted deviation in day to day values was - incredibly - widened to 15% (either way of the central value).

So in effect little or no true exchange rate discipline was required in currency behaviour prior to introduction of the Euro.

I was therefore strongly of the view that the new Euro system would prove to be highly inflexible in the wake of any sudden deflationary shock in the system.

And in 2008 we certainly experienced that shock through unprecedented problems in the international financial system.

Now if the old ERM system was in existence it is easy to imagine that a country experiencing special difficulties would find that speculation with respect to its currency would force the required devaluation before then switching to another currency. And in all likelihood this would have led to a major realignment with respect to the currencies of several member countries.

However because of the single currency, such adjustment is not possible. Rather speculation manifests itself in an alternative fashion in an investor unwillingness to accept the bonds issued by the government in question (as it is forced to borrow more to deal with the deflationary problem).

In effect that country then faces a sharply rising interest rate differential to be offered to borrowers to compensate for the perceived uncertainty (and growing possibility of eventual default on such bonds issued).

And for a country such as Greece already facing the prospect of severe and very unpopular cutbacks, such a burden could easily prove intolerable.

What makes the situation worse is that because of the need to protect the Euro experiment as a whole, the "offending" country Greece could easily take the view that it would be better to wait to be "bailed-out" by the other members of the Eurozone rather than implement extremely harsh deflationary measures in its own economy.

So what we are witnessing at the moment is an unconvincing game of bluff. At yesterday's meeting of the European Council it was announced that no aid was requested by Greece but that if the situation persisted through continuing speculation, that a rescue plan was in place to deal with the situation.

In other words the EU Council was hoping that this somewhat vague strategy would be enough to stabilise the bond markets (without having to declare its hand on the precise details of a recovery plan).

If however - as seems increasingly likely - that further assistance will indeed be required for Greece, then the EU could get into deeper water, for any rescue plan is bound to be seen as a "bail-out" irrespective of Council denials.

And once the concept of a "bail-out" is accepted with relation to Greece, why should this not apply next to Portugal, Spain and Italy (who are also suffering considerable financial difficulties)?

And as speculators are very shrewd, they will quickly realise that perhaps the will is not there to mount expensive "bail-out" rescues for every state suffering extreme speculative pressure with respect to the price of its bonds.

So the crisis in Greece is really pointing to the question of the very viability of EMU as presently conceived.

And in its present form it has to be admitted that it is crucially flawed.

I will propose now what I feel is actually necessary for a sustainable EMU and then suggest what I believe is actually feasible in the present circumstances.

When we compare the Eurozone to the US (which represents another EMU region) we can detect a noticeable difference.

In the US a considerable amount of fiscal activity is controlled centrally through the federal budget. This therefore enables stabilisation measures to be taken with a view to influencing economic activity throughout the whole region.

So for example in the past year, President Obama has implemented an expansionary plan with a view to boosting output and expenditure in the US.

However in the Eurozone no similar mechanism exists with the vast bulk of spending controlled at national budget level. Therefore no adequate fiscal means exists for presently attempting to achieve overall recovery in the Eurozone area.

Indeed for such a mechanism to exist we would need a much greater level of political integration whereby member countries would hand over considerable levels of fiscal control to a central budgetary authority. And needless to say such a degree of EU political integration does not actually exist.

In an attempt to influence fiscal policy at a national level, the Eurozone operates a Growth and Stability Pact. This is mainly designed to control the size of budget deficits and the consequent need for borrowing. However it has proved a very flawed mechanism of control.

Though financial penalties are supposed to be imposed for failure to meet guidelines, this has proven quite impractical as adequate means do not exist for collecting fines from offending members.

Also the guidelines are somewhat vague whereby the rules can be broken in - not clearly defined - exceptional circumstances.

Finally they are asymmetrical in that no similar rules are laid down with respect to the size of budget surpluses that governments should aim for during boom economic conditions.

Also there is a crucial problem in the way in which borrowing arrangements are financed for Eurozone countries whereby this remains the responsibility of each individual member.

This is causing a huge difficulty in Greece. Bond investors are clearly uncertain regarding the ability of the Government to take the necessary measures to cut its excessive budget deficit (13% of GDP). Therefore they are demanding a significant additional premium in terms of interest rates before lending money.

And this is not confined to Greece. It proved a significant problem for Ireland last year and with the present uncertainty could quickly spread to other troubled economies such as Portugal and Spain.

It would seem logical however in a true single currency area that euro bonds should be issued with borrowing required by any individual country thereby backed by all Eurozone members. Because of the lower risk of possible default on such loans, the interest rate attaching to such bonds should thereby stay much lower than that presently being paid by several of the weaker members.

Though this proposal has indeed been already suggested it was stoutly resisted. For stronger members, such as Germany and France, this would entail a large commitment, probably entailing higher interest rates on bonds than what they presently pay, without any obvious benefit in national terms.

So once again we have to face the fact that political integration is not yet sufficient to enable a true EMU to operate. Therefore it is not really feasible to maintain it in its present form without endangering the long run economic performance of many of its members.

My own suggestion as to a more viable alternative would run along the present lines!

A small core of economies (largely associated with original EU members) could indeed continue in a workable EMU. However even here, greater fiscal co-ordination and stricter control measures would need to be imposed. Also a common euro bond, guaranteed by all member states to fund borrowing requirements, should be considered.

Then we would have perhaps a larger layer of other economies in an exchange rate arrangement similar to the previous ERM. Basically these economies could use national currencies that closely track the Euro. However a degree of flexibility with respect to day to day movements could be maintained with the possibility of more substantial realignment of currency values in exceptional circumstances.

A degree of movement of switching as between both systems could be facilitated with poorly performing economies in the EMU facing eventual relegation to the 2nd tier and with successful countries in the 2nd tier becoming eligible for promotion to EMU.

Finally a small group of countries remaining especially resistant to further political integration, including perhaps the UK, Sweden and Demmark, might remain outside these systems altogether and maintain freely floating currencies.

It would be a mistake to push the notion of integration (both economic and political) further than is practically possible. Though I broadly supported the Lisbon Treaty, I would accept that political masters in the EU have been more in favour of integration than common citizens in the member countries. Much more therefore needs to be done to foster an authentic European identity before measures, properly dependent on further political integration, are pursued.