Spiegel Online is reporting that Germany is considering holding a referendum to transfer more powers to Brussels.
Click below to go to the article:
This is definitely a step in the right direction.
Meanwhile The Economist is reporting of a plan of a Euro Area breakup by Germany! Click to read the article.
Seems fictitious!
Earlier this year Paul Volcker said that “Europe is at an Alexander Hamilton moment”. Barry Eichengreen – who sometimes writes nicely – wrote this today in an article titled Europe’s Divided Visionaries:
… One strategy assumes that Europe desperately needs the policies of this deeper union now. It cannot wait to inject capital into the banks. It must take immediate steps toward debt mutualization. It needs either the ECB or an expanded European Stability Mechanism to purchase distressed governments’ bonds today.
Over time, according to this view, Europe could build the institutions needed to complement these policies. It could create a single bank supervisor, enhance the European Commission’s powers, or create a European Treasury. Likewise, it could strengthen the European Parliament. But building institutions takes time, which is in dangerously short supply, given the risk of bank runs, sovereign-debt crises, and the collapse of the single currency. That is why the new policies must come first.
The other view is that to proceed with the new policies before the new institutions are in place would be reckless. Mutualizing debts before European institutions have a veto over fiscal policies would only encourage more reckless behavior by national governments. Proceeding with capital injections before the single supervisor is in place would only encourage more risk taking…
Bloomberg investigates if there is an Alexander Hamilton in Europe: (edit: video no longer available.)
Paul Krugman was in Spain recently.
In this video which has a lot of discussion on the European crisis, Krugman says that the ideal solution for the Euro Area will be federal but doesn’t hope to see it in his lifetime unless advances in medical sciences is made which will make him live longer. (Time: 1:22:36)
click to watch the video on YouTube
He rightly points that a degree of trust required to do so.
This is lacking and someone really needs to build this!
Also, from NIESR (link updated to one from July 2014, as the original link doesn’t work), the pace of the recovery compared in various deflationary episodes in the UK’s history:
My previous post “Not In My Lifetime” – The Muddled Road Toward An Integrated Europe had some responses – mostly saying I was too kind to Angela Merkel and Wolfgang Schäuble and that ceding powers to a supranational authority will lead to imposing of draconian rules!
Meanwhile I came across these two articles from France 24: Europe needs ‘reinforced political union’, says Merkel and Merkel rejects debt-pooling proposal ahead of EU talks. According to the first article:
“We need more Europe… a budget union… and we we need a political union first and foremost,” Merkel told German public television. “We must, step by step, cede responsibilities to Europe.”
My answer is while the German leaders have panicked and imposed severe austerity rules on nations due to pressures from the financial markets, their intention of having “More Europe” is certainly a good one. It took me a while to understand that it’s Germany which is open to having a full integration while others do not. There’s a lack of trust here, given what has happened over the past 2-3 years.
There are three ways to approach the crisis as I see it.
The first is to impose trade barriers on each other. This gives fiscal policy more room to expand domestic demand without running into a balance of payments crisis (again) and the European Central Bank can act as the lender of the last resort if it were to understand that the stocks of debts would be sustainable. However imposing barriers is against the philosophy of the “common market”. Hence this is ruled out.
The second is to coordinate a fiscal expansion with the ECB acting as a lender of last resort if needed. But how does this coordination happen and on what terms? This also requires institutions and will require summit after summit – if previous experiences are any guide.
The third is the German plan to have a supranational fiscal authority which is given the power to make expenditures and earn via taxes. In my opinion this is what Germany is looking for and not a small institution which is obsessed with balanced budgets and no fiscal powers. Of course if there is a supranational fiscal authority the nations may have to balance budgets(!) while this institution itself runs a deficit and is involved in substantial transfer of fiscal resources (quite opposite of what Charles Goodhart thinks!).
Economists such as Nouriel Roubini object to the German plan citing surrendering of sovereignty as the reason. It should however be noted that by signing the Maastricht Treaty Euro Area nations have already surrendered their sovereignty. Now, they could either cede more powers to “Europe” or (since there is a lack of trust) decide to break the Euro Area.
There are advantages of breaking up but it will be a terrible thing for Europe. It is also unclear how it can be implemented – given that at some level the Euro Area is integrated. With a lack of trust, this may be the best thing to do but in my opinion, it is the task of the European leaders to work toward gaining each others’ trusts.
The reason Angela Merkel has rejected the “debt pooling” plan of Herman Van Rompuy, José-Manuel Barroso, Jean-Claude Juncker and Mario Draghi (and also pushed by George Soros) is that it really does not solve anything except satiating the instant gratification wants of the financial markets. The Germans haven’t rejected the €-bonds per se.
Merkel’s plan – what’s called transfer union in Germany may meet with substantial opposition by German citizens. The Germans tend to think that they will be paying higher taxes without knowing that at the same time their incomes will be higher because the new union will be substantially less deflationary. A referendum may likely fail and this remains a challenge. The Euro Area needs an Alexander Hamilton as Ronald McKinnon argued recently.
My purpose of writing this post was to point out the in the media – especially the financial media – Germany is shown to be the villain. For example I think Wolfgang Munchau – who generally writes well said this in the Financial Times (The real victor in Brussels was Merkel)
The most important event last week was probably not the agreement at the summit anyway, but the statement by Ms Merkel that there will be no eurozone bonds “for as long as I live”. My belief is that this statement reveals she is not serious about political union, to which she has been paying lip-service over the past few weeks. Her tactics remind me of the “coronation theory” of the 1980s: the Bundesbank used to say that monetary union was acceptable but only after full political union was completed. It was another way of saying never. I always suspected all this talk about long-term solutions might be a ruse. Now, it seems, we know.
If Ms Merkel is right and there are no eurozone bonds in her lifetime, the eurozone will not survive. Without eurozone bonds or a change in ECB policy, Italy’s and Spain’s debt – and eurozone membership – is not sustainable. That was as true on Wednesday as it is today.
This is a slight misrepresentation of Merkel because she said that there will be no €-bonds in the plan presented in the last week’s summit (which didn’t have a common fiscal policy) and hence not without any qualifications.
Both Angela Merkel and the German Finance Minister Wolfgang Schäuble have been quoted in the media as saying that they won’t go ahead with the “€-bills” and plans like that in their lifetime! Of course such quotes are incompletely reported and what they mean is that they won’t have a plan such as that without a common fiscal policy.
In the ongoing Summit, European leaders came up with a few plans which led to financial markets rallying. The Italian FTSE MIB Index was up 6.59% today!! There was one plan which didn’t take off and this was the plan of having a “redemption fund”. The formal proposal is here: TOWARDS A GENUINE ECONOMIC AND MONETARY UNION Report by President of the European Council Herman Van Rompuy
Of course this didn’t go through because the two German leaders wouldn’t have allowed it in their lifetimes! So what does Germany really want?
To understand this we must first understand that – as argued by Wynne Godley in 1992 – to join a monetary union nations should surrender their sovereignty with this sovereignty being taken over by a supranational authority (which was absent in the Maastricht Treaty):
I recite all this to suggest, not that sovereignty should not be given up in the noble cause of European integration, but that if all these functions are renounced by individual governments they simply have to be taken on by some other authority. The incredible lacuna in the Maastricht programme is that, while it contains a blueprint for the establishment and modus operandi of an independent central bank, there is no blueprint whatever of the analogue, in Community terms, of a central government. Yet there would simply have to be a system of institutions which fulfils all those functions at a Community level which are at present exercised by the central governments of individual member countries.
The counterpart of giving up sovereignty should be that the component nations are constituted into a federation to whom their sovereignty is entrusted. And the federal system, or government, as it had better be called, would have to exercise all those functions in relation to its members and to the outside world which I have briefly outlined above.
Merkel and Schäuble want to move ahead with the full creation of a federation – presumably headquartered in Brussels and they have the task of managing the fiscal decisions for the whole of the Euro Area. Since this institution will run deficits, it is natural that it will finance the difference between expenditure and taxation by issuing bills and bonds (which will be the real €-bonds). Hence the two leaders have qualified their statements but this has been quoted everywhere as some kind of comedy of errors!
The two leaders have the double task of convincing the German politicians and German public on the one hand and politicians from the rest of the Euro Area on the other hand. In the middle of this, they see this plan from Herman Van Rompuy, José-Manuel Barroso, Jean-Claude Juncker and Mario Draghi adding to confusions. The plan from the four EU leaders still has no supranational institution which makes financial decisions for the whole Euro Area but only a special purpose entity presumably retired after 25 years.
The important difficulty in the creation of a supranational institution which will manage the finances of the whole Euro Area (and not any “sinking fund”) is that the current setup is an incomplete one where nations’ governments still have a good amount of power in spite of them having surrendered most of their sovereignty.
While convincing the German citizens may be a hard task, Merkel and Schäuble are facing difficulties also in convincing other European leaders. Other nations do not wish to surrender whatever powers they still have but in the process do not understand what an integration means. Their leaders could have chosen to not join the Euro Area – just like what Mrs Thatcher did for the UK. Now that they have joined it and given it is difficult for any one nation to leave, it is in their best interest to go ahead with the full integration which has a supranational fiscal authority but this comes with surrendering more powers!
As Wynne Godley argued further:
If a country or region has no power to devalue, and if it is not the beneficiary of a system of fiscal equalisation, then there is nothing to stop it suffering a process of cumulative and terminal decline leading, in the end, to emigration as the only alternative to poverty or starvation. I sympathise with the position of those (like Margaret Thatcher) who, faced with the loss of sovereignty, wish to get off the EMU train altogether. I also sympathise with those who seek integration under the jurisdiction of some kind of federal constitution with a federal budget very much larger than that of the Community budget. What I find totally baffling is the position of those who are aiming for economic and monetary union without the creation of new political institutions (apart from a new central bank), and who raise their hands in horror at the words ‘federal’ or ‘federalism’. This is the position currently adopted by the Government and by most of those who take part in the public discussion.
As Jim O’ Neill of Goldman Sachs mentions in a recent interview to Bloomberg, the Germans are open to this but unfortunately, the French have objections to this route.
In the above video (edit: no longer available), O’ Neill (jokingly called Governor O’Neill by Tom Keene of Bloomberg because he is said to be the top man for the post of the chief of the Bank of England when Mervyn King’s term ends soon) argues the Europeans are known to leave it till the last moment – when it’s on the brink. Till then they will continue to muddle. Unfortunately for Merkel and Schäuble, solving short term issues makes the financial market conditions ease substantially, the opposite of what they want, because only when other Euro Area nations are in a lot of trouble will they be ready to accept the German solution. Of course this is a sad way to solve the problem but Schäuble has been quoted in the press saying that the EA needs a crisis to make any progress.
Unfortunately the financial markets rally!
How ironic!
There’s an interesting conversation between JKH and Marshall Auerback here on the constitutionality of TARGET2 balances of the NCBs of the Euro Area.
Rather than intervene in the comments, I thought I will let them exchange comments because I am not sure why Marshall Auerback thinks these are unconstitutional and more generally where he is headed in his series of posts. Links from Robert M Wuner who collects all the articles on TARGET.
The mechanics of TARGET2 are explained quite well in this ECB legal document GUIDELINE OF THE EUROPEAN CENTRAL BANK of 30 December 2005 on a Trans-European Automated Real-time Gross settlement Express Transfer system (TARGET)
It cannot be otherwise!
I had a comment by Alea (@Alea_) and since I don’t publish comments, I am posting it here. It is the opposite of what I thought.
Your guideline refers to TARGET and has been repealed. There aren’t any unlimited and uncollateralised credit facility between NCBs under TARGET2.
Ramanan here. Thanks Alea for commenting.
This seems right.
The ECB site for ECB/2007/2 has this:
I am still reading ECB/2007/2 and wonder how it changed it and if there is any dope on this – such as setting limits on TARGET2 flows.
According to Article 15 of Section IV of the ECB/2007/2, interlinking provisions of ECB/2005/16 continue to hold.
Hence it seems NCBs and the ECB indeed have unlimited and uncollateralised credit facility with each other!
Beate Reszat has written a very nice article on TARGET2 Target2 – Q&A which should be read by anyone interested. The article seems to be in response to a speech by George Soros earlier this month in Italy. The link appears in her post and the relevant section of the transcript quoted.
Although it is a very informative article, I think the writer gives a misleading picture by disagreeing with George Soros.
For a background, the whole debate started when a German Professor Hans-Werner Sinn wrote an article The ECB’s Stealth Bailout which led to a series of attacks from academicians to bankers to central banks seriously questioning Sinn. Sinn’s arguments are full of errors but this brought into focus the TARGET2 claims of creditor nations’ NCBs and the risks that this asset may “disappear”.
Critics of Sinn learned the TARGET system and to my surprise, their description had a lot of features on money endogeneity – surprising since most of these writers err on describing one pole (of the two poles) of money endogeneity – that between banks and their central bank.
In the end, the critics claimed victory – although powerful persons such as George Soros and Jen Weidmann of Bundesbank understood and saw the situation slightly differently. Even Martin Wolf who has differences with Weidmann on the German economic strategy – rightly in my view – agrees that it may lead to losses to Germany in case of debtor nations leaving the Euro Area.
(By the way this link by Robert M Wuner has the complete list of articles on the TARGET2 debate).
Now, I have myself written a set of articles on this: The Eurosystem: Part 1, Part 2, Part 3, Part 4, & Part 5.
On the specific issue about creditor nations taking a loss see this post: Who Is Germany and Deutsche Bundesbank’s TARGET2 Claims.
While it is difficult to summarize the whole debate, the point which comes to mind is that while those who have written about the TARGET2 system in a more technically correct way (central bank articles, banks’ research publications, academicians), they are seriously misleading. Some don’t see it while – in my opinion – the Eurosystem authors see it and downplay the risks.
So here’s from Beate’s article:
If the country in question refrains from staying connected to Target2 and, at the same time, is abandoning the ECB – in my understanding (but we must ask the jurists to find out) its paid-up capital will have to be returned plus its share of profit, or minus its share of loss according to a consolidated closing balance sheet and profit and loss statement.
Now this is serious underplay. She concludes:
The way the issue of Target2 balances is discussed in public is most regrettable. The ever new records of unmanageable bilateral debt allegedly heaping up in the system arouse fears which are wholly unreasonable and stand in the way to finding a viable crisis solution. Two points should be kept in mind: Monetary policy matters such as the creation of central bank money must not be confused with the process of payment and settlement of central bank money, and intra-group payment flows as part of the normal business of the system must not be confused with profits and losses.
At closer inspection, the €2 trillion debt scenario conjured up by some observers in an utterly irresponsible way is evaporating into thin air and the euro crisis – although still a very serious problem and a big challenge – appears as one that probably can be handled.
The error in analysis such as this is that of not thinking of “money” as simultaneously as an asset and a liability.
It is best to think of the creditor nations as a whole so that the complication of “capital key” can be avoided. In my post Who Is Germany I argue that the exit of debtor members of the Euro Area will lead to losses for the creditor nations because the debtor nations will not be able to pay the Euro-denominated TARGET2 liabilities. This appears via a direct loss on the central banks’ balance sheet. And since this is a loss of the balance sheet of a nation (or a group of nations as a whole), it is plainly incorrect to argue that it does not matter or that Soros is wrong. The complication of “capital key” is a bit of a sideshow – if Germany’s losses are less than its TARGET2 claims, other NCBs lose. It is true that the Bundesbank may be capitalized by the German government – in case – but no amount of domestic transaction can change the external assets (of Germany as a whole). The fact that it is a loss to Germany can be seen by looking at the International Investment Position. If the Bundebank loses its TARGET claims, it is a loss for the whole nation. As the chapter 7 of the IMF’s Balance Of Payments And International Investment Position Manual (BPM6) says:
The IIP is a subset of the national balance sheet. The net IIP plus the value of nonfinancial assets equals the net worth of the economy, which is the balancing item of the national balance sheet.
In fact, George Soros’ argument is that since exits of debtor nations from the Euro Area will lead to serious losses to creditor nations, this has the effect of forcing the latter – especially Germany – to do something and in fact in leading them to move toward higher integration! (as a title of his recent article The Accidental Empire from Project Syndicate suggests).
To the point of Beate Reszat’s dislike for the phrase – “evaporating in thin air”, the BPM6 and the 2008 SNA use similar terminology – “appearance and disappearance of assets”!
In exchange rate agreements and arrangements such as the ERM I and II, central banks would risk running out of foreign reserves in case of a speculative attack on the currency. They may commit to each other on defending the exchange rate but in extreme cases, the agreements may lose their significance.
When I saw first this guideline on the ECB Website on TARGET (on NCBs and the ECB providing unlimited and uncollateralized credit facility to each other) – a couple of years back – I was a bit shocked but later seemed to make sense:
In return, the Euro Area member nations had to irrevocably lock in exchange rates as per this nice article on TARGET by Peter Garber in 1998: Notes On The Role Of TARGET In A Stage III Crisis (h/t Tom Hickey). Garber also has another interesting article (a special report from Deutsche Bank) The Mechanics Of Intra Euro Capital Flight, December 2010.
According to Garber in the previously existing Very Short Term Financing Facility (VSTFF), central bank of the nation seeing private inflows theoretically has to provide unlimited credit to the central bank of the nation seeing private outflows.
The VSTFF is a facility to be used if serious intervention is necessary to preserve official bilateral bands in the Exchange Rate Mechanism. Under the Basle-Nyborg agreement, the weak currency central bank is to intervene in the exchange markets to prevent the exchange rate from breaching the band. The strong currency central bank is responsible for providing credit to the weak currency central bank through the VSTFF, theoretically in unlimited amounts but in fact limited by the effect on the strong currency central bank’s monetary policy.
More in the paper. Of course, Garber is incorrect in assuming that the central bank providing credit loses control of its monetary policy. (Expect a future post on Sterilization). Anyway interesting paper – especially on how capital flight from the “periphery” before a breakup can lead to huge losses for the creditor Euro Area nations.
In an article today Europe Mulls Major Step Towards “Fiscal Union”, Reuters reports that Angela Merkel is pushing for a “giant leap forward”:
After falling short with her “fiscal compact” on budget discipline, German Chancellor Angela Merkel is pressing for much more ambitious measures, including a central authority to manage euro area finances, and major new powers for the European Commission, European Parliament and European Court of Justice.
She is also seeking a coordinated European approach to reforming labor markets, social security systems and tax policies, German officials say.
Until states agree to these steps and the unprecedented loss of sovereignty they involve, the officials say Berlin will refuse to consider other initiatives like joint euro zone bonds or a “banking union” with cross-border deposit guarantees – steps Berlin says could only come in a second wave.
“Kaldorians” jumped to highlight the serious defects in the European plan for integration when officials were working on the Maastricht Treaty. One of the implicit assumption on which the dogma of “free trade” is pushed is that current account deficits do not matter. The government’s task is to only make markets free in this view. The Euro Area was formed with the highly incorrect notion (among various others) that nations can simply solve their “balance of payments problem” by getting rid of it altogether.
I was reading this article by Ken Coutts and Wynne Godley from 1990 [1] where the authors point to different kinds of arguments put forward by others to defend this position (“current account deficits do not matter” provided markets are made free).
There appear to be six different lines of argument to the effect that the current account deficit can be ignored …
… (v) A different kind of argument makes a comparison between a nation with an external deficit and a relatively poor region within a nation. It is pointed out that there is no balance of payments problem for Scotland or for Northern Ireland and from this it is concluded that as soon as Britain joins a European monetary union its balance of payments ‘problem’ will disappear permanently …
… The argument (v) that a region within a country cannot have a balance of payments ‘problem’ ignores the fact that if a region imports more than it exports its trade deficit is automatically paid for by fiscal transfers.[footnote: Strictly speaking, the fiscal transfers will always exactly compensate for any trade deficit only after allowing for the acquisition of financial assets by the private sector as implied by the ‘New Cambridge’ identity (exports less imports equals net government outlays plus the ‘trade’ deficit). The identity says, of course, nothing whatever about the level of real income and output which trading performance will have generated]. The point may be illustrated by considering an extreme case where a region consumes tradables but cannot produce them at all. In this case there will be a trade deficit exactly equal to imports of tradables, but the flow of government expenditure and net transfers will provide a minimum level of income support and keep life of a kind going without any borrowing at all taking place. If an uncompetitive region were not in receipt of fiscal inflows, its inhabitants would have no alternative but to emigrate or starve. This example illustrates that merely by sharing a common currency with another area, a region or country does not automatically dispose of its balance of payments problems since its prosperity still depends on how successfully it can compete in trade with other areas. The Delors Report itself correctly observes that a monetary union transforms a weakness in the ability to compete successfully from being a balance of payments problem into a regional problem to which there is only likely to be a solution by using the instruments of regional policy.
The movement toward more integration by giving higher powers to the European Parliament was also suggested by Wynne Godley and Marc Lavoie in 2007 [2]:
… Alternatively, the present structure of the European Union would need to be modified, giving far more spending and taxing power to the European Union Parliament, transforming it into a bona fide federal government that would be able to engage into substantial equalisation payments which would automatically transfer fiscal resources from the more successful to the less successful members of the euro zone. In this manner, the eurozone would be provided with a mechanism that would reduce the present bias towards downward fiscal adjustments of the deficit countries.
References
According to a Wall Street Journal article from yesterday Cyprus Seen Close to a Request for Bailout, Cyprus (2011 GDP: €18bn approximately) is set to become the fourth Euro Area nation to seek a bailout after Greece, Ireland and Portugal. According to the WSJ:
Late last year, the country negotiated a €2.5 billion ($3.1 billion) bilateral loan from Russia. Now, Cyprus is in talks with China for another bilateral loan, of an undisclosed amount, that looks unlikely to materialize in time.
Had to go into trouble considering that economists have been realizing that the Euro Area problems is an internal balance of payments crisis.
The closest proxy for a nation’s net indebtedness is the net international investment position (as opposed to “external debt” which excludes equity held by nonresidents). Here’s the chart as of 2011: the NIIP is at the end of 2011 and the GDP is the gross domestic product for the whole year.
(click to enlarge)
Note: Greece’s NIIP improved in 2011 (from minus 100% of gdp) due to large revaluation losses suffered by foreigners as Greece financial markets fell in 2011.
The financial markets is now nervous about Spain and Slovakia’s next in the line if the graph is to be believed and it’s external position is in dangerous territory also – at minus 64%.
According to Wynne Godley, anything between 20-40% of net foreign indebtedness can be highly dangerous. Of course his models also show that there is nothing intrinsically stopping such imbalances from continuing and can go on as long as foreigners do not mind but something has to give in – such as slower growth to prevent the imbalances from continuing before foreigners start minding or a crash.
At this point, Slovakia doesn’t seem to be in trouble with its generic 10-year government bond yield at 3.645% – with its public debt at 43.3% of gdp at the end of 2011 according to Eurostat. This of course means that the domestic private sector is a net debtor (i.e., its financial assets is lesser than its liabilities). A more detailed analysis is required on how internal imbalances will play out and spill over to the external sector. Here’s from Statistical Appendix of the “Alert Mechanism Report”.
(click to enlarge)
Moving on to something different:
Heteredox Economics In Playboy!
Via Twitter:
click to view the tweet on Twitter
John Cochrane of Chicago calls heteredox economists “kooks” and claims he and his colleagues use rigorous models!