Eurozone: is this the big one?

I'm scared again. I haven't felt this scared for over a year. Things were starting to look better, in Canada in particular, but around the world more generally. Now Greek bond yields are shooting up.

I was worried about the Eurozone in January 2009. And again in December. Maybe it was just my Euroskeptic "Anglo-Saxon" genes talking, but those old posts read quite well today. I mentioned my worries again in January 2010, when I made my New Year's forecast for Canada. "My main worry is that something will go badly wrong in Eurozone financial markets. I find it very hard to predict how that would affect Canadian financial markets."

That's what I want to try to do now: predict how the fallout will affect the rest of the world, including Canada.

The main problem with the Eurozone is that there's a central bank, but no central fiscal authority. To paraphrase Kissinger, "Who do I call, if I want to talk to the Eurozone?". (Or Gertrude Stein "There's no there there"?) They can't coordinate monetary and fiscal policy. The Bank of Canada can buy Canadian Federal government bonds. It can even buy Canadian Provincial government bonds, if it feels it really needs to. The Bank of Canada and the Federal government can decide whether or not to bail out a Canadian bank or province. Ultimately, the Canadian monetary and fiscal authority are spending out of the same pot. They can decide to deal with, or not deal with, a liquidity and/or solvency crisis. There's nobody in the Eurozone that can make that decision. The ECB holds Greek government bonds as colateral when it expands the monetary base. And commercial banks both inside and outside Greece hold those same bonds. Who bails out what if Greece defaults? And what if the liquidity/solvency crisis spreads to other Eurozone countries?

It's difficult to know what will happen in the Eurozone. My own guess, for a worst-case scenario, is that we will see multiple Argentinas. No country will want to leave the Euro, but some might have no choice. The only way for a government to pay wages will be in scrip. That scrip will become a new national currency. They will rewrite the laws to make debts payable in the same national currencies.

It's harder still to see how a Eurozone crisis will affect the rest of the world, and Canada.

My own event study, using the time-honoured "eyeball method", suggests that a Eurozone financial crisis will raise the exchange rate of the US dollar against the Euro (obviously), but also (less obviously) raise the US dollar against other non-Euro currencies, like the Loonie. Presumably because the US dollar is, by social convention, the ultimate liquid asset, and the Loonie isn't.

Since Canada does much more trade with the US than with the Eurozone, a Eurozone crisis would probably depreciate the Loonie on a trade-weighted basis. By itself, that would tend to raise Canadian aggregate demand. But the Eurozone is big enough to affect world aggregate demand, and directly or indirectly the demand for Canadian exports, including commodity prices. The net effect could go either way.

Then there's the effect on Canadian financial markets. As far as I know, Canadian financial institutions are not especially exposed to Eurozone assets (anyone know better?). But financial contagion, in a liquidity crisis, seems to follow symbolism as much as fundamentals, as can happen in any case of multiple equilibria. "Canada" doesn't sound much like "Europe"; but who knows.

That's all I can figure out. Anyone got any better ideas?

Comments

[Adam]

I'm scared, too - not because I worry that Greece will default, but because I worry that it WON'T. Everything I've read about the situation there tells me that there is no way for Greece to put its fiscal policy on a sustainable track (i.e., have Greeks pay for their own spending). Which means that there are only two other possibilities: a default or a bailout. A default is scary, but a bailout is much scarier. We've been bailing out auto makers, banks, and now countries (?) so much that it seems to be taken for granted that nothing will be allowed to go under. The one exception was Lehman Brothers, and the only lesson learned there appears to be that we should have bailed them out, too.

So what happens when the money runs out? Who bails out Portugal, Spain, Ireland and Italy? And more importantly, who bails out the US? American national debt is already crushing, is forecast to rise to over $20 trillion over the next decade, and doesn't even count unfunded liabilities such as Social Security (which has no trust fund assets other than $2.5 trillion in government bonds that will be repaid God knows how) and Medicare.

At some point, we either decide to say no or we keep going until there's nothing left and the whole thing just goes off a cliff. In other words, the US goes bankrupt and the global economy collapses.

Maybe a Greek default would trigger an actual 1930s-style depression (a real one, as opposed to the one that commentators keep saying we just went through). That would be awful. But that's a lot less scary than what appears to be lurking down the road if we keep going the way we are.

You can only keep pumping someone full of steroids for so long before the body starts to breakdown. We seem to be in a perfectly analogous situation with respect to the economy and borrowed government money. Either we ease off slowly, or one day the system blows up spectacularly and catastrophically.

[Qc]

Adam:
I'm afraid you don't understand anything to monetary operations. A country with its own floating currency that borrow mostly in its own currency cannot default. Period. Japan will not default. UK will not default. US will not default. Canada will not default. For starter, U.S. will NEVER run out of U.S. dollars. And before telling fairy tale about the US debt creating inflation down the road, please make a call to the most heavily indebted country in the world, Japan, to inquire how inflation is doing over there.

The only defaults that have occurred in the last 30 years to my knowledge were countries that were on a peg and therefore borrowing in a foreign currency (Argentina, Mexico, Russia, etc). Greece is basically in the exact same situation of a country on a peg; it is borrowing in a currency on which it has very little control (what is Greece weight at the ECB?). I agree with Professor Rowe, multiple Argentinas scenario is not outlandish.

For all the economists that are worried about the US debt, I invite you to put your money where your mouth is and short US bonds. You can do this easily at http://www.google.com/finance?q=NYSE:TBT. Economist like to discourse about incentives... the problem is that they have no incentives to be right in their forecast since they never have skin in the game. So it is real easy for them to keep spreading absolute non sense (Rogoff worrying about the US debt comes to mind).

Full disclosure: all my savings are in US dollars, I would not touch Euros with a 10 foot pole...

Qc

[Adam]

So if I understand what you're saying, no amount of debt will cause a problem as long as it's denominated in your own currency. And a country can expand its money supply as much as it wants without there being an issue. Is that what you're saying?

[Nick Rowe]

I basically agree with Qc. But there can be an issue from issuing too much money. (Sorry). Inflation. Not an especial worry right now though.

[Adam]

So even if the US runs up $100 trillion in debt, there's no issue?

[Nick Rowe]

Just to expand on the inflation thing: take Japan for example. The reason Japan is printing so much money and bonds is precisely *because* of the lack of inflationary pressure in Japan. The Japanese don't want to spend on newly-produced goods and services. So the Japanese government prints money and bonds to do the spending they won't do.

But there might be a danger in the longer term, if and when the Japanese change their minds. Japan would then have to raise taxes and/or cut spending a lot, to withdraw the bonds and money the Japanese don't want to hold any more.

[Alex Plante]

I have a solution for Greece and the other so-called PIGS: The economies of the PIGS are essentilly dependent on tourism and retirees from Northen Europe. The current crisis has disproportionately hit tourrism and retirees. To compensate, the Germans should subsidise Mediterranean vacations for their unemployed. The whole scheme could be underwritten by printing Euros. Problem solved.

[Nick Rowe]

Alex: yep. But the "printing Euros" is the key. One of the Neo Chartalists (Bill Mitchell? Warren Mosler?) said the ECB should cut a cheque for x Euros and give it to the Eurozone governments in proportion to population. Basically the right solution, because if they expanded the money supply, a lot of those deficits would fall anyway. It's essentially helicopter money. I can never understand why the Neo Chartalists don't like the helicopter metaphor.

[Guillaume]

What is extremely worrying is the kind of extreme bank run that might occur if it were only suggested that Greece drop out of the Euro. Since a Euro asset is a Euro asset, there would be massive liquidity flight from Greek banks (and Portuguese, Irish, etc. banks) to more stable countries. You can't simply put in capital controls like Argentina did: euros are euros are euros.

And I'm not even talking of the geopolitical implications of the European project going in reverse...

[Ian Lippert]

Isnt there some definition of technical default where the value of your currency drops? I thought mabey it was from the IMF. Saying that a country can never default because it can print money seems like it might be technically true but not really true in practice, as if there is no consequences. It seems like in cases like greece they could print for awhile but there is very likely to be a sudden change in the expectations in the value of their currency causing a tipping point where they see inflation increase at a greater rate than they are printing money.

[Torrens Hume]

A bankrupt government on a floating exchange rate can always pay its debts by printing cash, but that will be inflationary and cause the currency to depreciate and a currency cum BOP crisis (especially if debts are denominated in foreign currency). I believe it happened in Indonesia in 1997 (it was on a fixed ER, but it floated and had its crisis a few months later when the government couldn't raise sufficient funds to to bail out its banks and it had to resort to central bank funded lender of last resort loans). I think France also experienced this in 1926, anyone got a copy of Rogoff and Reinhart handly?

Japan was put on watch recently. The other problem in Japan is that the BoJ has a fear of any inflation over 1 percent, so the only way to restore equilibrium is through deflation, which it had for most of the last 15 years.

Paying out in scrip -- perhaps they should talk to Schwarzenneger.

[Qc]

Of course, if a country (with its own floating currency) increase aggregate demand so much through its fiscal deficit, then it might reach the physical limit of its economy to produce, which could generate inflation. At 10% unemployment in the U.S., don't worry about this type of inflation You may worry about cost-push inflation through the commodity prices channel, but this is a worry only if it is being transmitted to wage, and a feed back loop follow. This did not occur since 1970s. Workers seem used now to take gasoline prices hike on the chin.

A country with its own floating currency does not issue bonds to "finance" deficit, it strictly issue bonds to sterilise the effect of the deficit spending on the overnight rate. Without bond issue, deficit spending would push the overnight rate lower (deficit is an injection of liquidity). An alternative to issuing bonds is to reward deposit from financial institutions at the Central Bank at the target rate (just like the US, UK and Canada have done during the crisis). Similarly, money from a fiscal surplus has to be re-injected in the economy through purchase of govt bonds otherwise it would push up the overnight rate. If govt don't repurchase bonds with the fiscal surplus money, like the Canadian govt have done in the 1990s, then it must find another way to re-inject this money in the economy. In Canada, the Central Bank (as fiscal agent of the government) re-inject fiscal surplus money through short term loans to financial institutions. So fiscal surplus money that was not used to repurchase govt bonds is not left sitting somewhere in a dark account of the Canadian govt, it rather is re-injected in the private economy through short term loans to financial institutions. (this cannot wait few weeks after the fiscal surplus is generated, it has to be accomplished the same day to make sure the target for the overnight is achieved).

Anyone comparing the US, UK, Japan to Greece and Portugal is totally talking non sense. And yes, you have "star" economists like Rogoff and Sachs spreading this non sense. Their advice "to go on a peg and cut the deficit" have created crisis after crisis in the world (Bolivia, Argentina, Mexico). Surely, it is based on the precious advices of guys like them that the Euro zone mess was created in the first place. It is still based on their advice that Latvia is maintaining its peg right now while implementing austerity measures to tackle its deficit. These guys have absolutely no shame... they even like quoting Latvia as an example to follow for all of us (yes, Latvia, a country with 20% unemployment right now and where GDP have collapsed by more than 20%).

Qc

[Nick Rowe]

Guillame: You have a point. It could be worse than Argentina, if they can't impose capital controls. But Greek banks would presumably suspend withdrawals. And/or declare Euro deposits to be New Drachma deposits? But God it would be messy. I'm surprised there haven't been runs already, into Euro notes.

Ian: as Torrens says. There is a maximum amount of revenue from seigniorage (printing money). But since the real value of the nominal debt falls in proportion, you can still pay it off in nominal terms. $100 trillion in debt? Just print $100 trillion in currency, as the debt comes due. The currency (and the debt) might be worthless at the end, of course).(Indexed bonds would be a problem, however, because they are like foreign currency bonds). But yes, it can be thought of as just default by another name.

Qc: Are you an Abba Lerner fan?

But increases in AD will cause inflation before we get to *physical capacity* limits. There's a Long Run Phillips Curve; and the natural rate of unemployment is greater than zero.

[Qc]

Nick:
Don't know Abbba Lerner... but a quick search definitely makes me want to read about the guy.

So Japanese will eventually want to get rid of their yen? For which currency exactly? UK pounds? US dollars? Euros? Serbian dinar? Let me know.

Also, do you know why economists are so disinterested in basic day-to-day monetary and fiscal operations? Is it because knowing too much about it will prove them so wrong that they will have to go live in exile somewhere on a Greek island?

Qc

[Kosta]

Nick wrote ‹i> I'm surprized there haven't been runs already, in euro notes

There was an FT article from a week or two ago which reported that wealthy Greeks were transferring funds out of Greece, and the domestic Greek banks were asking the gov't for help to top up their deposit base. The particularly scary part about this storey was that it referenced out-of-date data from around the start of the year. Undoubtedly the trend strengthened in February and March. I'll post the link once I get near a computer and off my phone, but it sounds like the start of a run to me.

[Nick Rowe]

Qc: I guessed wrong on Abba Lerner. It did sound like you were channeling his "Functional Finance".

"So Japanese will eventually want to get rid of their yen? For which currency exactly? UK pounds? US dollars? Euros? Serbian dinar? Let me know."

None of the above. I'm talking about them buying real newly-produced goods and services. Consumption expenditure, not financial assets. One reason people save is so they can spend more at some later date.

"Also, do you know why economists are so disinterested in basic day-to-day monetary and fiscal operations?"

(Pedantic nitpick: I think that should be "uninterested"; judges are, or should be, disinterested, but not uninterested, in their cases. Sorry.)

I don't know. Part of the reason is that our little heads can never keep all the details straight. If we could remember all that sort of stuff, we would have majored in history, not economics.

Or so we can see the wood from the trees?

Kosta: actually, I vaguely remember reading that now.

[asp]

If there was no Euro, Germany's economy would not be doing as well as it has. Therefor they should lend money to Greece at 2%. Problem solved.

In Spain, the issue is high unemployment. Easy solution, Germany -which has benefited financially from the last decade- pays unemployment benefits to Spanish workers. Problem solved.

What is that you say? Germany doesn't want to be a good neighbour? Then kick them out of the Euro and see how well they do.

[Ian Lippert]

I guess the point im trying to make is that printing to pay off debts is dangerous because once other people catch they are going to be less willing to purchase your debt in the future, regardless of whatever inflation effects are caused by the printing of money. If I see you like to deflate your money 20% every 5 years I'm going to take that into consideration before I buy your bonds. If you really run the presses I'd imagine there is going to be a run on your debt and your rates are going to go through the roof. In a worst case scenario your access to foreign lending is going to be cut off completely, which totally limits your governments ability to borrow through future crises.

One of the points Rogoff made in his last book was that many third world countries suffered from this phenomenon because their lenders had very little tolerance for their debt, which led to cyclical collapse of their lending market, which further exacerbated the down swings of their business cycles. Surprisingly this has happened very often to Greece, its any wonder they let them into the Euro.

[Nick Rowe]

Ian: I absolutely agree with that. In that sense, paying the debt by inflation is exactly like default. You wouldn't precommit to doing that , and debt is by definition a pre-commitment. But when you can't print money, and you go into a deflationary recession, the government's capacity to repay in real terms falls. Which is *part* of what is happening in the Eurozone.

asp: maybe. But who is going to impose that solution, and decide who shares what proportion of the burden? Who do you phone, to make that decision?

[Mike Moffatt]

"One of the Neo Chartalists (Bill Mitchell? Warren Mosler?) said the ECB should cut a cheque for x Euros and give it to the Eurozone governments in proportion to population. Basically the right solution, because if they expanded the money supply, a lot of those deficits would fall anyway. It's essentially helicopter money. I can never understand why the Neo Chartalists don't like the helicopter metaphor."

I advocated the same thing at About - it just makes far too much sense.

A somewhat analogous situation happened in Ontario in the 1880s, when a lot of cities/towns/counties found themselves with a great deal of railroad debt (thanks to a railroad investment 'bubble') that they couldn't pay off. However not every town found themselves in this situation and those towns protested any kind of bailout plan, as they felt they were being punished for acting responsibly. Premier Mowat's plan? He gave every city/town/country $2 per capita, which the cities were to use for debt reduction. If they had any money left over, they could use it however they wished. This solved about 98% of the issues (a couple townships were in such severe debt that this wasn't enough and they had to be dealt with separately) and pretty much everyone felt like they were being dealt with fairly.

Why can't the ECB do the same thing? Seems like it should be easier for them, as the province of Ontario, circa 1885, couldn't simply print money.

[Qc]

Nick Rowe:
Thanks for the editing. You can guess by now that my first language is not English. C'est la vie.

When you said:
"If we could remember all that sort of stuff, we would have majored in history, not economics."

Have you ever considered that it may be the economists that can't remember all that sort of stuff that are in the wrong profession? This "sort of stuff" as you say has huge implications on public policy, on which mainstream economists are so good at providing advices.

Cheers,
Qc
PS- For someone who has his nose in day-to-day fiscal and monetary operations, there is absolutely nothing controversial in what I wrote below:

"A country with its own floating currency does not issue bonds to "finance" deficit, it strictly issue bonds to sterilise the effect of the deficit spending on the overnight rate. Without bond issue, deficit spending would push the overnight rate lower (deficit is an injection of liquidity). An alternative to issuing bonds is to reward deposit from financial institutions at the Central Bank at the target rate (just like the US, UK and Canada have done during the crisis). Similarly, money from a fiscal surplus has to be re-injected in the economy through purchase of govt bonds otherwise it would push up the overnight rate. If govt don't repurchase bonds with the fiscal surplus money, like the Canadian govt have done in the 1990s, then it must find another way to re-inject this money in the economy. In Canada, the Central Bank (as fiscal agent of the government) re-inject fiscal surplus money through short term loans to financial institutions. So fiscal surplus money that was not used to repurchase govt bonds is not left sitting somewhere in a dark account of the Canadian govt, it rather is re-injected in the private economy through short term loans to financial institutions. (this cannot wait few weeks after the fiscal surplus is generated, it has to be accomplished the same day to make sure the target for the overnight is achieved)".

[Nick Rowe]

Qc: Lots of anglophones also say "disinterested" for "uninterested".

What you say in that quote is almost right, but not exactly right (at least, "right" in my view). If you replaced "change the overnight rate" with "change the money supply" it would be right. Take a standard ISLM model, for example. If you start with a balanced budget, then change fiscal policy to run a deficit, the IS shifts right. If the BoC buys all the extra money the government spends, so that the deficit is bond-financed, the money supply stays the same, so the LM does not shift. But the rate of interest will rise. Essentially, an expansionary fiscal policy will change Y and/or P, so the demand for money will increase, and the BoC would have to increase the money supply to satisfy that demand if it wanted to keep the overnight rate constant.

That's a woods from the trees question.

There's a separate issue with what you said, that involves who actually creates the money, the BoC or the government. Does the govt create it by spending, then the BoC withdraw it by selling bonds (your view?). Or does the BoC create it, use it to buy bonds from the govt, then the govt spend it? This is largely a semantic and accounting issue. You may probably want to debate it with me. But I have already spent too much time debating it with MMTers, so I won't bite here ;-).

[Ian Lippert]

thx for the response Nick, I think I see this discussion as being more about those countries that cant print and already have that option cut off as opposed to those that might be making the cost benefit analysis of deflating versus paying higher interest rates

[Kosta]

Nick wrote in a comment I'm surprised there haven't been runs already, into Euro notes.

Here's an FT report from April 7, 2010 http://www.ft.com/cms/s/0/edbfc18c-4268-11df-8c60-00144feabdc0.html
"Local savers transferred about €10bn of deposits – equal to about 4.5 per cent of the total in the banking system – out of Greece in the first two months of the year, according to the central bank."

It wouldn't be surprising to see the trend worsening in March and April.

[Adam]

Three questions (which are probably off-topic with respect to the post itself, but related to the discussion above:

1) How much of Canada's debt is denominated in Canadian dollars? The point about being able to print money must be moot to the extent that debt is denominated in a foreign currency.

2) To the extent that it's denominated in Canadian dollars, why did the federal government spend so much political capital on balancing the budget in the 1990s if they really could expand the money supply at all without any adverse consequences, which is what Qc seems to be implying above (I may not understand his/her statements correctly)?

3) My original post was about the fear of a US default, which was then dismissed, which then segued into a discussion about printing money and inflation. If I understand that discussion correctly, printing money leads to inflation unless the holders of that money in turn reduce the money supply by hoarding it. But the bottom line is that more money = more inflation, which is exactly what I thought was Econ for Dummies (too much money chasing too few goods). If that's the case (and devaluing the currency to worthlessness is equated to a default), how does that not bring us back to my original concern about a US default (call it a devaluation, if you prefer)?

No, I'm not an expert by any means and obviously you guys know a lot more about this than I do. But it's just not possible that we can just keep borrowing money in ever-increasing quantities, indefinitely and at no cost. I must be missing something or misunderstanding what was said above.

[Adam P]

"because the US dollar is, by social convention, the ultimate liquid asset, and the Loonie isn't."

it's not by social convention, it's because there are many more dollars in circulation and so much trade (both in goods and capital) goes throurgh the US that you can always find smoeone else to hold them. USD really is more liquid than CAD, for reasons that have nothing to do with social convention (or the social construction of reality).

[Nick Rowe]

Thanks Kosta.

Adam: you're not missing much.

1. As far as I know, all Canadian Federal govt debt is denominated in Loonies, except for a small proportion that is indexed to inflation, and so is effectively denominated in the CPI basket of goods (i.e. we can't inflate away those real return bonds).

2. Because they didn't want inflation. And thought they might need to borrow again in future, and inflating away the debt would harm their reputation as borrowers.

3. Yes. There is a legitimate concern that if the US government cannot eventually control it's deficits, it may at some future time suffer very bad inflation, because the only way to pay the debt, if people are unwilling to hold any more, would be through printing money.

[Adam]

Thanks Nick. Not to flog a dead horse, but if it is indeed the case that printing money to service your debt (which I believe is what the Germans did in the 1920s) leads to massive inflation, doesn't my original concern about the US economy still stand? That was my point, that it's all well and good to worry about Greece defaulting but if they're bailed out and we continue along our merry way without acknowledging that you can't just keep borrowing larger and larger sums of money forever, aren't we setting ourselves up for an even more massive failure down the road? If the US reaches a point where it has tens of trillions in debt to pay and can't do so through taxation, what then?

Out of curiosity, does anyone know how much US currency is in circulation, world-wide? How large an expansion of the supply would it be to print, say, $10 trillion?

[Nick Rowe]

Adam P: Yes, but there's also positive feedback in that process. For example, I think about half the US currency is held outside the US. Some people use the USD simply because they expect that others will use the USD. It's like language. A path-dependent equilibrium. Latin, then French, hung on as international languages for a long time, and had way more speakers than any "fundamentals" would suggest. That's what I call a "social convention". Like driving on the right vs the left. And ultimately, even the use of the USD in the US is a social convention. Witness Zimbabwe, where the social convention eventually broke down, despite what the government said, but history kept its influence for a long time despite massive rate of return dominance by other monies.

[Bob Smith]

Nick,

I do believe that the Canadian government does issue some foreign currency denominated debt (mosly Euro and US, although at present I think they only have a few billion in US dollar securities outstanding). Once upon a time, they did this to raise their foreign currency reserves, though I gather at present, they manage that through various cross-currency stops. In any event, on $500+ billion of national debt, it's not a material proportion. (the same goes for real return bonds, which are roughly 1%)

[Nick Rowe]

Bob: yes, I remember now. A few months ago, they issued a few forex bonds. I thought they said they did it just to keep a market open, in case they ever wanted to use it more in future.

Surprising (to me) that real return bonds are such a small proportion.

Adam: Yes, but there's a very big difference between the long-run analysis of a country that has a structural deficit and can print money, and the short run analysis of a country that's in a deflationary recession and has a cyclical deficit as well, and can't print money and can't devalue. The latter country has all the potential long run problems of the former country, plus a lot of short run problems on top of those. And that's Greece right now.

[Adam]

Thanks Nick, I understand what you mean. Although it sounds a bit like saying there's a difference between someone who's been hit by a car and someone with chronic degenerative osteoporosis. Sure, the first person has much larger short-term problems, but the second person is going to end up just as crippled in the long-term. We don't know when the long-term is, exactly, but we know that short of the end of the world, it's coming.

[Kosta]

I'm going to try to bring this discussion back to the question of the effects on Canada which might arise from the Eurozone crisis and tie in the issue of moral hazard. Greece's fiscal crisis is a serious issue in part because of the likely contagion to Portugal, and then Ireland, Spain and Italy. Even at that point it is unclear if there will be any knock-on effects to Canada, but as Nick originally wrote, "but who knows"?

Over on the Baseline Scenario, Boone and Johnson opined today that "it would surely help to have clear signals that President Obama himself, and the Federal Reserve, are taking an active stance now on making sure this does not spread to become another threat to global financial stability. A broader wall of preventive financing must now be put in place." http://baselinescenario.com/2010/04/23/greece-the-imf-and-what-comes-next/

Boone and Johnson are advocating coordinated global action to prevent the financial contagion from spreading across the Atlantic.

There's a good case for concerted global coordination to help prevent a destabiling round of financial contagion, which if it spread wide enough, will affect Canada directly or indirectly (a most obvious indirect pathway is the contagion hitting the US, dropping US demand of Canadian goods). Maybe some sort of global bailout is called for, but should Canada participate?

What about moral hazard? To paraphrase a comment from the IMF bank tax thead: "If I were running a very small country, I would be very tempted to do the following: support a global bank tax [bailout system], and then encourage my country's banks [economy] to take some very big risky bets (get my regulators [EU officials] to turn a very blind eye). Heads I win; tails the rest of the world will bail us out.

Greece is very guilty of running their finances poorly, and now the Greek crisis is threatening to spread through Europe and possibly into North America. If the crisis continues to grow, should Canada somehow involve itself in a preventitive bailout, or should we stand aside on the basis of not encouraging moral hazard?

[Thiess]

Nick Rowe wrote:

>If there was no Euro, Germany's economy would not be doing as well as it has. Therefor they should lend money to Greece at 2%. Problem solved.

For many years Greek had access to cheap debt due to the monetary union. That helped the Greeks to build up huge stocks of debt. Cheap debt is a cause of the problem not a solution.

Nick Rowe also wrote:
>Germany doesn't want to be a good neighbour? Then kick them out of the Euro and see how well they do.

In order to be a good neighbor, Germany agreed to the euro and pays a large fraction of the European funds that make up for a substantial part of the Greek budget.

Perhaps Canada is too far too understand what is going on?

[Adam]

Kosta, to continue on your post, is there a way to make the Greeks bear the consequences of their poor fiscal management without having the whole thing blow up? In other words, can anything be done that avoid contagion without creating a moral hazard? Ideally, other countries should look at whatever happens to Greece and say, I definitely don't want to go down that road.

Thiess, you're quoting asp, not Nick.

[Thiess]

Adam: thanks. Nick: sorry.

[Nick Rowe]

Very good find Kosta! And it makes depressing reading. And they don't offer much concrete in the way of a solution (because there perhaps isn't an obvious solution).

At this stage, I would lean towards some sort of ECB "monetary policy a l'outrance". Buying government bonds outright, across the Eurozone. God knows in what proportions.

Off-topic. Qc: I have now learned, from serious authority http://english-jack.blogspot.com/ , that the disinterested/uninterested distinction is much fuzzier in practice than I pedantically thought. Oh well. Guess I should stick to economics.

[Qc]

Nick, Adam,
One pre-condition to have your own floating currency is confidence from your citizen in national insitutitions. This is why small dictatorial corrupt countries de facto have US dollars as their currency, since their citizen have way more confidence in US institutions than their own. This occurs notably even in countries that are supposedly arch-ennemies of the U.S. Before Zimbabwe could have a credible currency, it would need first to build trust in national institions. Of course, this will not happen tomorrow. It will be long long road. In any case, IMF prescriptions for developping countries often runs counter to this logic since it often advices to maintain the peg at all cost, even at the cost of demolishing national institutions through massive deregulations/privatisation.

Drawing a causality relationship between inflation and debt levels in countries where trust in national institutions exist totally fails the test of reality. It used to be the case that we had only Japan as an example of a heavily indebted country with its own floating currency where inflation is non existing or very limited. Now we will have two new case studies in the future:
-US
-UK

Remember, modern Central Bank target interest rate, not money supply (target price rather than qty). People put way too much emphasis on money supply. It almost seems to me that Monetarism have never left us. Deficit increases aggregate demand and could create inflation if it, so to speak, overheats the economy by pushing it at the limit of its productive capcity. I would argue that Japanese debt is not high enough right now.

I have heard this week that a Credit Rating Agency has "warn" Japan about its debt level, I am just wondering if these are the same guys that were given AAA rating to toxic garbage assets before the financial crisis.

The only thing we have to fear is that politicians listen to the deficit terrorists (eg. Concord Coalition in the U.S.), and try to eliminate the deficit. The only thing this will accomplish is killing the recovery.

Qc

[Kosta]

Adam, you're right. A great way to handle the moral hazard issue is by ensuring that whatever bailout ensues is so painful to the recepient that other recepients don't want to ever need to resort to it. Of course, that's difficult to do in practive, especially as the goal of whatever bailout would be to make the recepient viable again.

Having lived in Greece, I think it would do that country a world of good to have the IMF come in and clean it up. I have many friends and relatives that would suffer, but it is the elite of that country which ran Greece into the ground, and it's the elite that need to removed.

What Greece needs, in my opinion, is a Chapter 11 bankruptcy, where their stockholders are wiped out, and their board of directors and upper management are removed. They could be recapitalized and then set free. I have no idea if such a thing could be done to a country (short of at a conclusion of a war), but that's what Greece needs.

Nick, thanks for the compliments. Any thoughts on what comes next if ECB intervention proves insufficient (from the prevention viewpoint)?

[Nick Rowe]

Qc: I agree with you on trust and money.

But doesn't the IMF normally recommend "devalue"? (Which is why Greece will be a problem for them).

Disagree on "modern" central banks targeting i. They target inflation. Read my old post here, you will hate it! http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/03/why-the-lm-is-usually-vertical-and-the-ad-curve-usually-horizontal.html

Kosta: I have no idea. Problems arising from "Inherent structural flaws" are sometimes not preventable.

[Adam]

Kosta, that's exactly what I would suggest (to keep it Canadian, let's call it a restructuring under the Companies' Creditors Arrangement Act)). Which I suspect is what should have been done with the financial institutions in Fall 2008 and (certainly) with the auto makers, but that's another story and obviously a moot point.

The problem is that as you say, independent states, being sovereign, can't be subject to court proceedings in this way. There's really no way to do it that I can see. The IMF's usual technique seems to be swooping in, telling governments what to do and disbursing, but there's no way to force the country to keep on the IMF-mandated path.

Ultimately, the problem in Greece is the same as in every other debt-laden country: people want more than they're willing to pay for. If Greeks were happy to pay whatever chunk of their income as taxes that it would take to fund their government, we wouldn't be here. But they're not (and from what I've read, tax-avoidance is a national sport over there).

So the recipe seems to be spend, get bailed out, spend more, get bailed out again? And lather, rinse, repeat? It'll be interesting to see how long this goes on for.

[Adam P]

Nick@10:17

Well, I would have said that what you were describing was a pretty standard example of network externalities. I guess you could make a pretty reasonable argument that that's the same as a social convention but I tend to think of social convention as something different.

To me a social convention is more like saying "please" when making a request or "bless you" after someone sneezes. On the other hand, the convention of shaking hands while greeting is both. Having a standard greeting could facilitate social interaction and in that sense be a network externality but the form it takes (handshake vs head nod say) is definitely path dependent. But, the role of social convention here is only to delineate the possible gestures that would work in the role, the history dependance doesn't change the fact that society choosing a single standard is due to the network externality.

In the case of USD as the most liquid currency, while it certainly is history dependent, it became the most liquid currency for a very good reason (after WWII). At that time it simply was the most liquid currency, nothing at all to do with convention. For the most part that is still true now. However, to the extent that its current status derives from its post-war status, that I think is really due to the need to coordinate on something, it solves real problems that way. I don't see that convention played much role here.

[Qc]

Nick Rowe:

We have to distinghish the policy objective (targeting inflation) from the policy tool ( targeting the overnight rate or alternatively M1 in a monetarist world). I was exclusively comparing two policy tools: targeting overnight rate vs targeting money supply.

IMF has team of advisors in Latvia right now. Do you think they are advising Latvia to strenghen their national institutions and give up their ruinous peg ? Listen to this interview from IMF staff in Latvia (http://www.youtube.com/watch?v=j9VS9mrfuFA ) , IMF staff is praising the Government and people in Latvia for "working so hard in 2009" to bring their deficit under control and defend the peg (this is no small irony to say "work so hard" when unemployment is at 20%... again, these guys have absolutely no shame).

Qc

[hosertohoosier]

Great powers often hold reserves for non-economic reasons. Holding a large percentage of another country's reserves gives you leverage over their decisions. Such power-plays were common in interwar Europe, and the prospect of building a monetary weapon against the United States is surely part of China's decision to maintain an undervalued Yuan. The status of the US dollar as the international reserve currency is based on its relative immunity to that kind of manipulation, due to the American military and economic primacy. Any attempt to do so would result in asymmetrical retaliation.

However, those days are coming to an end. The notion that the US will never be pushed to default is somewhat correct, but not in a meaningful way. Yes, foreign debt is denominated in US dollars and could be paid off with inflation (never mind the negative implications of that for the moment). Americans would also have to either curtail current borrowing levels, or experience the massive currency devaluation that reserve currency status has thus far prevented. In other words, I think a currency crisis is more plausible than a debt crisis.

Adam, simply because something solves a coordination problem, does not mean that it will organically emerge. For instance, the interwar period saw an era of competing currency blocs, though that was destabilizing.

In conclusion, economists need to think more about power and coercion.

[Tom Hickey]

NIck/Qc, not just Abba Lerner in that period. Have you seen "Taxes Are Obsolete for Revenue" (1946) by Breadsley Ruml, Chairman of the Federal Reserve Bank of New York? This was eclipsed by Bretton Woods but reinstated by Nixon's shutting the gold window on August 15, 1971.

http://home.hiwaay.net/~becraft/RUMLTAXES.html

[Just visiting from Macleans]

I had a chuckle listening to the news on the radio today concerning Greece's requested bailout. A response from some German MPs is spelled out in this online story's headline:

'We give you cash, you give us Corfu!' German MPs suggest Greece sell its islands (and the Acropolis) to pay off its debt

Now, where did I encounter that idea before? Ahhh, yes:

Too much debt? Just sell off parts of the country - say Nova Scotia - home of the Blue-nosed people.

:)

[Nick Rowe]

Adam P. Take a more general case, where the equilibrium is determined by a mixture of pure dominant strategy 'fundamentals' ("I would do this anyway, whatever other people do"), plus strategic complementarity ("I will do whatever others do"). A "multiplier" model, in other words.

At one extreme, as the strategic complementarity gets stronger relative to the fundamental, we get a pure social convention, like which side of the road to drive on, or whether to shake hands or nod heads. Two Nash equilibria, and we coordinate on one.

So I exaggerated when I called the use of the USD as the world's ultimate liquid asset a social convention. It's not pure; the fact that the US is big is a fundamental, as you say.

And if the strategic complementarity is strong enough (positive feedback bigger than one), we can get stuck in one equilibrium even when the fundamentals change to support the other equilibrium.

I don't think we are disagreeing much, if at all.

I prefer "strategic complementarity" to "network externality" in this case, since the latter refers to the effect of others' actions on my utility, while the latter refers to the effect of others' actions on my marginal utility. If my action is x and others' actions are y, and U is my utility, then a strategic complementarity is Uxy is positive. (Or is "network externality" that both Uxy and Uy are positive??)

Qc: Yep. But so many Post-Keynesian "horizontalists" never seem to grasp the fact that the horizontalist perspective lasts for 6.5 weeks only (8 Fixed Announcement Dates per year). Past that horizon, they should be verticalists.

I'm curious: where are you "from" (in terms of economics)? I guessed wrong on Abba Lerner (at least directly, though maybe indirectly). Ignore this question if you like. Just my curiosity, plus I'm miffed at guessing wrong.

I'm trying to remember if Latvia is trying to join the Euro. Maybe that's why the IMF encourages the peg. Silly sods (IMF and Latvia).

Tom: I hadn't heard of Ruml. Certainly a provocative title. That was indeed the heyday of Keynesianism. Supply-side? Never heard of it!

Just: Well, it does show how the EU is supposed to be dissolving national sovereignty. But what exactly would the Germans be really "buying". The right to *tax* those Greek islands? Hmmm. Not sure how much that would be worth. I thought that (part of) the underlying problem is that Greeks don't pay taxes. Even less willing to pay taxes to Germany, I would think. More social conventions?

hoser: interesting perspective. But I would say the power flows both ways. If China holds a lot of USD reserves, that also gives the US leverage over China.

[Qc]

Nick Rowe:
"where are you "from" (in terms of economics)?"
Quick answer: nowhere.
I am a micro guy. Got curious about monetary and fiscal operations, and quickly realise that applying micro principles (liquidity problem, insolvency risk, revenue constraint) could never possibly apply to a country with its own floating currency. So I started reading everything I could find on day-to-day monetary and fiscal operations (weird, but there isn't much out there in term of official govt document thoroughly explaining day-to-day fiscal and monetary operations, and the link between the two). I quickly realised that notorious economist (eg. Roggof, Krugman, Sachs, Stiglitz, etc) are generally totally clueless about these operations. Krugman even dare to say "you really don’t want governments financing themselves largely with very short-term debt — that makes them too vulnerable to liquidity crises." (http://krugman.blogs.nytimes.com/2010/03/05/debt-is-a-political-issue/ ) This is so wrong, and it's not funny... this guy is a Nobel prize winner!

In any case, I want to thank you, I will definitely start reading about functional finance and Abba Lerner. Note: don't take my sometimes harsh words against economists personally, they are really directed at the profession, not at individuals. It is the profession that is responsible for the current curriculum in Universities and the fact that there is no mandatory economic undergrad course on day-to-day fiscal and monetary operations (from this angle, individual economists could be seen as innocent victims :-)

Cheers,
Qc

[Nick Rowe]

Qc: Good luck! But just remember that macro changes like a kaleidoscope when you change focus from the very short run to the short run (AD), long run (vertical AS), very long run (growth theory). All the things that were exogenous become endogenous, and vice versa.

[Kosta]

Adam, thanks for the reminder about Canadian content -- I couldn't come up with the name of the Compainies' Creditors Arrangement Act on my own ;)

You're right about the problem being that the "people" want more than they're willing to pay for, although I think one should add "or able to pay for". Being a little closer to the situation than most, I think it is a slight mischaracterization to blame all the people in Greece. Really, it's the elite of the society that led that country on this unsustainable path since the early 1980's, and it is the elite that have profited the most. The tax-avoidance of the everyday Greek is a side-issue at best. Really, it just reduced to the effective tax rate being lower than the one on the books (as well as a bloated tax collection agency to match the rest of their bloated bureaucracy). It's hard to blame the middle- and working-class Greeks for resisting the moves to austerity, given that they profited less in the last two decades of largesse than the top of society, and that the austerity is going to hit them much harder than the elite.

As I mentioned earlier in the comments, Greece really needs to have their board of directors and upper management removed (the elite), and that way maybe their shareholders (the everyday Greeks) might have a chance for sustainable growth.

[Rick]

The fallout is already occurring..... there is a capital flight fro Europe and some irrational fear of inflation in the US that is for sure transferring money into commodities. The effect is higher direct investment into Canada.... this results in from lowering of exports (balance of payments)

We have a lot of free money that isn't really going to put towards anything useful... except maybe to lobby for a lower capital tax rate and less regulation in Canada....

This is how the mess in the US started... except it was China that was funding the direct investment... this time it the rest of the world funding us.....

anyone for a bubble watch?

[Panayotis]

To those worried about runs on Greek banks please be assured nothing is happening. Even a new drachma is introduced, keeping euro accounts will be mantained as there are dollar accounts.

Why you are not considering debt restructuring with maturity extension and discount/par bond issue, especially since mark to market has validated debt value discounts in portfolios and the effect is neutral. It is even easier since 82% of Greek public debt is foreign owned. From then own public debt will be issued domestically since the private sector is a net saver with low debt to income ratio!

[Kosta]

Yiasou Panayiotis, ti kanete?

I'm not so sure that a "bank run" hasn't started happening. To quote from an earlier comment:

"Local savers transferred about €10bn of deposits – equal to about 4.5 per cent of the total in the banking system – out of Greece in the first two months of the year, according to the central bank."http://www.ft.com/cms/s/0/edbfc18c-4268-11df-8c60-00144feabdc0.html

I'm not so sure that introducting a new Drachma could be done easily or effectively. The whole purpose of introducing the New Drachma would be to devalue it. Upon its introduction, the New Drachma would immediately drop in value versus the Euro. If Euro accounts were still open, the incentive would be for people to sell the New Drachma and buy Euros, putting further downward pressure on the new currency. Basically, you would see a massive flight of capital out of the new currency into Euros until that currency stabilized, and it would be ugly.

The alternatives are also ugly. The Greek gov't could introduce the New Drachma at a peg with respect to the Euro and install capital controls. They might also seize all local Euro-denominated deposits and pay them out in New Drachmas (Argentina did something like this). I'm sure that fear of this possibility has driven the capital flow quoted above.

With regards to debt restructuring, if it's done voluntarily, it would avoid a default, but what is the likelihood of the foreign owners of 82% of the debt voluntarily giving up some of their claims?

As for relying on the private sector, if Greece could rely on domestic sources for all of its funding needs, it would not be having the problem it presently has.

[Panayotis]

Kosta,

The 4.5% of the total deposits you mentioned includes withdrawals from normal course of business and this outflow has not continued. As far as introducing a new drachma for transaction purposes, of course it can devalue! However, economic units can mantain euro accounts for savings purposes with no problem for the banking system. As far as restructuring is concerned, lenders have no choice because a sovereign state cannot be forced to repay if it has not pledged collateral.It better to get 70% than none at all! Turning to domestic savings answers the threat of future financing of a development program that Greece needs based on deficit spending because the private sector will not invest unless the economic conditions improve!

[Kosta]

Panayiotis,

That's good news if the withdrawals did not continue into March and April. Of course, we won't know for sure for another month or so, but let's hope that you're right.

I'm not sure that an introduction of a New Drachma will run as smoothly as you suggest. We both agree that the New Drachma will devalue. If economic units can maintain a euro account for savings, why would they transact in the New Drachma, knowing that it will devalue? People and businesses would be happy to have liabilities in the new currency, but who would be willing to take the other end of those transactions (i.e., own the assets) given the likely devaluation? There will be continuous flight from the New Drachma to the Euro, leading to constant devaluation and very high inflation. Interest rates for New Drachma denominated loans would be astronomical to contend with both the inflation risk and the currency risk. The results will be catastrophic for everyone in Greece without access to Euro-denominated income (which is most everyone). If Greece left the Euro and introduced a New Drachma, it would impoverish all of Greece's middle- and working-class through the combination of devaluation and inflation. I don't this is at all a good outcome.

With regards to restructuring, I really see two potential paths: either it is a cooperative deal between Greece and its lenders which avoid a default, or it's done after Greece defaults. I think the distinction is important in part because if Greece defaults, its creditors (and the EU) will take a much harder stance (and also because a default will lead to CDS payouts which will force certain players to take certain actions).

I am all for Greece restructuring its debt if it can do so without actually defaulting. However, there are some doubts about a restructuring being sufficient to rescue Greece. Two Barclay's Capital research notes suggest that even with a large haircut to their debt (post-restructuring), Greece will still have to cut its fiscal spending by 7.5% to 10% of it's GDP http://ftalphaville.ft.com/blog/2010/04/26/211846/restructuring-the-parthenon/ . So while restructuring will help, it won't save Greece.

But really, I'm skeptical about Greece's ability to restructure its debt without defaulting. Given that there's a wide range of Greek debtholders, undoubtedly some of them will take hardline stances forcing Greece to either settle to their terms or formally default. Subsequently, I think negotiating with all the bondholders to restructure the debt is unlikely to successful, at least in the timeframe we're looking at.

The other option is for Greece to formally default. That would give Greece extra leverage against its present bondholders. But it would also mean that Greece would lose access to additional funding. Given that Greece presently has an 8% or so primary deficit, the loss of the external funding would be very painful. Also, defaulting would likely result in Greece's exit from the Euro. Most of the Greek debtholders are Europeans, and while they might not hold collaterol, they do hold the ears of their gov't's, and somehow I would think that those gov't's would not be happy if Greece defaults and stiffs the bondholders.

Finally, lest we forget, I assume Greece wants to stay in the EU. If Greece does, then it will have to try to meet all of its obligations. Greece really can't pull an Argentina and force restructuring on its own terms, not unless it's willing to be isolated like Argentina was isolated.

[Patrick]

Greece downgraded to junk. Portugal downgraded too.

I wasn't really all that worried but I am now. I figured the Germans where just, well, being Germans and they would see sense after playing hardball for a while. But it seems that they aren't and won't - which strikes me as odd because it's German (and French) banks that are going to collapse and need bailouts if there is a cascade of defaults.

Maybe they're thinking they'd rather bailout German bankers than Greek citizens?

[Nick Rowe]

Patrick: "Maybe they're thinking they'd rather bailout German bankers than Greek citizens?"

That's what Felix Salmon said yesterday: http://blogs.reuters.com/felix-salmon/2010/04/26/the-depressing-outlook-for-greece/

I started to write a post yesterday, saying that with bond yields over 13%, it's game over. Never finished it. Couldn't get my head around what the ECB could and would do.