Weekend reading links

1. WSJ has an article which questions the widespread belief that failures help make a better entrepreneur.

Failed entrepreneurs were more likely to go bankrupt or dissolve their business than first-time entrepreneurs. In fact, even if an entrepreneur had run a business successfully before, they were just as likely to see their new business fail as a first-time entrepreneur. Other researchers have reached similar conclusions. A Harvard Business School study of venture-capital-backed firms in the U.S., published in the April 2010 Journal of Financial Economics, found that previously failed entrepreneurs were no more likely to succeed than first-time entrepreneurs. A study of German entrepreneurs by a researcher at KfW Bankengruppe found that entrepreneurs who started a company after a failure performed poorly compared with other founders. “Their probability of survival in general as well as their risk of failure in particular is worse than that of other startups,” according to the researcher, who added: On average, “there is no indication that business failure triggers a reflection process in which entrepreneurs look back on mistakes they have made and adapt their future behavior accordingly.”

2. An RCT evaluation shows that microfinance can indeed help certain types of entrepreneurs,

In Hyderabad, India, we find that “gung ho entrepreneurs” (GEs), households who were already running a business before microfinance entered, show persistent benefits that increase over time. Six years later, the treated GEs own businesses that have 35% more assets and generate double the revenues as those in control neighborhoods. We find almost no effects on non-GE households... These results show that heterogeneity in entrepreneurial ability is important and persistent. For talented but low-wealth entrepreneurs, short-term access to credit can indeed facilitate escape from a poverty trap... 

Essentially all of the benefits of credit access accrue by increasing entrepreneurship on the intensive margin: for those individuals with an existing business before the entry of microfinance (who we call gung-ho entrepreneurs or GEs), we find economically meaningful, positive effects on household businesses and consumption. Within this group, the bulk of effects come from households who escape from the fixed-cost-driven poverty trap and move into a more productive technology (with the remainder coming from already-productive businesses scaling up to exploit constant returns). The rest of the sample–those who start new businesses, or who never start a business at all–exhibit essentially zero impact of credit access. Notably, for this group the effect is a fairly precise zero throughout the distribution: while these reluctant entrepreneurs and consumption borrowers do not experience benefits from microcredit access, neither do they appear to experience harm.

The paper has several important academic insights. The big policy insight (one which the authors do not draw) is the reinforcement of the fact that SMEs in general are credit constrained, and, importantly, of them certain types of enterprises could benefit from even micro-finance. So add in the management practice support and with small amounts of credit, there can be out-sized productivity effects. The problem is how to identify them?

3. The lemon effect in used car markets can be very significant. Sample this from a Danish study,

We estimate the model using data on car ownership in Denmark, linked to register data. The lemons penalty is estimated to be 18% of the price in the first year of ownership, declining with the length of ownership. It leads to large reductions in the turnover of cars and in the probability of downgrading at job loss.

4. The work of folks at the BIS have demonstrated how globalisation has contributed to lowering and reducing domestic policy control over inflation dynamics. Kristin Forbes adds a nuance to that argument,

CPI inflation has become more synchronized around the world since the 2008 crisis, but core and wage inflation have become less synchronized. Global factors (including commodity prices, world slack, exchange rates, and global value chains) are significant drivers of CPI inflation in a cross-section of countries, and their role has increased over the last decade, particularly the role of non-fuel commodity prices. These global factors, however, do less to improve our understanding of core and wage inflation. Key results are robust to using a less-structured trend-cycle decomposition instead of a Phillips curve framework, with the set of global variables more important for understanding the cyclical component of inflation over the last decade, but not the underlying slow-moving inflation trend. Domestic slack still plays a role for all the inflation measures, although globalization has caused some “flattening” of this relationship, especially for CPI inflation. Although CPI inflation is increasingly “determined abroad”, core and wage inflation is still largely a domestic process.

5. The biggest obstacle to the emergence of Euro as a competitor to dollar,

A new study by economists Ethan Ilzetzki, Carmen Reinhart and Kenneth Rogoff... argue that “a central reason is the scarcity of high-quality marketable euro-denominated assets, and the general lack of liquidity compared to dollar debt markets”. Because of credit downgrades in the previous crisis and a still-fragmented private securities market, the euro has too few of the reliable assets that global investors use as reserves: typically ultra-safe triple A-rated bonds issued by creditworthy governments or companies.

The European Central Bank agrees, according to Benoît Cœuré, a member of its executive board. “In our analysis, [the most important move] would be a deepening of European capital markets and the introduction of a safe asset. That would be a game-changer.” In fact, no currency has ever gained predominance without liquid markets in a benchmark asset, says Mr Eichengreen. “If [Europe] succeeds in significantly enhancing the international role of the euro without that step, it would be a first.” The lack of safe euro-denominated assets was aggravated by the 2010-12 eurozone sovereign debt crisis, when investors feared the single currency might fall apart. “It’s a perfectly fine idea to promote the euro in international markets,” says Gita Gopinath, IMF chief economist. “But the necessary condition for that is to improve the euro area architecture to strengthen resilience — centralised fiscal capacity, capital markets union, banking union.”

6. Jonathan Ford in FT has a nice article on how accounting practices can cover up for corporate failings, this time in the case of Thomas Cook - the art of paying out massive dividends through accounting tricks despite the company not having the wherewithal to pay out even a cent.

7. Fascinating article about the use of back-channel diplomacy by American Presidents.

8. As the latest PISA results indicate, student learning outcomes is a problem in the US too.

9. Very good graphic explanation of the New York subway map here.

10. Finally, a new working paper comparing fiscal multipliers in developed and developing countries,

The clear theoretical implication that public investment multipliers should be higher (lower) the lower (higher) is the initial stock of public capital has not, to the best of our knowledge, been tested. This paper... finds robust evidence in favor of the above hypothesis: countries with a low initial stock of public capital (as a proportion of GDP) have significantly higher public investment multipliers than countries with a high initial stock of public capital... Our results thus suggest that public investment in developing countries would carry high returns.

Here is a good primer about fiscal multipliers from the IMF.

The age of negative interest rates

Nothing captures the consequences of the obsession of world'a major economies with monetary policy fixes to their real economy problems better than this graphic which shows the five year sovereign debt of six countries trading at negative yields.

In other words, investors are paying to hold the debt of these countries. Fundamentally, in a deflationary environment, lenders can make money even with negative interest rates. Further, if market expectations are for further decline in yields, investors can make money by buying even negative yielding bonds as long as their prices keep rising.

The ECB's big bazooka decision to purchase 60 billion euros worth sovereign bonds every month for a prolonged period has jolted central banks outside the eurozone to respond to its potential vulnerabilities. Faced with a weak eurozone and the potential for a break-up of the currency union, speculators have been piling into safer assets of economies like Denmark and Switzerland with the hope of making large profits if those currencies appreciate. Given this and the prevailing deflationary environment, the risks are mainly two-fold - appreciation of currency and accumulation of bad quality assets.

The SNB's decision in mid-January to revoke the euro-franc peg, itself put in place in September 2011 to stem an appreciating currency, was motivated by growing apprehension about the riskiness of rapidly rising stock of eurozone sovereign bonds. The result of revoking the peg was that Swiss franc appreciated over 15% overnight. In order to mitigate the adverse impact on the currency, the SNB simultaneously lowered what it costs lenders to keep money at the central bank from minus 0.25% to minus 0.75%. In contrast, Denmark, which has pegged the krone with euro, appears to believe that the negatives from currency appreciation outweigh the threats from accumulating euro-zone assets. Accordingly, since January the Danish central bank has spent about $24 bn buying euro assets and has lowered rates four times to minus 0.75% on commercial lending.

Sweden and Finland are the latest entrants to the negative interest rate club. The former lowered the benchmark interest rate, the rate at which Swedish commercial banks can take out loans from the Riksbank to minus 0.1%. Last week Finland raised $1.14 bn in a five-year bond auction at minus 0.017%, becoming the first nation in the region to pay negative rates on its debt. Apart from stemming currency appreciation, especially important for countries deeply dependent on exports, negative rates are also aimed at encouraging companies and individuals to invest and spend more and possibly stoke inflation.

It is not just countries that are seeing negative interest rates. Nestle's two year corporate bond, which is due to mature in October 2016, touched the negative territory last week. The eurozone government's austerity programs (and resultant lower deficits) and ECB's sovereign bond-buying program have shrunk the pool of government bonds available for financial institutions (which need safe bonds as collateral for short-term borrowing), forcing them to turn to blue-chip corporate debt. The stock of negative yield sovereign bonds have risen to $3.6 trillion or 16% of global sovereign bonds. See also this and this for more on negative interest rates. 

A sustainable currency union has to embrace some form of political union

The debate surrounding the future of Eurozone, especially how it should redesign its institutions to prevent the recurrence of such crises, is essentially one about what are the pre-requisites for a currency union.

In the context of the ongoing crisis in Eurozone, I have blogged about optimal currency areas and how countries like India manage a single currency zone. In both cases, it is amply clear that some form of fiscal transfers are critical to manage asymmetric shocks faced by members. Such shocks are inevitable when members start out from different economic backgrounds and exhibit considerable heterogenity in their social and political systems. In simple terms, the loss of flexibility with monetary and exchange rate policies that accompanies any currency union will have to be traded off with a mixture of free labour market mobility and fiscal integration. See this brilliant description by Paul Krugman.

The Economist has an excellent graphic of federal fiscal transfers among the 50 American states that puts this in perspective. Would be interesting to have a similar graphic for India!

Derek Thompson in The Atlantic contrasts the difference between US and the Eurozone,

The poorest states like Mississippi, New Mexico, and West Virginia rely on enormous transfers of federal taxes in the form of unemployment benefits and Medicaid. Like the United States, the euro zone is all on one currency. Unlike the United States, the euro zone collects a teensy share of total taxes at the EU level and has no legacy of permanent fiscal transfers from the richer countries, like Germany, to the poorer countries, like Greece.

As Krugman writes, in addition to fiscal transfers and labor mobility, a currency union should also embrace banking union (a single banking regulator and area-wide deposit insurance) and monetary union (mitigate liquidity risk by the creation of a single currency-zone wide lender of last resort). His assessment of Eurozone as a currency union is spot on,

Members of a currency area, it turns out, should have high integration of bank guarantees and a system of lender of last resort provisions for governments as well as the traditional Mundell criterion of high labor mobility and the Kenen criterion of fiscal integration. The euro area has none of these.

Whatever its denouement, as the Eurozone lurches from one crisis to another, there is increasing realization that some form of banking, monetary and fiscal union is inevitable. The latest Eurozone leaders summit saw the first step in a banking union with agreement to replace the 17 national banking regulators with a Eurozone-wide single banking supervisor under the control of the ECB.

This first step to a banking union will be followed by the EU bailout funds being injected directly into Spanish banks (to recapitalize them) instead of the current practice of being routed through the Spanish government's balance sheet. This means Spain can remove the burden of bailouts off its sovereign books. Further, instead of being subjected to Greek-style austerity programmes, these countries will have to maintain their EU debt and deficit commitments, though EU authorities could mandate tighter deadlines and timetables. The bailout funds will also be able to directly buy sovereign bonds in the market and loans from rescue funds would not be senior to existing loans. All this is likely to be followed by the slow introduction of the other elements of a banking union like a Eurozone wide deposit insurance.

If the Eurozone comes out of the current crisis in one piece, or at worst minus Greece, then we can say with some certainty that it would have advanced more down the path of a political union than would have been possible through negotiations and deal-making during the normal times. Historians of European integration will then take the name of Angela Merkel in the same breath as that of Robert Schuman and Jean Monnet. But that's going far ahead in time!

Two summaries of the Eurozone crisis

Simon Johnson has an excellent summary in Economix of how Europe fell into the current mess. Deserves to be quoted at length. He writes, 

The underlying problem in the euro area is the exchange rate system itself – the fact that these European countries locked themselves into an initial exchange rate, i.e., the relative price of their currencies, and promised never to change that exchange rate. This amounted to a very big bet that their economies would converge in productivity – that the Greeks (and others in what we now call the "periphery") would, in effect, become more like the Germans. 

Alternatively, if the economies did not converge, the implicit presumption was that people would move; Greek workers would go to Germany and converge to German productivity levels by working in factories and offices there... In fact, the opposite happened. The gap between German and Greek (and other peripheral country) productivity increased, rather than decreased, over the last decade. Germany, as a result, developed a large surplus on its current account – meaning that it exports more than it imports.

The other countries, including Greece, Spain, Portugal and Ireland, had large current account deficits; they were buying more from the world than they were selling. These deficits were financed by capital inflows (including some from Germany but also through and from other countries). In theory, these capital inflows could have helped peripheral Europe invest, become more productive and "catch up" with Germany. In practice, the capital inflows, in the form of borrowing, created the pathologies that now roil European markets.

In Greece, successive governments overspent – financed by borrowing — as they sought to stay popular and win elections... In Portugal and Italy, the problem is a longstanding lack of growth... As financial markets become skeptical of European sovereign debt, these countries need to show that they can begin to grow steadily – and bring down their debt relative to gross domestic product (something that has not happened for the last decade or so)...

In Spain and Ireland, capital inflows – through borrowing by prominent banks – pumped up the housing market. The bursting of that bubble has shrunk their real economies and brought down all the banks that gambled on loans to real estate developers and construction companies. Their problems have little to do with fiscal policy. As conventionally measured, both Ireland and Spain had responsible fiscal policies during the boom, but they were building up big contingent liabilities, in the form of irresponsible banking practices.

Paul Krugman highlights the importance of fiscal union in the success of any currency union. This is a throwback to something I had written earlier comparing the Eurozone crisis to a similar crisis among a few Indian states and about optimal currency areas. Anyways, Krugman writes,

Greece and Portugal are relatively poor, with GDP per capita of 82 and 77 percent, respectively, of the EU average; this means roughly 76 and 71 percent of the eurozone average, since the euro countries are a bit richer than the EU as a whole. Meanwhile, Germany is at 120 percent of the EU, or 112 percent of the EZ. But it’s no different, really, than the US situation. Alabama is at 74 percent of the US average, Mississippi at 67, with New England and the Middle Atlantic states at 118 and 116.

In other words, as far as underlying economic inequalities are concerned, the EZ is no worse than the US. The difference, mainly, is that we think of ourselves as a nation, and blithely accept fiscal measures that routinely transfer large sums to the poorer states without even thinking of it as a regional issue — in fact, the states that are effectively on the dole tend to vote Republican and imagine themselves deeply self-reliant.

The EMU's spectacular forced risk convergence

Excellent graphic (from The Economic Crisis, via Frances Woolley, via Mark Thoma) about how fear and contagion has erupted across the Eurozone and how the EMU Project contributed to the artificial supression of sovereign risk in its members. I have blogged earlier about how over a four year-period, beginning 1995, the bond yields more than halved and converged around 4% across most of the eurozone economies.

As the pre-EMU Greek bond yields indicate, the low borrowing costs enjoyed by Greece for many years now had merely papered over serious structural inefficiencies. Now these unattended problems are resurfacing with some vengeance as risk gets re-priced at its original level.

How the "Euro penalty" is damaging the EMU?

Europe's immediate challenge is to stave off the possibility of some members not being able to refinance their debts. The bond market yields on government debt of the peripheral economies have been rising swiftly. Markets now perceive the strong possibility of a Euro exit and are pricing in that possibility. And that's being reflected in these higher yields. In the absence of measures to mitigate this concern, a messy unravelling of the Eurozone is inevitable.

In many ways, this run on sovereign debt is surprising. The sovereign debt positions of these economies, except Greece and Italy, is better or no worse than that of many others outside the Eurozone with much lower bond yields. For example, Spain has among the lowest debt-to-GDP ratios among all the major economies. But it is now at the greatest risk of being denied market access for its debt. But United States and Britain with much higher public debt ratios are enjoying historic low cost of public borrowing. Even within Europe, many of the economies outside the Eurozone with higher public debt ratios have much lower yields.

In other words, solvency and economic fundamentals are not at the heart of the issue. All these economies appear to be facing a liquidity crisis. In fact, the financial crisis and economic recession threatens to precipitate a sovereign debt crisis. So clearly, there is something amiss. In his excellent new book, Paul Krugman has this explanation,

Just about every modern government has a fair bit of debt, and it's not all thirty-year bonds; there's a lot of very short-term debt with a maturity of only a few months, plus two-, three-, or five-year bonds, many of which come due in any given year. Governments depend on eing able to roll over most of this debt, in effect selling new bonds to pay off old ones. If for some reason investors should refuse to buy new bonds, even a basically solvent government could be forced into default...

This immediately creates the possibility of a self-fulfilling crisis, in which investors' efars of a default brought on by a cash squeeze lead them to shun a country's bonds, bringing on the very cash squeeze they fear. And even if such a crisis hasn't happened yet... ongoing nervousness about the possibility of such crises can lead investors to demand higher interest rates in order to hold debt of countries potentially subject to such self-fulfilling panic.

The fundamental issue is that all the major economies are backed by their respective central banks which have unlimited cheque writing powers (atleast technically) and are virtual lenders and insurers of last resort. Markets have realized that with the ECB statutorily barred from lending directly to governments, the Eurozone members face no such backstop facility. If Spain or any other country faces a run on their banks, they cannot count on the ECB to step in with emergency cash assistance. Nor can the countries themselves print Euros. Eurozone members, therefore, face a Euro penalty which reflects in their sovereign debt premiums.

In fact, the importance of this is underlined by the manner in which the last round of such panic was redressed with the second round of Long Term Refinancing Operation (LTRO) loans in March. These unlimited three-year loans by the ECB at low interest rates were quickly lapped up by the Eurozone banks and then used to buy sovereign bonds, which in turn experienced a sudden fall in yields. However, once its effects tapered off, market confidence has dipped and yields have been soaring.

Now, instead of this circuitous route, Eurozone needs ECB to explicitly emerge as a lender of last resort. Only this alone can allay market fears and stabilize the sovereign debt market.

Update 1 (9/6/2012)

Nouriel Roubini and Niall Ferguson advocate direct bank recapitalisation (by purchases of preferred non-voting shares of eurozone banks by the European Financial Stability Facility and its successor, the European Stability Mechanism), European deposit insurance (which has to be coupled with appropriate bank levies and a resolution mechanism in which unsecured creditors take the hit before taxpayers money is hit), and debt mutualisation (through some form of Eurobonds) as necessary for any resolution of Eurozone debt problems.

They make the point that the current approach of recapitalising the banks by the sovereigns borrowing from domestic bond markets and/or the EFSF, as was done by Ireland and Greece, leads to a surge of public debt and makes the sovereign even more insolvent while making banks more risky as an increasing amount of the debt is in their hands. Spain, which faces a severe banking crisis, wants the ECB or EFSF to make equity injections directly to the banks, whereas Eurozone officials want it to be routed through the Spanish government with conditions.

The FT reports that under the most widely backed scenario, the eurozone’s €440bn rescue fund would funnel loans to struggling banks through the Spanish government, a condition demanded by Germany to ensure the Spanish state bears ultimate responsibility for paying back the loans.

Update 2 (10/6/2012)

After resisting it for so long, Spain has finally sought a bailout of its banks by the EU. The loan, estimated to be upto $125 bn, to Spain will recapitalize ailing Spanish banks (hit by Spain's property bubble) by shoring up their depleting capital base and will impose no new economic reform conditions on Madrid other than existing EU budget rules. However, it will include financial sector and banking reforms. Spain is the fourth country after Greece, Ireland, and Portugal to seek EU's emergency assistance. However, unlike Spain, all the other three had strict macroeconomic adjustment, including sever fiscal austerity, conditions attached to the bailouts.

The money will be channeled through the Spanish bank-bailout fund, Fund for Orderly Bank Restructuring (Frob), which will funnel the funds to needy banks. The bailout loans would be on Madrid’s sovereign books and the Spanish government will ultimately be responsible and will have to sign the memorandum of understanding and the conditions that come with it. Spain's borrowing costs have been pushed to close to record highs in part because of the problems at its banks, which are struggling under the weight not only of significant losses in their real estate loan portfolios, but also the country’s broader economic malaise.

The decision to seek aid was reached after the IMF issued a 77-page report on the Spanish banking sector that found it was suffering through a crisis “unprecedented in its modern history”. In its report, the IMF also urged Spanish and European authorities to move quickly, strongly signalling that Madrid has not done enough to inspire confidence in the sector’s strength in its recent handling of the crisis. IMF officials recommended new capital injections of at least €40bn, but they noted the weakest banks’ needs “would be larger than this” once all bad loans were accounted for and restructuring costs taken into account.

Eurozone leaders did not specify whether the money would come from the current €440bn rescue fund, the European Financial Stability Facility, or the new €500bn fund, the European Stability Mechanism. It could be a combination of the two, since the ESM is due to go into force next month. Loans from the EFSF do not have preferred seniority status; under the terms of the ESM treaty, however, loans from the ESM take priority over all private sector debt, potentially spooking Spanish sovereign bond markets.

Update 3 (12/6/2012)

Gideon Rachman cautions against the fullscale rush to debt mutualization and argues that there are several important issues to be addressed before taking this step. He writes,

Once you take a big step towards the mutualisation of debt across Europe, you are forced towards much deeper political union. It is not just the much-discussed need for a European “minister of finance”, with the power to override national governments. To avoid bitter disputes over fairness, you would also need to harmonise European social-security systems. That would be the work of decades.

The moral hazard with a Greek exit

With Greece looking certain to default or exit, the critical question is whether it is possible to hold the rest together and maintain stability in Eurozone even after a Greek exit? In this context, John Kay and Gillian Tett point to an existential threat to the single currency union from a Greek exit - the unravelling of the Eurozone's financial integration.

As I have blogged earlier, the build up to the single currency agreement saw a rapid convergence of sovereign risk ratings among the Eurozone economies. Interest rates fell dramatically for the peripheral economies and the bond spreads with German bund dropped. In the firm belief that any Eurozone sovereign debt would be ultimately enjoy collective guarantee of all members, capital moved across borders unhindered. John Kay writes,

When countries joined the single currency, a relatively simple piece of domestic legislation converted contracts in drachmas, pesetas, markkas and Deutschmarks into contracts in euros at a prescribed exchange rate. But you cannot simply reverse that process when countries leave the single currency. You have to prescribe which contracts are now to be fulfilled in drachmas and which remain in euros or converted into Deutschmarks. That determination is politically fraught, technically complex and subject to long legal challenges.

Now that a Euroexit for Greece appears a real possibility, the financial integration process has started reversing. The first indicator of this has been the widening sovereign bond spreads of the peripheral economies (with respect to the German bund) and the near freezing of cross-border inter-bank lending. As speculation about an imminent Greek exit mounts, lenders and investors are looking to cover for cross-border risks. Gillian Tett writes,

Banks are increasingly reordering their European exposure along national lines, in terms of asset-liability matching (ALM), just in case the region splits apart. Thus, if a bank has loans to Spanish borrowers, say, it is trying to cover these with funding from Spain, rather than from Germany. Similarly, when it comes to hedging derivatives and foreign exchange deals, or measuring their risk, Italian counterparties are treated differently from Finnish counterparties, say.

As this trend gathers pace, banks and investors will increasingly seek to match lenders and borrowers within national boundaries. This matching will enable them to cover for the exchange rate and interest rate risks that would surface when Euro-era contracts are forced to be discharged in the respective individual currencies.

This would amount to a virtual repudiation of the process of financial integration that is the objective of the monetary union. Since any Greek exit would put an end to the belief that Euroexit is impossible and would also have laid out the blue-print for any exit, the moral hazard caused by the broken belief would be unleashed.

If this moral hazard gains ground, as it is certain to if Greece exits, it will stretch out the banks across Eurozone. Banks from the core economies, who have large exposure in the peripheral economies, will hasten their deleveraging process. This has the potential to force many of the debt-laden peripheral economies out from the credit markets and send their yields soaring. Wholesale defaults are a strong possibility.

Wolfgang Munchau advocates four steps to mitigate this moral hazard. They are a eurozone-wide deposit insurance scheme with an unequivocal guarantee that deposits will be repaid in euros even if the host country leaves the eurozone; a eurozone-funded resolution trust company with the power to force a recapitalisation of the banks – without national veto; a proper eurozone bond to cover a large portion of outstanding and new debt; and a change in the mandate of the European Central Bank to include specific responsibility for financial stability so that it can conduct secondary market operations.

Taken together, they would mean an effective fiscal union. In fact, the issuance of Eurobonds, which would be guaranteed by all the Eurozone members, would be the strongest signal of the commitment of the members to maintain the monetary union. And, given the inevitability of this moral hazard, the only meaningful way to mitigate it would be to backstop losses by a collective guarantee. But this carries its own risks in the sense that it would amount to the ECB playing its last card and its failure will virtually nail the monetary union. 

What ails Eurozone?

This from Ezra Klein is instructive, 

After it joined the euro area in 2001, Greece went from paying about 7 percent interest on a 10-year bond to a bit more than 3 percent because investors assumed that its debt was backed by Germany and the European Central Bank. This encouraged profligacy in Athens.

When the European economic and monetary union (EMU) became operational from 1 January 1999, all the peripheral eurozone economies experienced windfall gains from the sharp reduction in bond yields and resultant cost of borrowing. Over a four year-period, beginning 1995, the bond yields more than halved and converged around 4% across most of the eurozone economies (see graphics on France, Spain, Portugal, Greece, Italy, Ireland, Belgium).

Governments and, especially, corporates piled up debt, especially by way of borrowings from banks in the core area economies, as they splurged on this sudden access to cheaper capital, triggering off resource mis-allocation and asset bubbles. The boom also led to rise in wages and input prices, with the resultant decline in relative economic competitiveness. Therefore, deleveraging and restoration of external competitiveness is critical to a sustainable resolution of Eurozone's problems.

Update 1 (7/5/2012)

Paul  Krugman has this excellent analysis of how Germany managed its successful reforms last decade. As he writes, Germany benefited hugely from an export boom, driven by a combination of inflation in its periphery and rise in trade competitiveness vis-a-vis its Eruozone partners.

Update 2 (10/5/2012)

Spain is a classic example of a country brought to its knees by reckless private external borrowing. Even today, the government debt as a percentage of the total economic output for Spain is a relatively low ratio of 70 percent, compared with 165 percent for Greece and 120 percent for Italy. But, according to a recent report by McKinsey on global debt, Spain’s nonfinancial private sector debt is 134 percent of gross domestic product, higher than any major economy in the world with the exception of Ireland, where the figures are skewed by the outsize presence of foreign multinationals. Factoring in bank, household and government obligations, the total figure rises to 363 percent of GDP, trailing only Japan at 512 percent and Britain at 507 percent.

Corporates borrowed heavily to invest and to diversify by buying large equity stakes in companies in Spain and elsewhere. Massive public investments in infrastructure helped boost the demand for private supply. The Times writes about a "relentless private sector downsizing in Spain — by individuals weighed down by mortgages and corporations tethered to their boom-time loans — that threatens to make the Spanish economic collapse semipermanent as opposed to cyclical".

Update 3 (23/6/2012)

Jay Shambaugh argues that Euro area is bedevilled by three crises - of banking, sovereign debt, and growth. He writes,

The euro area faces three interlocking crises that together challenge the viability of the currency union. There is a banking crisis – where banks are undercapitalized and have faced liquidity problems. There is a sovereign debt crisis – where a number of countries have faced rising bond yields and challenges funding themselves. Lastly, there is a growth crisis – with both a low overall level of growth in the euro area and an unequal distribution across countries. Crucially, these crises connect to one another. Bailouts of banks have contributed to the sovereign debt problems, but banks are also at risk due to their holdings of sovereign bonds that may face default. Weak growth contributes to the potential insolvency of the sovereigns, but also, the austerity inspired by the debt crisis is constraining growth. Finally, a weakened banking sector holds back growth while a weak economy undermines the banks.

Update 4 (9/7/2012)

Nice article in the Times chronicles how in Spain the regional governments, the regional cajas, and property developers formed a system of trading favors during the boom years. Now that the party is over, the central government is forced to pick up the cost of the revlery.

Why devaluation is the most effective route to regain competitiveness?

As many Eurozone economies face their winter of discontent, there is an intense debate about the best possible route to recovery. Since, the underlying problem is one of eroded competitiveness, its recovery can be achieved either through internal (austerity and wage freezes) or external (currency depreciation) devaluation.

Paul Krugman points to this brilliant description of why external devaluation is a far superior alternative from Milton Friedman's 1953 essay, "The case for flexible exchange rates".



How I wish I could have written that!

However, as Krugman and Matt Yglesias write, some like John Cochrane prefer the ciomplicated solutions.

Update 1 (26/12/2011)

Paul Krugman has this graphic which shows how Iceland could let its currency devalue and achieve a quick 30 percent fall in wages relative to the euro zone.

The Italian mess in a graph

The Eurozone authorities, both governments and the European Central Bank (ECB), have to bear a great deal of the responsibility for worsening the impact of the American sub-prime crisis and the Great Recession and taking the region to the brink of a potential collapse of the Euro project.

The graphic below captures the magnitude of ECB's failure. Even as the Italian economy lurched into crisis, ECB's tight monetary policy squeezed the Italian credit markets. All the three major credit growth indicators plunged steeply.



Update 1 (26/11/2011)

The Times likens the ECB to "a fire department that is letting the house burn down to teach the children not to play with matches". It writes that though the ECB "has a fire hose — its ability to print money... the bank is refusing to train it on the euro zone’s debt crisis". Influential ECB members and Germany believe that ECB cannot be a lender of last resort to backstop falling bond prices and its charter forbids them from using bank resources to finance governments.

Greece's selective default

After prolonged foot-dragging, the inevitable has happened. The Eurozone leaders approved the second bailout of Greece, one that bears clear signatures of a partial default. The €109 bn ($157 bn) bail-out of Greece will force private bondholders to take losses on their bonds through debt swaps, roll-overs and buy-backs. In return, the Eurozone economies collectively guarantee the repayment of Greece's debt principal.

Instead of significant "haircuts", bond holders will now have to accept smaller losses and agree for maturity extensions at lower interest rates. Private bondholders will be required over the next three years to swap or roll over debts for new 15-30 year bonds. Whatever its form, this will ensure that Greece becomes the first western developed world country to default in more than 60 years.

This bailout deal comes after consistent opposition among the main economies, especially Germany, against any form of selective or partial debt default by any Eurozone economy. In the circumstances, the preferred policy was to continuously keep rescheduling Greek debts by swapping it with longer-term bonds in the hope that austerity measures would restore growth and ease the debt burden. It was also argued that this would prevent a run on Greek debt and ensure that Greece and other PIIGS economies were not elbowed out of the nobd markets. However, these measures had failed to reassure the bond markets, especially in light of recent fears of a similar crisis in Italy.

In an attempt to limit contagion effects, the debt deal also contained provisions to enable the European rescue fund, the €440 bn European Financial Stability Facility (EFSF), to assist countries like Spain and Italy that have so far not received any assistance. All three bail-out countries – Ireland, Portugal and Greece – will see rates cut to about 3.5%, or about 100-200 basis points, and will not have to repay the loans for up to 30 years. The EFSF will now be able to buy government bonds (or alternatively lend to these economies) on the secondary market (presumably at a discount rate, compared to the high rates that each of the peripheral economies would have to pay) and to help recapitalize banks, moves long resisted by Germany.

Further, holders of short-term obligations would be able to swap their notes for debt with longer maturities and backed by high-rated bonds. It is expected that 90% of all Greek bonds will be exchanged. The terms of the aid package from Europe to Greece would be eased, with maturities lengthened to 15 years from 7.5 years, at very low 3.5% interest rate. Most encouragingly, the deal also includes a commitment from Europe’s leaders to support Greece until it is able to return to the financial markets – a potentially unlimited guarantee that could see European taxpayers fund Greece for years.

As the FT reports, bondholders will be given four options – three forms of debt exchange and one rollover plan – with different durations and interest rates. The first exchange plan and the rollover would flip existing paper into new 30-year bonds at par value and with interest rates beginning at 4% and rising in 0.5 percentage point increments during the first 10 years to 5.5%.

The other two exchange plans – one for 15 years and the other for 30 – would pay higher coupons of 5.9-6.8% as compensation for taking an upfront 20% "haircut" on the value of the bond. All plans would be backed by an obligation on Greece to reinvest a portion of receipts from the rolled-over or exchanged financing in European AAA bonds, which would act as collateral against default. These bondholder programmes, limited to Greece only, amount to a 21% reduction in the net present value of their current bondholdings, and amount to a selective default.

Though voluntary, it is estimated that upto 90% bond holders will participate. Most major investors and financial institutions have welcomed the plan. Accordingly, private bondholders are expected to contribute €54 bn from mid-2011 to mid-2014 and a total of €135 bn during the period to 2020. On top of all this, an additional €12.6 bn is expected to come in commitments from bond owners to sell their holdings at a reduced price as part of a bond buy-back programme.

The financial institutions that own Greek bonds would effectively contribute 54 billion euros through 2014, largely by accepting reduced interest payments, and will stretch their maturities to as long as 30 years. The plan does not immediately reduce the total Greek debt is 350 billion euros ($496 billion) which form nearly 150% of GDP by much. Greece will benefit by way of reduced interest burden, extended loan maturities, discounted rates for Greek bond repurchases by EFSF, and even some haircuts on debt principals. The benefits are conservatively estimated to shave off atleast €26 bn off the country’s €350 bn debt pile by 2014. Further, the maturity profile of Greek debts will increase from six to eleven years.

The selective default is also an admission of the failure of the fiscal austerity policies. Over the 12 months ending in March, the Greek economy shrank by 5.5%, while unemployment, at 12.2% when the country was first bailed out, rose to 15%. More importantly, it is the first step in acknowledging that the solution to Eurozone problems lies in a fiscal union. The bailout virtually involves fiscal transfers from the better off economies to the beleaguered ones. Further, the EFSF, with its explicit financial stabilization mandate, becomes an effective European Monetary Fund.

The Hellenic sovereign default draws closer

The inevitable sovereign default climax to the Hellenic tragedy appears to get closer with the downgrading of Greek debt by Standard & Poor to CCC. The three-notch downgrade makes Greece’s debt the lowest-rated in the world by S&P and Greece the lowest rated country in the world. This follows Moody’s Investors Service lowering Greece’s credit rating by three notches to Caa1.

Underlining this market belief about a sovereign debt default being only a matter of time, with 85% of respondents in a Global Investors Poll predicting a Greek default. Most investors also feel Ireland, with fiscal deficit at a staggering 32% of GDP in 2010, too will default and atleast one nation will leave the Euro by 2016.

Anticipating this, the Greek CDS spreads and 10 year bond yields have gone up. The CDS spread is close to 1600 points.



The benchmark 10 year government bond yield has touched 17%, shooting up from 13% at the begining of May. Two year bonds are at a staggering 26%.



On the macroeconomic front, Greece has an unemployment rate of 16.2% and fiscal deficit was 10.4% in 2010 and is set to rise. It has financing needs of close to 160 billion euros ($229 billion) through 2014. The government is struggling to get through the latest round of fiscal austerity measures.

It is amazing that Euro area policy makers have let things drift this far. For nearly a year now, even when the Greek bailout was engineered, it was amply clear that without significant restructuring, a sovereign default was only a matter of time. However, on ideological grounds and to avoid causing losses to its own banks (who have massive exposures in the peripheral economies), Germany and other major economies opposed all forms of debt restructuring. It was thought that austerity measures in these economies will bring back macroeconomic stability, increase revenues, and help them repay their debts. The bailouts, it was argued, will help reschedule the loans and insulate Greece from the credit markets for some time.

A year on, things have obviously got worse. The costs inflicted far outweigh the possible benefits of an early restructuring. The Greek economy has contracted far more and debt position worsened, not to speak of the damaging impact on Eurozone economies. A quick and decisive debt restructuring, while temporarily painful, would have avoided this prolonged hemorrhage.

Update 1 (17/6/2011)

Times writes about the steep increase in Greek CDS spreads, "An investor now has to pay about $2 million annually to insure $10 million of Greek debt over five years, compared with about $50,000 on the same amount of United States government debt".



Update 2 (6/7/2011)

Moody’s cut its rating on Portugal’s long-term government bonds to Ba2 from Baa1 or junk status and said the outlook was negative, hinting at more downgrades. Even though Portugal negotiated a $116 billion rescue package in May, the ratings agency cited the risk that the country would need a second bailout before it could raise funds in the bond markets again and that private sector lenders would have to share the pain. It expressed scepticism at the country's ability to meet the challenges it faces in reducing spending, increasing tax compliance, achieving economic growth and supporting the banking system.

The downgrade came a month after a general election in Portugal in which voters unseated the Socialist government of José Sócrates. Since then, the new center-right coalition government, led by the Social Democrats and Prime Minister Pedro Passos Coelho, have pushed ahead with austerity measures and other reforms pledged by Portugal in return for its bailout.

Euro and Germany

Floyd Norris examines the widespread belief that the the big winner from the introduction of Euro has been Germany. He points to an ECB study which finds that since its introduction in 1999, Germany has gained competitiveness, not only against other major industrial nations but against all other members of the euro zone.



The study also finds that over the same period, Germany’s balance of payments has gone from a small deficit to a strong surplus, but in the euro zone as a whole the balance of payments position has deteriorated slightly. Norris writes,

"With the exception of Germany, each of the countries shown has lost competitiveness because unit labor costs have risen more rapidly in those countries. Absent the euro, many of the countries probably would have devalued their national currencies, but that is not possible as long as they remain in the euro zone."

I have already blogged about how decline in competitiveness has played an important contributor to the problems of countries like Portugal and Greece.

Angela Merkel's Eurodenial?

Any country is, among other things, also a currency union. But a currency union can succeed only when complemented with some other factors. Consider this.

Imagine if the city of Bombay (or the state of Maharashtra), which contributes an over-sized share to India's gross tax revenues, refuses to share the taxes collected within its territorial jurisdiction. Or the central government at New Delhi refuses help to beleaguered wheat farmers of Punjab devastated by floods. Or Tamil Nadu restrains Telugu speaking people from Andhra Pradesh working in Chennai and elsewhere in the state.

Any currency union immediately takes currency and monetary policy autonomy out of the equation. You sink or swim along with all others within the union. The problem arises when different areas within the union are at different stages of the business cycle.

Denied off the freedom to lower interest rates (and thereby stoke inflation and lower the real domestic debt burden) or devalue the currency (and thereby increase competitiveness and lower the real external debt burden), the struggling areas need help from outside. They need fiscal transfers from elsewhere to cushion the impact of reduced output and lower tax revenues and there should also be freedom for labor migration that would take the load off the local job market.

The first requires fiscal integration and the second political union. This does raise questions about the difficulty of sustaining a currency union without greater political and financial integration. Bombay or Tamil Nadu cannot have the benefits of a national economy without the costs imposed by fiscal transfers and labor mobility. Similarly, Eurozone economies cannot enjoy the benefits of a currency union without greater political and economic integration.

Fiscal federalism and (less so) labor mobility are the fundamental attributes of any national economy or any successful optimal currency area (OCA). The critical component of fiscal federalism is the transfer of resources across areas - from the well-off (or resource-rich or economically vibrant) to the poorer areas - and to those experiencing output declines and job losses during downturns.

In the circumstances, the intransigence of Angela Merkel on any efforts towards stronger fiscal integration of Europe is baffling. A case of Eurodenial?

Update 1 (25/1/2011)

French finance mininster Christine Lagarde too is not too keen and sure about closer fiscal integration within Eurozone.

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.

Restoring competitiveness in PIIGS

An article in the Economist points to erosion in competitiveness suffered by the peripheral economies over the past decade. It writes,

"In the decade and a half before the crisis, countries such as Greece, Ireland, Portugal and Spain lost a lot of competitiveness. Low interest rates led to a surge in domestic demand. That, coupled with rigid labour markets in some places, led to sharp rises in nominal wages. At the same time productivity growth was not vigorous enough to compensate. By contrast, for a decade after its reunification boom turned sour in the mid-1990s, Germany took bitter medicine, holding wages down and boosting productivity. The result was a steady erosion of the peripheral countries’ competitiveness, especially relative to Germany."

This again draws attention to the difficulty of maintaining competitiveness in a single-currency union. External competitiveness depends on prices, which in turn is a function of exchange rate and cost of production. The former, which is the commonest instrument to manage export competitiveness, in unavailable for eurozone members. This leaves them with adjusting the cost of production by managing prices of goods and services and wages - internal devaluation. This can be done either by negative or slower price and wage growth (which carries the dangers of deflation), or increased productivity growth rates.

Increasing productivity, especially to the extent required to make any meaningful dent on real prices, may be difficult to achieve. This leaves with deflation as the only option available. However, as the Economist article highlights, the experience with deflation in other countries has not been very satisfactory. Deflation also carries the risk of increase in the real value of the already unsustainable debt burdens of the peripheral economies.

Further, far from any deflation, the peripheral economies today face a greater threat from inflation. The higher than eurozone average inflation rate in peripheral economies mean that their competitiveness relative to the others, especially Germany, is declining further. All this means that the options available for the troubled economies are limited and exit looks increasingly inevitable.

Further, as the graphic also indicates, external competitiveness is critical for the peripheral economies to not only match Germany, but also compete with China in many export markets.

In this context, Dani Rodrik, one of its supporters, has opined that "an amicable divorce is a better option than years of economic decline and political acrimony" and suggests that members "can rejoin, and do so credibly, when the fiscal, regulatory, and political prerequisites are in place".

EU and US - divergent policy responses

Here is my op-ed in Mint about the divergent policy responses to the crisis facing the Greek economy. The backgorund material is available in the links here.

Comparing sub-prime bailout with Greek crisis

Historians and economists will surely judge the recent sub-prime meltdown and the Euroland crisis as classic studies in contrast. The contrasting policy responses to these two systemic risk generating events are reflective of a deep ideological divide - intervene swiftly and massively to limit damage or wait and watch while the dynamics of the market plays itself out. This also points to the deep limitations of macroeconomic policy making and the lack of any unanimity among policymakers in effectively responding to such crises.

The EU and IMF may have finally cobbled up a 110 Euro (or $140 bn) joint bailout of Greece, but it is increasingly looking like a "band-aid on a corpse".

Assume Greece is AIG, Portugal is Wells Fargo, Italy is Citibank, Spain is Bank of America, and so on. In fact, bellweather Iceland may be seen as the Lehman of Europe. There are striking similarities between them, as they faced existential crises and generated an explosion of systemic risk. The large leverage that those firms ran up is similar to the unsustainable debt burdens of these European economies. These firms posed the "too-big-to-fail" problem, whereas the economies pose the "too-interconnected-to-fail" (German, French, and British banks own the bulk of Greek debt) challenge.

However while there are striking similarities in the problems facing them, the remedial actions taken by policymakers to address the respective situations could not have been more starkly different.

In response to the "mother of all credit squeezes" that followed the sub-prime meltdown, the US Federal Reserve, and the Bush administration first and then the Obama administration, moved in swiftly to contain the crisis. They hurled every available policy option at the problem ("shock and awe" the financial markets) and the Fed emerged as the lender and insurer of last resort. Even though the bailout programs changed course repeatedly, were characterised by much confusion and lack of clarity, and faced widespread criticism, the central thrust of bailing out the beleaguered financial institutions remained a constant. It is by now widely-acknowledged, that the swift action to bailout financial institutions and its enormity, have been responsible for averting a disastrous, long-drawn out meltdown of the financial markets and ensuring that Wall Street returns to some semblance of normalcy quickly.

In stark contrast, the response to the Euroland crisis has been marked by indecision, a stubborn refusal to confront the reality and the recent example of US bailouts, and a reluctance to commit anything other than the barest minimum of assistance to keep Greece afloat. The ECB has been virtually paralysed, deeply constrained in carrying out any monetary expansions by the rigidities inherent in the Stability Pact and its own ideological reluctance to undertake such operations. In the absence of a powerful enough central executive, the larger Euroland members, led by Germany, have been loath to volunteer with any assistance, in the mistaken belief that it was Greece's problem and any largesse would engender moral hazard.

Unlike the Bush and Obama administrations, the Germans and French governments have shown a remarkable preference to let Greece fail, strongly rationalizing against picking up the tab for Greece's indiscretions. This is all the more surprising given the fact that any Hellenic default, could devastate their own massively over-exposed banks. A recent estimate by the New York Times pointed out that the German, French, and British banks own $704 bn, $910 bn, and $420 bn respectively of Greek, Spanish, Portuguese, Italian and Irish debts (PIIGS). Therefore letting Greece default and force a "haircut" on its bondholders would be tantamount to cutting the branch while sitting on it.

Adding to the interconnectedness tangle is the fact that the banks from PIIGS themselves own large amounts of debts in each other. And dramatically amplifying the problem and giving it a global dimension is the fact that United States banks have $3.6 trillion in exposure to European banks, according to the Bank for International Settlements. That includes more than a trillion dollars in loans to France and Germany, and nearly $200 billion to Spain.

If worries about the safety of European banks intensify, it could push up their borrowing costs and push down the value of more than $500 billion in short-term debt held by American money-market funds. Uncertainty about the stability of assets in money market funds signaled a tipping point that accelerated the downward spiral of the credit crisis in 2008, and ultimately prompted banks to briefly halt lending to one other.

The Times has an excellent article that sums up the challenge facing the EU about the need to speed decision-making before irreversible damage is done and the euro itself slips into history,

"The delays are inevitable, most experts say, stemming from the nature of the European Union and its own institutional voids: no single government, no single treasury, no effective fiscal coordination, no mechanism for crisis management.

Every major decision on the euro must be negotiated among member states and European institutions, a torturous process that also plays up political fissures both within and among member countries. That breeds uncertainty and even panic among investors, who already doubt that the Greek deal that the European leaders finally sealed on Friday night will forestall an eventual restructuring of Athens’ crippling debt."

In the deeply interconnected global financial market, where market confidence can erode with spectacular speed, and contagion effects can be amplified dramatically, a "wait and watch" game can be fatal. In fact, it is now certain that the costs, to everyone including the Germans, of the inevitable default-cum-bailout of Greece will be many times more than what would have been required if a large enough debt restructuring bailout was executed at the first signs of the crisis. In many respects, given the strong moral hazard effect on other beleaguered peripheral economies, Europe will be facing the worst of all worlds now with its late bailout of Greece.

Both these events are testimony to the fact that the cascading effect of crashing market confidence can be far more damaging than the moral hazard concerns and dangers of "socializing private losses" generated by any swift tax-payer sponsored bailout. Once the crisis breaks out, a delayed response will only exacerbate the problems and leave policymakers to traverse a path which is both longer and more inclined, before some semblance of normalcy can be restored.

As economists like Paul Krugman have argued by pointing to the wage and price increases of these economies with resultant erosion of external competitiveness, the origins of the Euroland crisis goes much beyond the large national debt burdens. The Stability Pact, governing the rules of macroeconomic management of Euro members, and the single currency, have meant that the individual members do not have access to any of the conventional monetary and exchange rate tools - like lowering rates, stoking inflation, or even devaluation - to address such crises.

The Euro Project therefore highlights the ineffectiveness of economic union without much greater political integration. They underline the importance of a strong central co-ordinating power and fiscal authority within the EU, apart from a more powerful European Central Bank, with greter willingness to effectively manage such crisis. Some have suggested setting up of a European Monetary Fund to combat debt and balance of payments crisis among EMU members.