Is and ought for the Eurozone

In a correctly specified economic model, the number of equations equals the number of unknowns, and the model tells you what will happen. If you think that the model is telling you something bad will happen, and you want something better to happen, you have to remove (at least) one of the equations, and replace it with a different equation, so that the model now tells you that something different will happen. And you try out different equations until the model tells you something will happen that you like a lot better than what the model originally told you will happen.

Then you say that the original equation ought to be replaced by the new equation. That's your advice.

Which is a bit strange, when you put it like that.

You can't just replace any of the equations with anything you feel like replacing it with. Well, you can, but nobody would take your advice very seriously if it consisted of saying "If we doubled productivity we would be better off". They might believe you, but if there's no way to double productivity your advice would be useless.

Normally we get around this problem by only messing with the equations that describe government policy. If the government asks for your advice on what it should do, or if you at least think that there is some small chance it or a future government might listen to your unsolicited advice, and roughly shares your beliefs about what is a good or bad thing to happen, then it makes sense to mess around with the equation that describes government policy.

But I just can't get my head around how to apply this normal way of getting around the is/ought problem when it comes to the Eurozone.

The fundamental problem is that it's very hard to get 17 governments to agree on how the European Central Bank should act in its role as lender of last resort. Which sovereigns get helped, and how much? Which countries' banks get helped, and how much? If a bust bank gets nationalised, which sovereign takes it over? Can you nationalise a bust sovereign?

You can't really give economic policy advice in that sort of context. The best you can do is act like a mediator trying to keep a disfunctional 17 person marriage from breaking up.

Why even bother? Even if you could find a magic cure for this crisis, you don't solve the problem. The problem is the marriage itself. The best advice you could give would be to propose some way of breaking up which minimised the costs to all 17. The Eurozone doesn't work. It's going to break up anyway, I think. The only question is when, and whether it's a negotiated break up or a break up from force majeure when sovereigns default, and banks go bust, and countries will have no alternative but to issue their own currency if they want to pay their government workers and pensions and re-open their banks.

I've written a lot of posts about the Eurozone. But they are "is" posts, about what I think will happen. And the things I think will happen are bad things. And I feel some sort of obligation to say at least something about what I think ought to be done to try to prevent some of those bad things happening, or at least make them less bad. This is as near as I can get to an "ought" post about the Eurozone.

Each country ought to restore its own national currency. I think this will happen anyway. But it would be better if they all did it at the same time, rather than one after the other. It will still be very nasty. But the nastiness won't last as long. And what's happening now while we wait for the break-up isn't so great either.

Comments

[Kevin Donoghue]

I don't see why the restoration of national currencies needs to be all that nasty. It probably will be, but that's only because governments often postpone quite a simple step, like abandoning the gold standard, until they are faced with civil unrest. In this case all that's really needed is for each government to introduce its own currency which is allowed to circulate in parallel with the euro. Those who have contractual obligations in euros must meet them in euros. If they can't, there are laws governing that sort of thing.

Of course the Greek government, for example, won't be able to pay its creditors in euros, so it will default. That's nasty for sure. But the nastiness has nothing much to do with the introduction of the New Drachma. More generally, debts need to be adjusted to debtor’s ability to pay. But national currencies will help to streamline that process rather than impede it.

I'm not saying it's a simple fix, but it's about the least troublesome part of fixing a complicated mess.

[Nick Rowe]

Kevin: what I had in mind was: since the Greek (and maybe other) government won't be able to pay its creditors in Euros, and won't be able to bail out its banks in Euros either, it would pay them in New Drachmas instead. Effectively converting debt into "equity". It's still a default, of course. All other governments would do the same.

Canada's contribution: we will print up 17 batches of currency. That way the 17 countries can honestly deny they are planning anything beforehand.

[Nick Rowe]

Actually, if this plan were adopted, would there even need to be a *legal* default? The ECB could just print as many Euros as the 17 governments asked for, and hand them out for free to the 17 governments. Greece could then offer to pay its debts in Euros, or New Drachmas, whichever the creditor wanted. They would chose New Drachmas.

[Paul Friesen]

I still have a hard time imagining this happening in an orderly way. It would need absolute secrecy before the switch to avoid massive bank runs. If Euro depositors in German banks get their Euros converted to new Deutschmarks and Greek depositors get new Drachmas, that is what would happen. As you have said before, a disorderly situation where banks fail and close and new national currencies are issued in desperation is easier to imagine.

Kevin, I haven't yet figured out if there could be a way to work your parallel currencies idea or if it would solve anything. Perhaps you could spell it out a bit more. Are you thinking of this as a permanent or temporary measure? Would the Euro eventually disappear?

[Nick Rowe]

Paul: see my new post. It would help if Canada could keep step one secret. But even if it can't, Canada is deniable. They can't stop us printing 17 batches of banknotes. There are already questions being raised in the Irish parliament about whether Ireland is printing punts.

[Sina Motamedi]

Nick: "Canada's contribution: we will print up 17 batches of currency. That way the 17 countries can honestly deny they are planning anything beforehand."

Haha, yes! Canada always comes through to do the sensible thing!

[Paul Friesen]

I do have my own solution for the European mess and it does not involve abandoning the Euro. Of course, it also has little chance of being adopted.

The ECB should just print as many Euros as it needs, and buy up sovereign bonds of all countries in sufficient amounts to keep the interest rates on all of them at the same level. Under current conditions, that level needs to be low. This should allow countries like Italy and Spain to continue servicing their debts. Greece and perhaps Ireland might still need some part of their debts written off.

Obviously, this creates a moral hazard problem. If governments know that, however much deficit they run, the ECB will always be there, they have no incentive to control debt. But there is a solution. Set a debt limit with real teeth. If any country exceeds that limit, they have to accept intervention by an outside, Europe-wide body that takes control of tax rates, setting them at rates necessary to bring down debt over the long term, but with flexibility to run deficits in a recession.

[J.V. Dubois]

Paul Friesen: that is exacly what I *think* is meant by an European Economic Government. The question is, if parliaments in those 17 countries and their will agree to possible change their constitutions to enable such thing to work. The completely different question is if such arrangement can actually survive politically.

[Kevin Donoghue]

Paul, I wouldn’t expect the introduction of New Drachma, New Francs etc. as parallel currencies to solve anything by itself. The Euro would remain in being, the ECB would continue to control its worth and solvent debtors would still be obliged to honour their debts in Euros. But government employees and contractors could be paid in local currency, which could also be used for paying taxes. Insolvent governments like Greece could forcibly redenominate their debts in local currency. Unlike Nick, I assume that solvent governments would repay existing debt in Euros, whether or not they issued new bonds in their own currencies.

Eventually the Euro might be left with a very minor role, like the Ecu which preceded it. But that would not be a goal of policy. If people wanted to go on using the Euro there need be no impediment. (AFAICR there was no law against having Ecu bank accounts and suchlike in the 1990s.)

Basically what reintroducing national currencies does is to remove the fear of a run on a government’s debt, a problem which Paul De Grauwe has been on about for some time, as Krugman mentions here:

http://krugman.blogs.nytimes.com/2011/09/10/starkness-falls/

[Paul Friesen]

J.V.Dubois: As far as I can make out, the European Economic Government proposals include an absolute requirement for balanced budgets. That would be a big mistake, as we can see from the U.S., where many states have such restrictions. It forces them to cut back on spending in a recession.

We need a system to balance budgets over the long term, but we need deficits during recessions.

[jesse]

Yet we do have examples of areas with varying productivity living under the same currency; we can even draw "fake borders" around certain regions within a country to see this in action, and the policy implications. Surely somewhere there are a bunch of "Greeks" happily and perpetually living in the same currency zone as a bunch of "Germans".

[Jacques René Giguère]

IN the 19th century, when government defaulted, the Powers sent the the bailliff, that is their armies.It always ended badly (see Mexico 1860's). If Greece don't want or is unable to follow whatever idiotic regulation fron the ECB, you get the BundesHeer goose-stepping at the Parthenon? Been there, done that, got the T-shirt...
Anyway, what about Canada? Mismatched economic cycles, necessity for equalization payments to replace (in part) floating exchange rates thus fueling animosity in a misunderstanding polity...
When do we break up the C$?

[Simon van Norden]

The Stability and Growth Pact (was it part of the original Maastrict treaty? or drafted shortly afterwards?) had teeth de jure but not de facto. It provided for fines to be levied as a share of GDP on any country that consistently failed to respect the 60% debt/GDP and 3% deficit/GDP target. (They had to be certified as such by the EC.)

Then France and Germany started consistently violating the guidelines. And the EC tried to impose fines. In the end, the politicians of France and Germany overruled the EC (who fought them all the way to the highest EU courts.) And the ECB objected strenuously about the lack of fiscal discipline and the moral hazard that this precedent would create.

This flaw was well understood by the architects of the Euro zone. And they provided a solution. You can't blame this one on the economists. Nor can you say that the Eurozone had a fatal economic flaw.

[W. Peden]

Paul Friesen,

"Set a debt limit with real teeth."

A Gold Standard? Because any straightforward parliamentary debt ceiling can (and always will be) overridden by politicians.

[Jacques René Giguère]

Simon; There are reasons the gold standard was abandonned. The designers of the Euro forgot them all. Under Mundell's influence, who managed to comvine optimal currency zone work with a belief in gard money ( mostly due to his social conservatism), the ECB recreated a gold zone. The reason the guidelines were violated was that they made no sense as they were procyclical. Even the Bundesbank could have its moment of sanity ( une fois n'est pas coutume as we say une french ( once doesn't make an habit...)