Saturday, January 15, 2011

Paul Krugman on the Euromess

It has become the convention that Paul Krugman sets the standard on most major issues on our times with his incisively brilliant essays in the Times. His columns heralding a Dark Age in Macroeconomics and Building a Green Economy generated intense debates on the state of economics and environmental policy making respectively.

Now, comparing the current Euro-zone crisis to a Greek tragedy, Paul Krugman has a superb essay on the origins and evolution of the Union, reasons for the crisis, and the prospects facing Europe. He sets the stage nicely,

"The tragedy of the Euromess is that the creation of the euro was supposed to be the finest moment in a grand and noble undertaking: the generations-long effort to bring peace, democracy and shared prosperity to a once and frequently war-torn continent. But the architects of the euro, caught up in their project’s sweep and romance, chose to ignore the mundane difficulties a shared currency would predictably encounter — to ignore warnings, which were issued right from the beginning, that Europe lacked the institutions needed to make a common currency workable. Instead, they engaged in magical thinking, acting as if the nobility of their mission transcended such concerns.

The result is a tragedy not only for Europe but also for the world, for which Europe is a crucial role model. The Europeans have shown us that peace and unity can be brought to a region with a history of violence, and in the process they have created perhaps the most decent societies in human history, combining democracy and human rights with a level of individual economic security that America comes nowhere close to matching. These achievements are now in the process of being tarnished, as the European dream turns into a nightmare for all too many people."

Krugman points to the most important and fundamental challenge facing the peripheral European economies - increasing their competitiveness. He writes,

"Imagine that you’re a country that, like Spain today, recently saw wages and prices driven up by a housing boom, which then went bust. Now you need to get those costs back down. But getting wages and prices to fall is tough: nobody wants to be the first to take a pay cut, especially without some assurance that prices will come down, too... If you still have your own currency, however, you wouldn’t have to go through the protracted pain of cutting wages: you could just devalue your currency — reduce its value in terms of other currencies — and you would effect a de facto wage cut... by giving up its own currency, a country also gives up economic flexibility... adjusting your currency’s value solves the coordination problem when wages and prices are out of line, sidestepping the unwillingness of workers to be the first to take pay cuts."

About the reasons why a currency union cannot survive without other complementary institutions and policies, he writes,

"When the single European currency was first proposed, an obvious question was whether it would work as well as the dollar does here in America. And the answer, clearly, was no... Europe isn’t fiscally integrated: German taxpayers don’t automatically pick up part of the tab for Greek pensions or Irish bank bailouts. And while Europeans have the legal right to move freely in search of jobs, in practice imperfect cultural integration — above all, the lack of a common language — makes workers less geographically mobile than their American counterparts...

Robert Mundell of Columbia stressed the importance of labor mobility, while Peter Kenen, my colleague at Princeton, emphasized the importance of fiscal integration. America, we know, has a currency union that works, and we know why it works: because it coincides with a nation — a nation with a big central government, a common language and a shared culture. Europe has none of these things, which from the beginning made the prospects of a single currency dubious."

The lead-up to and aftermath of a single currency zone resulted in a dramatic convergence of government bond yields and widespread euphoria and hope,

"By the middle of the 2000s just about all fear of country-specific fiscal woes had vanished from the European scene. Greek bonds, Irish bonds, Spanish bonds, Portuguese bonds — they all traded as if they were as safe as German bonds. The aura of confidence extended even to countries that weren’t on the euro yet but were expected to join in the near future: by 2005, Latvia, which at that point hoped to adopt the euro by 2008, was able to borrow almost as cheaply as Ireland...

As interest rates converged across Europe, the formerly high-interest-rate countries went, predictably, on a borrowing spree. (This borrowing spree was, it’s worth noting, largely financed by banks in Germany and other traditionally low-interest-rate countries; that’s why the current debt problems of the European periphery are also a big problem for the European banking system as a whole.) In Greece it was largely the government that ran up big debts. But elsewhere, private players were the big borrowers. Ireland, as I’ve already noted, had a huge real estate boom: home prices rose 180 percent from 1998, just before the euro was introduced, to 2007. Prices in Spain rose almost as much. There were booms in those not-yet-euro nations, too: money flooded into Estonia, Latvia, Lithuania, Bulgaria and Romania."

He finds striking similarities between the economies on both sides of the Atlantic and their respective contributions to the global economic crisis of 2008,

"This was, if you like, a North Atlantic crisis, with not much to choose between the messes of the Old World and the New. We had our subprime borrowers, who either chose to take on or were misled into taking on mortgages too big for their incomes; they had their peripheral economies, which similarly borrowed much more than they could really afford to pay back. In both cases, real estate bubbles temporarily masked the underlying unsustainability of the borrowing: as long as housing prices kept rising, borrowers could always pay back previous loans with more money borrowed against their properties. Sooner or later, however, the music would stop. Both sides of the Atlantic were accidents waiting to happen."

About the dilemma facing the peripheral economies - regain their competitiveness while also paying off their massive debts - he writes,

"Membership in the euro means that these countries have to deflate their way back to competitiveness, with all the pain that implies... Even when countries successfully drive down wages, which is now happening in all the euro-crisis countries, they run into another problem: incomes are falling, but debt is not.

As the American economist Irving Fisher pointed out almost 80 years ago, the collision between deflating incomes and unchanged debt can greatly worsen economic downturns. Suppose the economy slumps, for whatever reason: spending falls and so do prices and wages. But debts do not, so debtors have to meet the same obligations with a smaller income; to do this, they have to cut spending even more, further depressing the economy. The way to avoid this vicious circle, Fisher said, was monetary expansion that heads off deflation. And in America and Britain, the Federal Reserve and the Bank of England, respectively, are trying to do just that. But Greece, Spain and Ireland don’t have that option — they don’t even have their own monies, and in any case they need deflation to get their costs in line."

He sees four possibilities for Europe - toughing it out; debt restructuring; full Argentina; and revived Europeanism. Toughing it out is classic "internal devaluation" to restore competitiveness, where economies reassure their creditors by enduring pain (by cutting wages, prices, and government spending) and thereby avoid default or currency devaluation (similar to what the small Baltic nations appear to be doing, despite their Depression-type declines in output and employment). This would require time and dollops of good fortune.

Debt restructuring would immediately ease the debt burden, though the economies would still need to slash spending and raise taxes to balance its budget, besides suffering the pain of deflation to regain competitiveness. Krugman feels that this is inevitable, atleast for Greece and Ireland,

"A debt restructuring could bring the vicious circle of falling confidence and rising interest costs to an end... I find it hard to see how Greece can avoid a debt restructuring, and Ireland isn’t much better. The real question is whether such restructurings will spread to Spain and — the truly frightening prospect — to Belgium and Italy, which are heavily indebted but have so far managed to avoid a serious crisis of confidence."

The policies of the peripheral economies are strikingly similar to that of Argentina since 1991 when it embraced a "currency board" with a rigid peso-dollar peg to ward off a debt crisis. This disastrous experiment, which involved fiscal austerity and tax increases to regain market confidence and IMF bailout to buy time for the austerity to work, collapsed in 2002. Peso-dollar peg was abandoned, peso plunged by more than two-third, and Argentina defaulted on its debts, eventually paying only about 35 cents on the dollar. Since 2003, Argentina experienced a rapid export-led economic rebound. Krugman writes about Iceland's combination of default and devaluation,

"The European country that has come closest to doing an Argentina is Iceland, whose bankers had run up foreign debts that were many times its national income. Unlike Ireland, which tried to salvage its banks by guaranteeing their debts, the Icelandic government forced its banks’ foreign creditors to take losses, thereby limiting its debt burden. And by letting its banks default, the country took a lot of foreign debt off its national books. At the same time, Iceland took advantage of the fact that it had not joined the euro and still had its own currency. It soon became more competitive by letting its currency drop sharply against other currencies, including the euro. Iceland’s wages and prices quickly fell about 40 percent relative to those of its trading partners, sparking a rise in exports and fall in imports that helped offset the blow from the banking collapse."

The most desirable outcome would be greater fiscal union between members. Krugman refers to the proposal (Juncker-Tremonti plan) mooted last year of "E-bond". They would be issued by a European debt agency at the behest of individual European countries, and guaranteed by the European Union as a whole. Germany has rejected this as a "transfer union", where the irresponsible economies would be subsidizied by the responsible ones.

Currently Europe has decided to stick with "tough it out" policy stance, and Paul Krugman feels that this policy may not succeed,

"Governments that can’t borrow on the private market will receive loans from the rest of Europe — but only on stiff terms: people talk about Ireland getting a “bailout,” but it has to pay almost 6 percent interest on that emergency loan. There will be no E-bonds; there will be no transfer union... In any case, the odds are that the current tough-it-out strategy won’t work even in the narrow sense of avoiding default and devaluation — and the fact that it won’t work will become obvious sooner rather than later. At that point, Europe’s stronger nations will have to make a choice."

See also this assessment of Estonia's progress with toughing it out, even as it joined the eurozone early this year.

No comments: