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Okay, so suppose Germany +3 set up their own currency (they could call it "I-can`t-believe-its-not-the-Deutschmark"). And then Greece defaults (yet again), straining German banks. Germany now has a LoLR (because there is no way that their 3 partners want a banking crisis to start in Germany.) Doesn't that suggest that the new currency arrangement would work just fine (if we ignore the politics) for its members? So we should think of it as feasible?

True, it would do nothing to help with the terrible veto and incentive problems in the Euro zone. Unless of course, the credible threat of leaving was used to force some reforms....

Simon: "they could call it "I-can`t-believe-its-not-the-Deutschmark"

Laughing too hard to type!

calming down. Hmmm. Maybe. Would leaving the Euro make it harder for the Germans to get the Dutch to bail out Greek government/German banks? Dunno.

It is much harder to do things in common if one is way bigger than the other.
Would Netherlands essentially accept the inevitable German diktats? What about their near complete economic integration with Belgium dating from the late '40's Benelux?
Europe can work with 17 currencies, muddle through with one but just won't with 2.

An interesting parallel is to US states with varying economic output. Compare, say, California or Texas to Arkansas or whatever. Few seriously bandy the idea of California leaving the Union and creating its own currency. But being part of the Union allows relatively simple capital and labour mobility, so the imbalances can be resolved without crushing wages. At least that's how I understand it.

Now how is California's plight different than Greece? The one glaring difference is labour mobility, or is it significantly more complex than that?

I don't agree with your analysis. You are speaking here of a LoLR with respect to countries, but that is peculiar usage. The LoLR is conventionally a lender to banks; the ECB can play that role in the Euro zone just fine. It isn't obvious that LoLR exists in the sense you mean in most currency areas. If, say, Ontario were to bankrupt itself, would the rest of Canada really bail it out? I wonder. Yet Canada does just fine as a currency area; that is because its provinces have mostly avoided blowing up in the first place.

And that is what where you have misconstrued causality. Greece is Greece, and is habitually bankrupt - it should never have been admitted in the first place. But if it were just Greece, then the euro zone would be free to rescue Greece or let it hang according to their pleasure. The trouble is with the rest of Europe, which only has problems because Europe is not a (near-)optimal currency area. And the reason it is not an optimal currency area is that it contains Germany. Germany kept euro rates too low for everybody else during the boom and is now keeping them too high during the bust. Were it not for that, Ireland, Spain et al would never have developed problems and would not need a LoLR.

There is really only one country that the euro zone needs to get rid of to be viable, and that is Germany. Spain and Italy would be sufficient political counterweight to France. It is true that the minor northern European countries might not find monetary policy ex-Germany to their liking, but that is their problem not Europe's, which should be indifferent to whether they stay or leave.

As for the northern European minnows joining the German leviathan, that makes about as much sense as Canada putting itself on the US dollar. They have only to look to the other Scandinavian countries to divine the best course.

"There is really only one country that the euro zone needs to get rid of to be viable, and that is Germany"

Yeah. What benefit does Germany have in expanding the Euro? Well its current account should give a bit of a clue: they like being paid in a constant currency. Never mind they recycled payment into sov bonds in deficit countries to keep the taps flowing.




What benefit does Germany have from the Euro? What about that elephant named Politics?

Hi NIck. Good post.

I am wondering if the Optimal Currency Area (OCA) problem and the lender of last resort (LOLR) problem aren't related to a large extent. The greater the OCA problem, the more divergent the optimal monetary policies, the more likely is very tight money somewhere, the more likely the need for a LOLR.

Your analysis of Germany's interests assumes that the Germans think that the ECB will be the bailer-out of last resort, not the German taxpayer. It also assumes that the Germans will be able to live with what they will no doubt see as a massive increase in moral hazard on the event of either a fiscal union or more discretion for the ECB to act as the LOLR. Now, I suppose that the Germans could simply refuse any attempt at either of those indefinitely but, presumably, they do have an interest in some sort of sustainable resolution to the euro crisis, if for no other reason that continued uncertainty is likely to affect investment in Germany and prolong concern regarding their banks.

It's interesting that Hans-Olaf Henkel would suggest a euro covering Germany, Austria, Finland and the Netherlands. Short perhaps of a lingering interest in closer political ties with Austria, why would Germany want to take on the risk of other countries' budgetary problems and less than complete control of its monetary policy simply for the benefit of a currency union with three relatively small countries?

Also, if one was in the camp that believes that some sort of euro breakup is inevitable, presumably the best way for Germany to minimize the negative impacts on its own economy would be to leave on its own and leave first - no long drawn out messy negotiations done at least partly in public, fewer political compromises, etc.

"What about that elephant named Politics?"

Well then they should write off the Greek debt then, for politics. :)

The political elephant I see is that Germany was lending good money after bad and its populace can't admit it has any culpability.


The LOLR is used in a peculiar way here, but I think the argument is correct. Fundamentally, the central bank of a monetary sovereign country controls the interest rates of government bills, and in this sense is a lender of last resort to the government. Then the government debt is risk-free, and the only real risk is inflation, which fortunately, does not constitute a default. i.e. The government budget constraint applies only in nominal terms, not real terms. Despite Greece "being Greece", it never defaulted on sovereign debt after it had its own inconvertible currency. Greece being Greece, it did suffer from inflation and high import prices, which is the best that it can hope for now.

The ECB is odd, in that it has no risk-free assets with which to conduct monetary policy. But if we assume that german bonds are a close proxy for the 3 month risk-free rate -- then german bills yield 40 b.p., whereas greek bills yield 1100 b.p.

Clearly the problem is not an excessively high policy rate in the ECB, but that risk-spread, which is there because there is no Greek central bank that can guarantee that greek bills have a 40 b.p. yield.

As I recall, Canada almost faced a similar LoLR problem in the 1930s when the govt. of Saskatchewan was close to default. (I'm sure I saw a paper Bernard Bonin had written on this in the CJE or its predecessor.) The Bank of Canada only dates to 1935, so I'm not sure how it was involved. Any economic historians out there know more?

Nick: Glad you (and Stephen) liked the currency name.

But more seriously, I wonder whether we're mixing up two possibly distinct things in this discussion. One is the Optimal Currency Area idea, which is mostly about the commonality of shocks and the synchronization of cycles. But some argue that the Greek problem is not particularly cyclical; they'd characterize Greece as a fiscally incontinent state, a fact which recessions make more obvious. Everyone sort of understood the moral hazard problem associated with members who were fiscally irresponsible in a monetary union back when they were drawing up the Maastrict Treaty. They simply decided that other political concerns trumped the potential economic problems when it came to Greece (and Belgium, among others.)

But lots of places deal quite well with such problems. It could be argued that California is currently less fiscally responsible than Greece in many ways; a govt. default there could spark a nice banking crisis in the US (although I don't know how much debt they have outstanding.....anyone know?) But you don't see the US Federal Govt. rushing to help weak states borrow in financial markets (or our Federal govt. helping heavily indebted provinces.) Any you're not seeing our banks wobble as a result.

Obviously, there's a crucial difference here that I'm forgetting.....

jesse- Fiscal policy is the other difference, there are automatic stabilizers built into the system. If one state, such as NV or CA or MI is going through a deeper recession, a significant portion of the increased social welfare costs are picked up at the federal level. For Greece or Spain or Ireland, all of those costs have to paid by national government with virtually no help from the monetarily sovereign center.

In Ireland's case (and Spain's) there is the additional issue of the banking system being only backstopped by the national government leading directly to sovereign distressed debt levels. But, if you follow Bill McBride's Calculated Risk every Friday you'll see banks in Georgia or Illinois being taken over by FDIC, which is only viable because of the US wide risk pool and federal backing of FDIC. (It's surprising to me we haven't heard more about a Euro financial regulator and insurance scheme given the centrality of banks to the need to rescue Ireland, Spain, and, to a degree Portugal).

We don't think of those as transfers to state government, but they are in the sense of relieving them of burdens that might bankrupt them (especially if national monetary policy is too tight for their position in the business cycle.)

Simon (and jesse): the Greece=California question always does come up. I'm not sure I have the full answer to what's different, but I notice some differences:

1. If the California State government disappears, there's still the US Federal government doing stuff in California. If the Greek government disappears, there's not much government left. Difference in degree between California and Greece, but a big one.

2. If all US states default on their bonds, that's a smaller percentage of total US government debt than state+federal debt. Difference in degree, but a big one.

3. The Fed can buy Federal debt. The ECB can't buy Eurobonds. Difference in kind.

4. The US Fed and Treasury can decide whether or not to bailout California and California banks. Or take them over. Or impose restrictions. 2 vetos only. 2=1, really, since the Feds own the Fed. Difference in kind

5. Californians think of themselves as Americans. Texans think of Californians as Americans. "We're all in this together". Difference in kind.


"Clearly the problem is not an excessively high policy rate in the ECB

I disagree. If the relevant interest rate is the German bill rate, then the ECB should be targeting it at no more than zero and doing QE as well to simulate a negative short-term rate. But there's no need to use the risk-free rate as a target: the ECB could be targeting a riskier interest rate at near zero.

Admittedly, Greece's problem probably can't be solved with easier Eurozone monetary policy alone, because Greece is pretty much insolvent under any economic scenario. But it's easier to imagine an acceptable degree of debt forgiveness for Greece if its economy isn't tethered to German monetary policy. And Greece is fairly small, anyhow. Easy money (by which I mean appropriate monetary policy for the Eurozone ex-Germany) could well fix the problems in the rest of the periphery.

Offhand, I don't see Germany's leaving the Eurozone as a likely outcome, but I do think it would be a good idea.

Simon: one of the regular commenters here is well-informed about provincial defaults and bailouts in the 1930's. (Was it Jacques?). This question came up before. IIRC, 2 out of Alberta, Manitoba, Saskatchewan were baled out, and the third was offered a bailout but refused the terms?? Someone will correct me. Then there's Newfoundland, which went bust, was put into (put itself into) receivership, and taken over by Canada. (I'm crap at history, so don't all jump on me for getting stuff a bit wrong!)

If ECB interest rate policy is too loose for Spain, Ireland, etc. during the boom and too tight now, could this effect not be countered by using differential fiscal policy? If you keep monetary policy 'too' loose, but use fiscal policy (value added tax?) to vacuum up the excess money supply, using the proceeds to reduce government debt.

I expect this would cause an increase in private indebtedness. Is there another reason why this might not work (other than political economy, perhaps)?

Thanks david! "I am wondering if the Optimal Currency Area (OCA) problem and the lender of last resort (LOLR) problem aren't related to a large extent. The greater the OCA problem, the more divergent the optimal monetary policies, the more likely is very tight money somewhere, the more likely the need for a LOLR."

Hmmm. fair point. I had treated them as totally separate problems. But you are right: there may be some correlation there.

California's state debt to state GDP ratio is about 2%.

But california, as a state, does not tax as much of its GDP as the Federal Government. The bulk of taxes are collected by the Federal Government, and state revenues and expenditures are more pro-cyclical.

This is really a transfer issue. The Federal Government collects $1 in taxes for every 70 cents in spending in California. The state collects less in taxes then it spends in California. On balance, the sum of federal + state spending is in a large surplus position, with the state being a large net exporter to the other states. It is a bit like Germany, rather than Greece. Except that there are large fiscal transfers from California to the other states. In downturns, exports drop faster than this federal surplus, state post-federal tax income declines, and the state budget gets squeezed. It is a boom/bust state.

States often have balanced budget amendments that make it difficult to sell debt (legally), and California has a 2/3 voting requirement that makes it difficult to sell debt politically. This is similar to the debt ceiling "crisis" the U.S. as a whole faced. It is a crazy system. But it's not a LOLR problem.

Andy, I think what tethers the Greek economy to Germany is the use of the Euro, which makes it impossible for Greece to devalue in response to an upswing in German productivity.

Yes, in theory german bills could yield exactly 0, but I don't see that the difference between 40bp and 0 is important here.

I don't understand how the ECB could simulate negative rates. You can always hold cash or a term deposit in a bank, and get zero. Nothing that the ECB can do can drive short rates to be below zero. And nothing that the ECB can do today will tie its hands to prevent short rates from rapidly rising above zero in the future.

In terms of the ECB targeting a specific risky asset -- did you have one in mind? -- that is fiscal policy. In that case, send checks out to the poor or unemployed directly. Part of the reason why the ECB actions are so politically contentious -- the debates about what will be accepted as collateral, and Sinn's complaints about Target2 -- is because the ECB has no riskless assets, so there is always some level of fiscal transfer occurring every time it purchases a risky asset.

Normally, this fiscal aspect is small enough to ignore, but if you try to make this a key tool, then you bump up against the same political opposition to mailing out checks to a specific subset of the population.

The ECB is in a permanent position that is roughly comparable to the US Fed’s (transitory) “credit easing” mode, where the central bank takes on credit risk, manifested as interest rate spreads over the risk free rate, earned on assets. The risk free rate in the case of the ECB is, only by default, the lowest country risk rate in the Euro zone – Germany.

Germany is exposed pro rata to all ECB credit risk through its share of capital in the ECB. And in future it will be exposed through the EFSF and the ESM.

If Germany stays, it is exposed to credit risk via these mechanisms. If it leaves, it is exposed to credit risk via its banking system’s existing holdings of foreign currency (Euro) Euro zone debt. So Germany is exposed either way. The question there is the comparison of net pro rata exposure (cost versus benefit of “insurance”) versus separated gross banking system exposure.

It goes beyond resolving the LLR function. In the US, LLR was superseded by CLR (capitalizer of last resort), through TARP. And the LLR function is normally explicit for banks, implicit for governments. As it stands, the ECB LLR function remains “normal” to the degree that its implicit government LLR function is executed so far by purchase of individual EZ name debt in the open market.

Whatever way separation might be achieved, there’s the problem of cleanly separating the past (accumulated risk exposure) from the future (market efficiency), in terms of the reason for doing it one way or the other.

"This is really a transfer issue."

Well, I agree with that part. In my view, the OCAs that work do so because the continual, steady drip of transfers, not the occasional heroic cavalry charges of a LoLR. It is also true that the more ill-conceived an OCA was in the first place, the larger the transfers must be to make it viable and consequently the greater the political strains will be. To the extent that a bad OCA makes adequate transfers impossible politically, on account of their size, I suppose it is true that there is a linkage between the degree of optimality of a CA and the need for a LoLR. But since the underlying problem is political, that is exactly when the LoLR is least likely to be found. And is that not exactly the situation we observe in Europe?

Saskatchewan was apparently bailed out as recently as 1993 (http://www.cs.uwaterloo.ca/~alopez-o/politics/GandMarticle.html.) However, note that both crisis and bailout were kept secret from the public. Also, it is not clear from the linked article, but the bailout may have taken the form of a loan that was subsequently repaid, something that is not possible in Europe.

If Saskatchewan were to publicly default once every 10 or 15 years, and in doing so required substantial Federal payments each episode, would that be politically viable? I don't think so. It is only the steady, stealthy, below-the-radar infusion of transfers that can keep the ball rolling politically.

Simon, 170B against a GDP of 1.9T.

Afaik, banks aren't very vulnerable to a default by the state. A few years ago they stopped buying or accepting it. That led to the unusual occurrence of the governed putting out TV and radio ads urging the public to buy state bonds.

California's crisis arises because the budget has to be balanced (prop 58). The debt is tied to infrastructure and cash management only.

"There are two problems with the Euro. The first is the Optimal Currency Area problem. The second is the Lender of Last Resort problem. Splitting the Eurozone into two might help with the first problem. It doesn't help with the second problem."

You're thinking too like an economist for your own good here I'm afraid.

If Germany left the currency union there would be less political opposition to a centralised fiscal agent (LLR).

Now, to put on my economist hat, I think you've missed a key point: Germany leaves; neo-Deutschmark soars vis-a-vis the Euro; trade surpluses for all the periphery!

I agree with Philip Pilkington (something about being named Philip?) What Europe lacks is not a lender of last resort but a donor of first resort, and Germany is the main obstacle to establishing one. Outside the euro area, Germany would have to bear the costs of its own policies. The price of maintaining a hard deutschmark would be that imbalances would rectify themselves.

Philip: "You're thinking too like an economist for your own good here I'm afraid."

That's an occupational hazard ;-). I was trying to think a bit more like a Poli Sci in this post though.

"If Germany left the currency union there would be less political opposition to a centralised fiscal agent (LLR)."

Hmmm. Maybe. But a lot less support for it as well. What's the point if you can't tax the Germans? OK, I expect you have a point though. The greater equality of income between nations in the Euro, the less chance one of the richer countries would want to veto it.

"Now, to put on my economist hat, I think you've missed a key point: Germany leaves; neo-Deutschmark soars vis-a-vis the Euro; trade surpluses for all the periphery!"

Yep, it would probably move in that direction. They would be able to have a looser monetary policy in the periphery. But it still leaves the LOLR problem unresolved.

Everyone: I'm not responding much to comments. doesn't mean I'm ignoring them. Just can't think of much useful to say.

"But a lot less support for it as well. What's the point if you can't tax the Germans?"

Again, there's a lot of political considerations to be taken here. Just two off the top of my head:

(1) The fact that the Bundesbank is a bit of a 'control-freak' operation. With their lobbying out of the way a centralised fiscal body would have more traction.

(2) Germany tends not to run large deficits. This generates the perception that they are bailing out the profligates. I don't adhere to this view, but it is a popular one. With Germany gone none of the other countries would have the moral high-ground.

Germany are very anti-fiscal union. I don't believe other Euromembers are. At least not as much so. With the Germans gone I really do think there's a prospect that fiscal union could be a reality.

As for: what's the point without taxing the Germans. Well, I suspect our views our going to diverge here, but I don't see deficits as a problem provided there is a central fiscal agent. Japan would be the case in point. If a central fiscal authority had to allow large deficits to run to maintain banks or employment or anything else my guess is that bond-yields would remain low as they have in Japan.

As I said, I'll bet my shoes you'll disagree with me on this one. But my guess is this would be too long a discussion to get into.

Philip: "As I said, I'll bet my shoes you'll disagree with me on this one."

You would lose one shoe, because I would half agree with you, in present circumstances. But yes, too long a discussion.

Europe's problem is as a colleague of mine expressed it: Few people understand monetary policy and even fewer understand political economy.

My buddy Marshall Auerback over at NEP has been doing some of the best work on this I've seen. He called the potential German breakaway months ago -- when it seemed uber-crazy. He's also brilliant on consequences. You should check him out:

(1) http://neweconomicperspectives.blogspot.com/2011/05/to-save-euro-germany-has-to-quit.html

(2) http://neweconomicperspectives.blogspot.com/2011/08/tale-of-three-germanys-is-germany.html

There's much more. Some was run on Naked Capitalism. You'd have to search. But those two are very good representations and set out the main thrust well enough. Marshall's great when it comes to Euroland. He told me he was going to write a book on it but it fell through. Next time I see him I'm going to pester him on it.

Thanks for the discussion. Always fun.


Where are you getting your data for California debt?

Mine is admittedly old -- PPIC cites $60 Billion in debt, but that was pre-crisis. The Treasurer's Office cites $71B in General Obligation bonds currently outstanding. I think we should only count GO bonds -- and not, e.g. bonds sold by transit agencies and the like.

The latter is off-balance sheet debt. If we start playing the game of putting all that on the CA state balance sheet, then you can get very large debt numbers, but in that case you would need to put the asset on the balance sheet as well, as the special obligation bonds are sold to finance income earning projects and are funded from the designated income stream (e.g. transit fares, leases, etc.). In that case, we'd get into some hairy valuation issues as to which projects have a positive net present value and which do not.

No doubt some of the special obligation bonds are money losers, but to say that 100% of the assets financed by those bonds are worthless is a bit extreme.


Where are you getting your data for California debt?"

Not moi. Don't know much about Californian debt -- except that they ran an interesting IOU scheme a while ago which I think should have got more attention.


Have you done any posts on the "balanced budget multiplier"?

If not, could you do one sometime?

Shiller, Thoma, and Bill Mitchell have all pronounced, and each seems to be saying something somewhat different than the other.

Phil -- Sorry, the question should have been posed to Jon. And now I see on the (right-wing) California Debt Clock webpage that the state owes $375B! They have one of those ticking clocks. Obviously there is a lot of whacky counting going on here.

RSJ, I got my data from the state treasurer.


As to what debt should count, I dont see the point of excluding infrastructure debt. Under prop 58 that's pretty much the only kind of new debt the state can issue. The non-infrastructure debt is the rollover of the pre-2004 debt. I'd have to check of they can issue debt to make interest payments.

Again, the crises that keeps happen comes about because of prop 58s balanced budget requirement. Every budget and at every half year review revenue projections and spening must match. The constitution requires a supermajority to raise tax rates. That leaves one tool: spending management.

The discretionary portion of the budget is small. The reason for this is that the voters perceive the govt as cutting the things the people want so as to keep speeding going that lines the campaign coffers.

The next issue is that the tax revenue is unstable. A majority of the budget comes from income taxes and capital gains. Because of the progressiveness of the tax code this is heavily tied to the stock market and bonus payments.

Given this volatility you'd think the state would have an operating cushion but it does not. In good times and bad the legislatures manages to spend every cent while concocting schemes to sell off state assets to spend even more.

The tax code is extremely progressive.


The link you gave -- of 67 B in principle and 63 B in interest is not the state debt, it is the estimated debt service requirement. E.g. when you take out a 30 year loan of 100 K at 5%, your total interest obligation is 150K and your principle obligation is 100K.

That does mean you have 250K of debt.

You have 100K of debt.

This is why your figure is approximately double mine. The state is required to post this information.

In terms of what should and should not be included -- sure, add in the special obligation bonds as debt, provided that the NPV of the dedicated revenues are counted as assets as well. If you spend a billion to build a bridge that will take a billion in tolls, you should only add the billion of debt if you include the toll revenue as an asset.

In any case, special obligation bonds remain small fry -- 17 B versus 70 B for general obligation bonds.

Yes I interpreted that table a bit wrong. The par value of the debt is under 100B

"IIRC, 2 out of Alberta, Manitoba, Saskatchewan were baled out, and the third was offered a bailout but refused the terms?"

Saskatchewan was bailed out in 1936. Alberta went bankrupt in 1935 after refusing assistance from the Bank of Canada, which was appropriate since it was governed by the Socreds.

Ah! Thanks JP.

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