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Archive for the ‘Euro crisis’ Category

An optimality index of the single currency: internal asymmetries within the Eurozone and the USA since 1999

We have measured the macroeconomic dispersion within the Eurozone (see further details here on the indicators we have used) and this is in a nutshell how the euro (12 and 19) has performed since its launched in 1999.

 

As shown in the chart above we have added Target2 balances in the calculation of the (overall) index of internal dispersion; which is in fact an index of divergence within the Eurozone. The empirical conclusions are quite revealing, and somehow the expected ones: (1) in the good years (1999-2007), overall dispersion increased quite notably (it doubled!); (2) after the 2008-09 crisis, divergence deteriorated much more sharply and, leaving Target2 balances aside, the trend has been reversed and the index shows signs of improvement (though at a very slow pace).

We have also calculated an index of macroeconomic dispersion for the (mainland US) dollar area, using the same methodology. The chart below shows the trends in dispersion/internal asymmetries in this two major monetary areas:

 

There are many questions to discuss on this issue: among others, I will just mention three: (1) should we or should we not add Target2 balances to the calculation of the index of dispersion? (effectively, do Target2 balances matter?); (2) since the US is indeed a banking union, should we factor in monetary dispersion across States?; and (3) do the charts above suggest that the policies implemented during the recent crisis are the right ones in order to achieve a greater degree of convergence in the Eurozone?

We will discuss these questions and the charts above, and what they mean for the interpretation of convergence trends in the Eurozone, in a two-day conference at the University of Buckingham this week (21-22 February): The Economics of Monetary Unions. Past Experiences and the Eurozone. If you cannot make it, you will be able to follow the presentations live online. More information on the full programme here and how to follow it at the Institute of International Monetary Research social media.

All welcome.

 

Juan Castañeda

 

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A proposal for Target2 reform and a capped mutualisation debt scheme in Europe

‘Under a monetary union, fiscal and monetary discipline have to go hand in hand if macroeconomic stability is to be maintained. The question is how to set up the right institutions to achieve this stability in a credible manner. This policy brief proposes a new institutional arrangement for the euro area to restore fiscal discipline. It places the responsibility for compliance entirely on the shoulders of the member states. It also provides for the mutualisation of 30% of the member states’ debt-to-GDP ratio.
This would help to maintain a stable currency and to limit the risk of contagion should another crisis occur in the future. However, this comes at a cost. Under the fiscal scheme proposed, member states, which would be fully fiscally sovereign, would need to run long-term sound fiscal policies to benefit from euro membership. In addition, this brief proposes a reform of Target2 under which overspending economies would have to pay the financial cost of accessing extra euros, which would deter the accumulation of internal imbalances within the euro area. All this is expected to change the current fragility of the architecture of the euro, provide member states with the right incentives to abide by sounder economic principles and make them fully responsible for the policies they adopt.’

The above is the abstract of a research report I have just written on the reforms needed to undertake to re-balance the eurozone economy, published by the Wilfried Martens Centre for European Studies. As you will read in the report, I don’t favour more centralisation of fiscal competences to the ‘federal’ level (be it Brussels or Frankfurt), but instead to abide by the subsidiarity principle as much as possible; and thus to make Member States (MSs) fully responsible for their own macroeconomic policies and public finances. The euro is a sort of a ‘monetary club’ (some will claim, and quite rightly, that it is much more than that) with benefits and costs of membership. As to the benefits, these are particularly evident for those economies with a poor inflation record in the running of their own national currencies in the past; for which the euro has provided a strong monetary anchor and therefore greater  price stability and lower borrowing costs. As to the costs, these were more subtle before the Eurozone crisis (and indeed less publicised at the time of the launch of the euro), and have become much more evident since then: simply put, MSs do not have access to their own (national) monetary policy anymore in order to ‘alleviate’ the costs of adjustment to a crisis, and also have limited sovereignty over their fiscal policy.

The reforms introduced during and after the recent crisis have confirmed the direction of change in the eurozone towards ever more co-ordination of macro policies; and therefore more and more conditions and criteria are now in place to closely monitor and eventually fine MSs for the running of (severe) fiscal and also macroeconomic imbalances (see the the new ‘Fiscal Compact’ and the new ‘Macroeconomic Imbalances Procedure’ for more details). If anything, the experience of how the excessive public deficits and public debt by different MSs were handled by the eurozone institutions before the crisis is not very promising; even less so now that the complexity and degree of macroeconomic integration and regulation are even greater. The approach I adopt in this report is quite different.

In a nutshell:

(1) I put forward a (capped) debt mutualisation scheme, so those MSs running sound fiscal policies and sustainable budgets can benefit from it; and those in excess of the annual debt threshold will have to issue their own bonds, backed only by their own national revenues and credibility. The scheme, once launched, is communicated to the MS and it is not negotiable; the scheme also decreases in the coverage of the MSs public debt for the current levels down to a 30% ratio of the GDP in ten years. With this scheme, the MSs will have the incentives to meet the pre-announced annual targets, as their debt will be covered under the debt mutualisation programme, and thus will benefit from much lower borrowing costs. And, crucially, there is no need to monitor nor regulate further the fiscal or macroeconomic performance of the MSs.

(2) I also propose a major reform of Target2, which has accumulated (particularly since 2008) enormous imbalances among MSs (see the latest balances across MSs at the ECB website here): On the one hand, Italy holds a debit position amounting to approx. 30% of its GDP while Spain’s is 25% of its GDP; on the other hand, Germany holds a credit position close for the value of nearly 30% of its GDP. The reform proposed in the report would consist of setting a price for access to credit (if only the ECB policy rate), so overspending economies find it more and more costly to keep on borrowing and thus accumulate further imbalances. A way to settle the existing balances cross MSs must be also addressed.

(3) There are other key elements in the report for the proposals above to be effective, such as the return to the ‘no bailout clause’ of MSs, and the possibility of an errant economy to leave the eurozone (or be temporarily suspended). More details in the report.

 

Juan Castañeda

Full text of the report at: https://www.martenscentre.eu/publications/rebalancing-euro-area-proposal-future-reform

Feedback most welcome.

 

 

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In a fixed exchange rate system such as the euro symmetry in the application of the standard is key for the well running of the currency and even its preservation over the long term: i.e. surplus countries should overspend and run deficits (either private or public or a combination of both) so they suffer from an excess of money in the economy and thus ultimately higher inflation. And just the opposite in case of deficit countries within the euro standard, as they need to cut down their spending in order to cut costs and prices and ultimately regain competitiveness. This was for long considered, if only implicitly, as the main ‘rule of the game’ in the running of the classical gold standard at the time.

Of course we have heard about the application of adjustment policies in deficit countries in the eurozone during the recent crisis, the so-called ‘austerity policies’; or in the technical jargon, policies aimed at achieving ‘internal devaluation’ as an external devaluation is not possible at all. However, it is important to remember that it is the running of both policies in surplus and deficit countries what would lead to a balanced macroeconomic equilibrium over time in the eurozone. Just looking into the 2018 balances of each country (to be precise, each national central bank) in the Target2 payments settlement system in the Eurozone, we can see how far we are from symmetry in the area. Actually, the balances have been deteriorating quite dramatically since the summer of 2007; and now we have countries like Germany holding a significant creditor position against the rest of the Eurozone countries (and particularly against Italy and Spain) of nearly 30% of the German GDP.

 

Source: Institute of International Monetary Research, Monthly Update (2018). From ECB data. 

 

The gold standard is often taken as a predecessor of the euro standard; true, both systems are based on the commitment to fixed exchange rates but the euro standard is much more stringent and demanding in that it is amonetary union‘ (and not simply a ‘currency union‘ as the gold standard was, where national currencies ran at the announced fixed exchange rate and were ultimately governed by the national central banks). In an monetary union such as the euro standard the need to abide by symmetry, by both surplus and deficit member states, is even more difficult to articulate and achieve: the states do not longer have their national central banks to inject or withdraw money as needed be, and symmetry can mainly be achieved by expanding or tightening fiscal policy (and also by supply-side policies, that are indeed needed but take a longer time to be effective).

Along with two colleagues of mine, Alessandro Roselli (Cass Business School) and Simeng He (University of Buckingham) we have conducted a research on the measurement of asymmetry in the running of the gold standard from the 1870s to 1913. As shown in the table below, only the hegemonic economy, the UK, abided by symmetry, whilst the other 4 major European economies at the time did not (see table below).

See the following link for further details on our paper: https://www.researchgate.net/publication/328562649_A_measurement_of_asymmetry_in_the_running_of_the_classical_gold_standard

This is an extract from the paper with a summary of our conclusions, with striking parallels on the situation of the euro standard and the asymmetries mentioned above:

The consequences resulting from the running of the gold standard with a deficient degree of symmetry should not be underestimated, as countries like Germany and France refused to let the increase in reserves to be reflected in a greater amount of money supply. This created tension in the system, as countries like Italy or Spain would find it more difficult to regain competitiveness, and thus a greater internal devaluation was needed to be able to compete with their trade (surplus) partners.

Were the asymmetries of the pre-WW1 period the origin of the gold standard’s final collapse? The straight answer is negative: all the five countries here surveyed had to suspend the standard at the outbreak of the war, if not before such as Spain in 1883; it was the War, with the huge expansion of the money supply, dramatic inflation and social unrest that made later in the 1930s the gold standard unable to survive. In the post-war period, Britain had lost her hegemonic status and symmetry together with it.  (…) the asymmetry of the hegemonic country (the US) under the Bretton Woods System might well explain its collapse.

Should we infer from these experiences that symmetry of the hegemonic country is the precondition for a fixed rate system (or for a currency union with a single currency) to survive? And, referring to the Eurozone, should we think that Germany – unquestionably the hegemonic country – is behaving asymmetrically and that the Eurozone should collapse as a consequence? Another paper would be needed to answer these questions.

Some claim the Eurozone must be completed with a full fiscal (budget) union, so a meaningful ‘federal EU budget’ can transfer resources within the area when needed; however, even if politically feasible, this option will take time to take place and the imbalances within the Eurozone keep on accumulating day by day. There are pressing issues resulting from the lack of symmetry in the running of the euro standard no one can now deny: How are the Target2 balances going to be settled, if they will be at all at some point? Can persistent trade imbalances among member states run within Eurozone countries? Can more flexible goods and services as well as labour markets reduce asymmetries within the Eurozone enough? Can the Eurozone force surplus countries to be more expansionary when needed be?

The eurozone member states clearly opted for a more centralised monetary union during the crisis, and the questions above are some of the key questions still pending to address for the euro standard to stop accumulating internal asymmetries. The other option would have been to abide by the no bail-out clause stated in the Maastricht Treaty and the application of the subsidiarity principle in the construction of the eurozone, and thus let errant countries fail if they could not fulfil the strict requisites to remain in the eurozone; but this was clearly not the option taken.

 

Juan E. Castaneda

PS. For information, we will address these issues in a conference on ‘The Economics of Monetary Unions. Past Experiences and the Eurozone’ at the University of Buckingham (21-22 February 2019). Please check the speakers and the programme online should you want to attend (by invitation only).

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How has the Euro performed? Are the economies of the Eurozone countries more homogeneous today than in 1999?

The 2017 optimality index 

Professor Pedro Schwartz and myself have conducted a research to (1) assess the trend in macroeconomic imbalances within the Eurozone since 1999 and (2) compare it to those in the US dollar monetary area. This is an extension of the research paper published last year in Economic Affairs (October, 2017), ‘How Functional is the Eurozone? An Index of European Economic Integration Through the Single Currency’. We have collected 10 different economic indicators per country (that is, for the 19 Eurozone Member States and 50 US states plus Washington DC) to measure how homogeneous or asymmetric the Eurozone Member States’ economies are, and calculated an overall index of economic dispersion, as well as four separate sub-indices to measure for asymmetries as regards (1) cycle synchronicity, (2) public finances, (3) competitiveness and (4) monetary and credit growth. The overall index can be interpreted as a measure of macroeconomic dispersion and thus of the asymmetries existing within the currency area.

In a nutshell, what the calculations and indices tell us is the following:

  1. Overall, the economies of the Eurozone Member States are less homogeneous today than in 1999. Integration did deteriorate even during the ‘good years’ (the expansionary phase of the cycle; specifically, a 86% accumulated increase in macroeconomic asymmetries from 1999 to 2006.
  2. During both the Global Financial Crisis and the Eurozone Crisis asymmetries escalated, in particular those regarding differences in competitiveness across Member States. Since 2015 the overall index of dispersion had shown a slight recovery: the new fiscal measures adopted at the EU level, along with the adjustment in costs and prices in those Member States mostly affected by the crises, seem to have been effective. In addition, the new programme of Quantitative Easing by the ECB, which began in 2015, has also helped, by reducing monetary growth dispersion across the Member States.
  3. However, this positive trend has been reversed in 2017, due to a deterioration in the competitiveness and monetary dispersion indices. This raises concerns about the stability of the Eurozone, since it shows that the return to macroeconomic stability and integration to something like pre-crisis levels is not an easy task even in times of economic growth. It also shows that the changes introduced in the euro architecture during the crisis have not been as effective as hoped.

For further details, you can access the summary of our project here: https://www.mv-pt.org/staff-research. You can also access the tables and figures with the comparison with the indices of dispersion in the USA here. These indices are now part of the research agenda of the Institute of International Monetary Research (IIMR) and an update with new figures will be published every year.

Note: Euro-12 and Euro-19 overall index of dispersion, 1999=100  (https://www.mv-pt.org/staff-research). The higher the value of the index the greater asymmetries are.

A full academic article by Pedro Schwartz and myself with further explanations on the figures and the calculations will follow soon. As always, comments most welcome!

Juan Castañeda

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Confronting financial crises under different monetary regimes:  Spain in the Great Depression years

This is the title of the paper I have written with my friend and colleague Professor Pedro Schwartz, which is being published in May 2018 as a chapter in a book, Money, Currency and Crisis. In Search of Trust, 2000 BC to AD 2000, edited by R. J. van der Spek and Bas van Leewen (Routledge). As we put it in the first section of the chapter, “the thesis of the present essay is that the recession was much lighter in Spain than in the US, Italy, Germany or France (see Figure 1); that the causes of the contraction were domestic rather than epidemic; and that the relative shallowness of the contraction in Spain, and of the UK after abandoning gold, may have been due in some measure to similarly flexible monetary arrangements.

 

The exchange rate system does matter in coping with a major crisis, and both the 1930s and the 2000s crises are good examples of this. Spain in the 1920s and 1930s, free of exchange rate commitments, and thus with full monetary sovereignty, led the Peseta float  in response to quite dramatic changes in both domestic and international market conditions. Being a very rigid economy at the time, the depreciation of the Peseta was an effective and timely tool to cut down costs and prices. This is not to say that depreciation is panacea; it is not! If not followed by orthodox both fiscal and monetary policies, it will just lead to greater and greater inflation over time, and we have plenty of examples of this. It is useful though to compare the adjustment of the Spanish economy to the Great Depression in the 1930s to that to the Global Financial Crisis in the 2000s via ‘internal devaluation’ (i.e. cutting domestic wages and prices); the charts below are quite revealing of the effects of these two alternatives (see Figures 15 and 16) and do provide a textbook case-study on the advantages and disadvantages of each.

 

As figures 15 and 16 above show, the depreciation of the Peseta carried most of the burden of the adjustment to the 1930s crisis, while it has been domestic costs (Unit Labour Costs) in the 2000s crisis.

Over the medium to the long term, both an internal devaluation and a standard (external) devaluation achieve the same (necessary) goal: to cut down costs, prices and spending in the economy in crisis. This is something unavoidable in either policy scenario; the economy cannot continue spending as it used to before the crisis. In addition, an internal devaluation also brings greater competitiveness over the long term, given that the economy will be able to produce with lower costs than its competitors. However, the economic and political costs of this latter policy option are not negligible in the short term. This is the trade-off every economy confronts in a major crisis, (1) either to opt for a quick devaluation to cut down domestic costs and prices almost instantaneously, or (2) to cut down public and private spending (internal devaluation).

  • The external devaluation option, when the country retains its currency and its domestic monetary policy, is the most appealing option in the short term; especially by politicians, as it may be unnoticed by the public for a time. But, if not accompanied by fiscal and monetary restrictive policies, it will surely lead to inflation very soon.
  • The internal devaluation option was the only available for the Eurozone countries in the 2000s crisis, and was the right policy to pursue, however painful as indeed it was. The experience of Spain, and the other Eurozone countries in crisis from 2009 to 2014, shows again how stringent the conditions to remain in a monetary union are in times of crisis: both labour and good and services markets must be as flexible as possible to let prices go up and down whenever needed; otherwise, the adjustment will be even more painful and will take longer, and more jobs and output will be lost.

The preference for one or the other policy will depend very much on how rigid markets are to adjust to new market conditions, and the commitment of policy-makers to run orthodox monetary and fiscal policies. In the absence of committed policy-makers to adjusting costs and prices, an external devaluation will just be a gateway to rampant inflation.

 

Juan Castañeda

 

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For those interested in the chapter, please find the abstract below (more in the book!):

Spain was effectively on silver from 1868 down to the II Republic in 1931. Being off the gold standard and on a depreciating silver standard from the 1890s on helped the economy adjust almost painlessly to the several economic crises it suffered during that period and resulted in a much milder recession than the rest of the world in the 1930s. This proves how relevant is the monetary regime to deal with shocks and economic crises, particularly when confronting financial crises. 

Devaluation corrects past policy mistakes at the cost of making the country poorer; but it will only hold in the longer term if it is accompanied by sound fiscal and monetary policies. During WWI a neutral Spain had accumulated a large gold reserve by selling to all belligerent countries. Pressure to move to gold was resisted but the slow depreciation of the silver anchor after WWI was accompanied by a surprisingly sound Bank of Spain monetary policy. Though the Treasury did use its power to borrow from the Bank from time to time the Board of the Bank correspondingly tightened interest rates to maintain monetary stability. This resulted in quite moderate rates of growth of the money supply that helped keep internal prices in check. In fact, the peseta behaved like a properly managed nominal currency. In the ‘twenties the rate of exchange of the peseta versus the pound sterling fell along with silver against gold, due to a persistent structural deficit in the balance of payments; and though from 1929 to 1935 the peseta fell less rapidly than silver, it did fall more than if it had been on gold.

Being on the silver standard dampened the effects of the Great Depression in Spain. Under a gold standard regime the balance of payments would have rebalanced quickly but with a large restructuring cost such as that suffered by Spain today under the ‘euro-standard’: Then as now, almost immovable structural inflexibility makes external depreciation a more politically and socially acceptable policy than harshly imposed internal devaluation.

Another positive effect of the peseta being anchored on a depreciating silver standard was to allow the Bank of Spain freely to act as lender of last resort in 1931 and thus prevent the deep banking crisis that struck other developed economies.

However one must not exaggerate the effect of a flexible monetary policy in a country like Spain in the 1930ies: Spain still was an agricultural country and she enjoyed two bumper crops in wheat in 1933 and 1935; and in any case the relative smallness of the foreign sector helped dampen the effects of what was happening in the rest of the world.

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‘How functional is the Eurozone? An index of European economic integration through the single currency’

This is the title of the paper I have just written with my good friend and colleague, Professor Pedro Schwartz (Camilo Jose Cela University in Madrid and University of Buckingham), which will be published in Economic Affairs (October issue, 2017).

We deal with a quite straight forward question: How can we measure the optimality of a currency area? When does it become more and more difficult to run a single monetary policy? If there are internal asymmetries in the currency area, how do they evolve? To answer, if only tentatively, these questions we have developed the method to calculate the index of optimality of a currency area, which we have split up in four major categories and components: (1) fiscal synchronicity, (2) public finance, (3) competitiveness and (4) monetary. Both the overall index and the above partial indices will inform us about the performance of the currency union and how internal asymmetries have increased or decreased. We have applied it to the eurozone, from 1999 to 2016. The results and calculations give us a metric to identify the building up of internal tensions in the running of the single monetary policy since the inception of the euro in 1999.

If only a chart, this is the summary of what we found in our research; in a nutshell, the adoption of the euro has not increased convergence among eurozone economies. The overall index of dispersion increased by 25% from 1999 to 2005 (see figure below),  and so asymmetries amongst member states even during an expansionary cycle. Of course, as expected, internal dispersion soared during and immediately after the outbreak of the Global Financial Crisis. This increase in dispersion in the crisis years ‘s not a symptom of the malfunction of the euro; what we should rather focus on is on the time taken for asymmetries to resume pre-crisis levels. Overall, even after 10 year since the start of the recent crisis, the optimality index still shows the Eurozone has a long way ahead to resume pre-2007 crisis levels (such as 1999 levels, when even countries joining the Eurozone were far from convergence).

 

 

This is the abstract of the paper:

‘This is a step in empirically assessing how near the Eurozone is to becoming an ‘optimal currency area’, as originally defined by Mundell (1961). For this purpose we have compiled ten indicators, organised them in four chapters, and summarised them in an overall indicator of ‘optimality’. The resulting picture is mixed, with zone optimality not increasing when circumstances were favourable but the trend towards integration returning after the 2008-2014 crisis. The suggestion is that dis-integration during the crisis, rather than an evidence of failure of the Eurozone when the going was tough, showed a self-healing mechanism at work. However our measurements and indices show that optimality is much lower than that in 1999.’

Feedback most welcome, as ever.

Juan Castañeda

 

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Following up my last post on the eurozone crisis and the monetary policy of the ECB (see IIMR esearch Paper 3: Have Central Banks forgotten about money? by my colleague Tim Congdon and myself), please find below a video with further details on the changes made to the monetary strategy of the ECB since its establishment.

What I claim in the video is that the ECB did give a prominent role to the analysis of the changes in broad money up to 2003, when it reviewed its strategy, and not surprisingly it led to a higher rate of growth of money in the Eurozone in the years running up to the Global Financial Crisis. Just to be clear, I do not support that any central bank should adopt a ‘mechanistic’ monetary growth policy rule, by which the bank adheres to an intermediate M3 (or broad money) rate of growth target come what may. The link between money and prices and nominal income is indeed very strong over the medium and long term, but it is of course affected by other variables/phenomena in the short term that need to be properly considered and taken into account by policy makers. So rather than a mechanistic approach to such a monetary target, changes in money growth should be given a primary role in assessing inflation and nominal income forecasts, and thus in the making of monetary policy decisions; and this is precisely what the ECB did from 1999 to 2003 under its two-pillar strategy. So when money growth continuously exceeds the rate deemed to be compatible with monetary stability, this would signal inflationary pressures and even financial instability the central bank would eventually tackle by tightening its monetary policy. This rationale would show the commitment of the central bank to both monetary and financial stability over the long term, and the use of a broad monetary aggregate would serve as a credible indicator to make monetary policy decisions and as a means to transmit the central bank’s expectations on inflation and output growth.

As ever, comments very welcome.

Juan Castañeda

PS. More videos on the IIMR YouTube channel

 

 

 

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