Thoughts on the news from Greece

This is just to record my thoughts, so I can look back on this and see what I got right and what I got wrong. Or at least, what I changed my mind about.

The Euro was a mistake. I hoped (and still hope)  to see the Euro dissolved. But the Euro is now stronger than before. With enemies like Syriza, the Euro does not need friends. The government of Greece made a bad situation (that was maybe slowly improving a little) worse. And it will get much worse in the future, regardless of the vote in the referendum. If this is what an exit from the Euro looks like, who would want to follow Greece in exiting the Euro? And the perceived willingness of the ECB to do open market operations was probably what nullified the Greek threat to destroy the Euro unless it got what it wanted.

Monetary policy is important. What we have been seeing for the last few years is the effect of a monetary policy that was too tight for Greece. It caused a bad recession. But a monetary system that breaks down completely is far worse than bad monetary policy, and the monetary system in Greece is breaking down. Currency is extremely inconvenient for some transactions. And there isn't anywhere near enough currency to satisfy the demand. So the recession is getting worse and will get much worse. The Lucasian olive trees are still there, and still yielding fruit. But it's hard to trade olives for apples without some sort of functioning monetary system. A recession is first and foremost a fall in the volume of trade caused by an excess demand for the medium of exchange. Any fall in production and employment is a side-effect of the fall in trade. We are going to be seeing some very big side-effects.

I do not know whether Greece will now stay in the Euro or leave the Euro. The most likely outcome is a situation so messy that it can best be described as "neither". Network externalities make it hard to introduce a new money, even for a competent government that has the trust of its people. But with tax receipts falling even further, I think the government will be forced to issue scrip to cover basic expenditures, and that scrip may circulate as a medium of exchange, to some extent, alongside the Euro notes. And the banks won't be able to issue Euros any time soon, regardless of the vote in the referendum.

An agreement (like most trades) is an exchange of promises. It's hard to get a good agreement if the people you are negotiating with don't trust you. The Nash bargaining solution in a cooperative game (with credible promises) is normally better for both players than the Nash equilibrium in a non-cooperative game. If the Germans had trusted the Greeks, they could have offered an agreement that would have been better for both Germans and Greeks. But the Germans did not trust the Greeks. It seems they trust them even less now. It's not obvious to me the Germans are irrational in this.

If you are a member of the (Euro) club, you can try to change the rules of the club. But if you fail to persuade the other members to change those rules, you either follow those rules in good faith, or else leave the club. A good club should also have rules for members who want to leave the club, but if it doesn't have those rules, you just politely walk out the door.

I think Greg Ip [link? Found it.] is right about the mistake made by economists like me. We underestimated the popular support for the Euro as a political symbol of identity, despite all its economic disadvantages. Playing golf hurts your back, but you want to be a member of the golf club because of who the other members are and the sort of people who are not members.

Or maybe you could argue that the Euro is a bad monetary system, but Greeks believe that a monetary system run by Greeks would be even worse in practice, and that's why they want to keep the Euro.

Comments

[Rajat]

I think for countries like Greece, the Euro is not only a symbol of political identity, it's also a symbol of respectability. I was in Greece just last week and managed to get ripped off buying a bottle of Greek wine at a small tourist shop for five times its online price (I got my money back!). I was naive, but there's something about being in a country that uses the Euro that makes one more inclined to trust the bona fides of its traders than if the country had its own currency of soft repute! Or maybe that's just an excuse...

[Jim Rootham]

What evidence do you have that the Troika ever negotiated in good faith? It seems clear they never had any wish to see Greece recover.

[john]

Hey Nick!

when you say that 'monetary policy was too tight for Greece', what is the implicit time frame you are referring to?

[Nick Rowe]

Rajat: "I think for countries like Greece, the Euro is not only a symbol of political identity, it's also a symbol of respectability."

I think you are probably right, "respectability" is part of that identity.

Jim: the only vaguely plausible motive I can think of is if the Germans wanted Germany to be flooded with lots of cheap Greek workers. But if that were the motive, it would have been easier and cheaper just to let in more Turks, or whoever.

john: since about 2009, when Greek NGDP stopped growing and started declining. Before that it was too loose.

[Roger Sparks]

"Monetary policy is important. What we have been seeing for the last few years is the effect of a monetary policy that was too tight for Greece . (my emphasis).

I would like to couple this quote with a quote from Angel Gurria, Secretary-General of the OECD

"This Greek problem happened because, one day a few years ago we had a rounding problem. They said they had a 5 percent deficit and it was 15 percent. We've been struggling with the problem ever since."

which is found at http://www.cnbc.com/id/102808101.

I find a lesson in this pair of quotes. The lesson is that economic stimulus that is delivered through excessive government borrowing becomes stable (for a while). Stated in another way, the lesson is that an economy can adapt to annual doses of stimulus, becoming stable but dependent upon the annual dose.

If this is so, then Greece, by concealing the true amount of annual stimulus it was supplying when it entered a currency union having a limit of 5% annual stimulus, was setting up itself for a period of economic adjustment. Stated another way, by entering the euro zone, Greece should have expected the annual rate of stimulus to decline from 15% to 5%. A decline would induce a period of recession.

The expected decline did not occur. Why not?

I would suggest that the annual cost of stimulus was shifted from the sole Greek economy to the entire of the euro zone. The change in Greek inflation rate should be matched with the increase in Greek euro debt. (I have not attempted to confirm this suggestion with actual data.)

But, despite no confirmation, I close this comment repeating that Greece seems to be an example of an economy experiencing a decrease in the rate of stimulus.

[Nick Rowe]

Roger: standard macro theory agrees with you. Even under fixed exchange rates (so there is no monetary offset), a fiscal deficit will only have a temporary effect on output and employment (though "temporary" may mean several years). Eventually the price level (and nominal wage level) rises, so the "real" (adjusted for price levels) exchange rate appreciates, so net exports fall, and so output and employment return to (roughly) the original level, with smaller (i.e. negative) net exports balancing bigger G. And then if you eliminate the deficit you get a recession, because it takes the same several years for prices and nominal wages to fall to bring the real exchange rate back down again.

[Phil Koop]

the only vaguely plausible motive I can think of ...

Well some people can think of other reasons. See Yglesias here: http://www.vox.com/2015/6/27/8856297/greece-referendum-euro. The capsule version is that it is in the interests of the troika to destroy Greece to deter other eurozone members from defaulting on their debts. The "reforms" demanded by the troika in return for renewing its loans to itself are obviously destructive; eurocrats are both highly intelligent and highly educated so there is no good reason to assume they cannot perceive this fact. Since it is in the interests of the troika to destroy Greece, and they are taking actions to destroy Greece, the parsimonious explanation is that the troika is in the process of deliberately destroying Greece in order to advance its own interests.

Trust between Germans and Greeks seems to be beside the point; the issue is that Greeks don't trust Greeks. Greece has neither a primary fiscal deficit nor a trade deficit; if it defaulted, it would have no economic requirement for new euros. The demand for euros is generated by Greeks moving their money out of Greece. If Greeks wanted to, they could default on their debts and stay in the euro and there's nothing anyone could do about it.

[Nick Rowe]

Phil: paying debts is itself a punishment, in that it is costly to the debtor. It's like paying a fine. Think of the range of outcomes that satisfy the constraint that other debtors are deterred. Why would the creditor choose a corner solution along that constraint, if interior solutions (where the debtor pays some amount) would be better for the creditor? If it were a choice between kneecapping the debtor vs letting the debtor off scot-free, I can see why the creditor would choose kneecapping, pour encourages les autres. But (with trust) if the debtor would be willing to pay an amount up to $X to avoid kneecapping, the creditor would strictly prefer to accept $X rather than engage in (costly) kneecapping. The mob uses kneecapping only because it can't enforce promises to pay a fine.

[Nick Rowe]

Phil: a few months back the Greek government had a small primary surplus. But I think I read that tax collections fell after Syriza was elected. And there is no way they have a primary surplus this week, except maybe by failing to pay things like pensions. The government has run out of cash even for basic stuff, let alone paying debts.

And I think I read yesterday that half the deposits that left Greek banks went to non-Greek banks, and the other half went into currency.

I think you are right that there is a scenario where the Greeks use a mixture of Euro currency and foreign Euro bank accounts. But what will the Greek government do?

[Market Fiscalist]

The idea of scrip sounds like it might provide some wiggle room that allows Greece to stay in the euro while addressing its monetary disequilibrium.

I have a thought experiment.

Suppose the current government of Greece resigns and a market-friendly one takes over.

Suppose they announce "We are committed to letting market forces align Greece's economy with the rest of Europe. However our economy has a huge misalignment between the price level and the supply of money and we do not have any monetary policy space to correct that. Our policy therefore will be this: We will target NGDP growth of 5% and we will achieve this by buying stuff for scrip until we hit the target." (The NGDP target and nominal value of scrip would be in Euros).

is there any chance that such a policy would work ? (If they had enough credibility when they made this statement - perhaps being backed by the ECB ? - they presumably wouldn't actually have to issue much scrip).

[Nick Rowe]

MF: if the nominal value of scrip is in Euros, how would they prevent it depreciating? Is it just another form of debt? Is it redeemable on demand in Euros (they can't pay)?

[Majromax]

@Fiscalist:

I don't think that would work. Scrip would suffer from hyperinflation.

As long as Greece remains in default, it will be unable to borrow from international capital markets. This could be transient if Greece were also running a primary surplus, where absent the existing stock of debts its operations would face a liquidity but not solvency issue, however Greece could not sustain a primary deficit.

Without recourse to capital markets, the nation would have to make up the difference with seigniorage revenues. However, since it cannot print Euros it would have to do so via scrip. But in turn, that printing of scrip to finance the deficit would cause holders to very credibly doubt that they would be able to exchange scrip for Euros at par.

That would cause the de facto exchange rate to move, and it would make it very difficult and expensive to re-adopt the Euro wholesale. If Greece promised that scrip could be used to pay tax burdens at par, then we would see very little private circulation as everyone would return it to the government as soon as possible.

The only useful outcome would be the circulation of scrip as a floating currency, but then we may as well call it a drachma and be done with it. Even still, without recourse to capital markets Greece would find itself unable to finance significant primary deficits.

Unfortunately, I think the country's bargaining position evaporated with its primary surplus. If the nation still had one, it could tell its creditors to go fly a kite and (on the balance) been fine, even within the Euro.

[rsj]

I think that Greece's particular struggles have to be seen through the lense of tax avoidance.

When Greece had it's own currency, the government wasn't able to tax the Greek elite and small business classes -- which hold substantial wealth -- but could impose an inflation tax. The euro closes the door to that, so the euro is preferred, even if the unemployment rate is very high. If you take the point of view of "every man for himself", then the unemployment rate isn't nearly high enough to justify an exit from the euro for these groups. The vicious cycle is that as the government stops functioning and providing basic services, the "every man for himself" argument becomes more, rather than less, persuasive.

These types of arguments hold more weight for me than ones based on identity. Identity is a fluid concept that can be used to explain many things, whereas the desire to preserve your family's wealth leads to much more focused action.

[Nick Rowe]

rsj: good point about the inflation tax. Like import tariffs, its a bad tax, but if it's hard to collect the better taxes, it might be the best of a bad lot.

[Nick Rowe]

rsj: and your point about arguments based on "identity" reminds me of Frances' argument that "culture" is a lousy explanation.

Can't help but think there's something to it though.

[Market Fiscalist]

"MF: if the nominal value of scrip is in Euros, how would they prevent it depreciating? "

Lets assume they swap the scrip for assets they will be able to sell later (perhaps they pay people to build bridges etc if no-one will sell them existing financial assets for scrip) and the value of scrip is allowed to float against the euro.

If Mike Sproul is correct then as long as they make wise decisions as to what they buy for scrip it shouldn't depreciate.

If he is not right, and people start to expect scrip inflation, then that would speed up scrip velocity which would help NGDP growth as long as the depreciation could be kept manageable.

If (for example) scrip was offered as an option for paying taxation then it may become a viable alternative currency until full stabilization is achieved, and help reduce depreciation risk.

[Nick Rowe]

MF: the Greek government is bust. If there's (say) a 10% probability the scrip will be redeemed at par in the future, it might simply drop in value instantly to 10% of its face value, then just sit there in speculators' portfolios, without circulating. Now if the scrip does circulate as a medium of exchange, there will be a demand to hold it even if people expect it to depreciate in value as more scrip is issued. But it's not obvious that it will circulate. There are always two equilibria with something that might be used as money: everyone uses it because everyone else uses it; nobody uses it because nobody else uses it.

[Market Fiscalist]

"There are always two equilibria with something that might be used as money: everyone uses it because everyone else uses it; nobody uses it because nobody else uses it.'

Yes, I see it does depend upon scrip being accepted as money and that is not a given. But if is backed by the (new ,trustworthy) govt and accepted for tax payments etc, it doesn't seem out of the question it would be a viable option. There is after all a shortage of money at current price level that is hampering trade and scrip might partially address that. If you've got a bunch of olives you can't sell for Euros you may as well take scrip, which you then use to hire a plumber who likewise can't sell his services for Euros etc.

[Lord]

It is hard to get much worse than the depression they have already been in. As long as residents have accounts outside of Greece, it shouldn't be difficult to operate, only difficult to come by the cash to fund them. Easier for exporters than importers, easier for tourism than locals. Mostly it would move to cash in advance, possibly with a discounted (due to liquidity) script circulating domestically, government spending it and collecting it in taxes, or domestic banks issuing it for withdrawals and accepting it for deposits. Maintaining a surplus with a buffer would make script unnecessary or only temporary for the time to establish it. I expect they will keep the euro as those with it will want to see its value preserved and want to minimize disruptions in the hope of some future relation to it. Once running a surplus the government could then be selective about which claims it may pay, favoring domestic institutions.

[Jordan Charbonneau]

Nick, in a nutshell, what is the economic argument against the Euro (which I, from the vantage point of a consumer, see as facilitating exchange among the member countries)? If you've already posted on this subject, feel free to point me to it.

[rsj]

Nick,

"Can't help but think there's something to it though."

Of course there is! And if, in the next generation, the EMU has serious problems with inflation and governance, while the Greek drachma is stable, the exact same people who are now partaking in the joys of a common European identity will discover the joys of Greek Identity, and as they get used to thinking of themselves as exceptional Greeks, they will be authentic in their identity-based arguments. Same damn people. Identity is a flag that we drape around things -- it hides rather than reveals -- because no one wants tax avoidance to be a rallying cry for national policy.

[Nick Rowe]

Jordan: I have posted on it before (I think) but in a nutshell:

1. A monetary policy that is too loose for one country may be too tight for another country, or vice versa. If each country has its own central bank, one can tighten and the other can loosen, or vice versa. "Asymmetric shocks".

2. If you have a recession (too little money), and your government bonds are seen as risky so interest rates are rising, if you have your own central bank you can print money and buy bonds, fixing both problems at the same time. "Lender of last resort".

But yes, the advantage is that it facilitates international trade.

[Jacques René Giguère]

Nick: but what trade is facilitated if you !"/$% up your partner's economy?
Anyway, I remember an article in The Economist where they tabulated the cost of starting in London to Parisand exchanged all your money into FF then go to Brussels and changed into BF and then on to every country in Europe. Everything was eaten up by transaction costs. Except that nobody have done that since the Middle Ages when you went from the County of Krapusnick to the Margraviat of Pomfritt through the Earldom of Madnosia,melting all your coins at each border...
That was the intellectual level of pro-euro arguments at the time. It just got worse...

[rsj]

But the trade argument is really silly i think. We have computers now. It's really easy to convert currencies -- the foreign exchange market turns trillions of dollars worth of currencies each day. You can pay with your credit card and they will do the forex on the back end, so you don't even need to think about it.

What facilitates trade is harmonized business licensing and regulations, so that if you are a pharmaceutical company, you don't need to get approval from 40 different governments to sell your drugs in each nation. Or if you sell milk, you don't need to deal with inspectors from 40 different nations. The "difficulties" of going from pounds to francs are non-existent and have no bearing on trade.

[Jim Rootham]

Just a reminder about how this all got started in the first place (hint, the Greek government wasn't really involved) http://www.interfluidity.com/v2/5965.html

[Kevin Donoghue]

Jim Rootham,
I hope Nick follows that link. Ut's a very sound post. As to your earlier question, I think Voltaire had a better theory than Nick as to why the Schaeubles of this world treat the Greeks as they do: pour encourager les autres.

[Nick Rowe]

Kevin: I followed it. I usually read his posts. There's much there I agree with. See my discussion with Phil Koop above, on Voltaire's theory.

Jim: Sure. This is really about the Euro, more than about Greece. Greece is just the worst end of the spectrum. Even governments that were sensible and trustworthy got hit hard.

[Ralph Musgrave]

Nick concludes by saying "Or maybe you could argue that the Euro is a bad monetary system, but Greeks believe that a monetary system run by Greeks would be even worse in practice, and that's why they want to keep the Euro."

The "maybe" there is wrong. That is, Greeks DEFINITELY prefer the Euro plus austerity to returning to the Drachma according to a recent survey.

[Ralph Musgrave]

Jordan Charbonneau,

What’s wrong with the Euro is nicely illustrated by the austerity being imposed on Greece and other periphery countries. That is, in a common currency area, individual countries which lose competitiveness cannot devalue. Ergo they have to go for INTERNAL DEVALUATION, and that’s achieved by years of austerity. Not a brilliant system.

And the reality is that EU countries OUTSIDE the EZ have fared better since the Euro was created than those INSIDE. See:

http://www.independent.co.uk/news/business/comment/hamish-mcrae/the-eurozone-has-underperformed-since-the-single-currency-launched-10359630.html

[Ralph Musgrave]

Jordan Charbonneau,

What’s wrong with the Euro is nicely illustrated by the austerity being imposed on Greece and other periphery countries. That is, in a common currency area, individual countries which lose competitiveness cannot devalue. Ergo they have to go for INTERNAL DEVALUATION, and that’s achieved by years of austerity. Not a brilliant system.

And the reality is that EU countries OUTSIDE the EZ have fared better since the Euro was created than those INSIDE. See:

http://www.independent.co.uk/news/business/comment/hamish-mcrae/the-eurozone-has-underperformed-since-the-single-currency-launched-10359630.html

[Ralph Musgrave]

Nick’s concluding para isn't quite right. He says “Or maybe you could argue that the Euro is a bad monetary system, but Greeks believe that a monetary system run by Greeks would be even worse in practice, and that's why they want to keep the Euro.”

It’s not a case of “maybe”. According to a recent survey, Greeks DEFINITELY prefer the Euro plus austerity to reverting to the Drachma. Doesn’t say much for their confidence in their ability to run a currency, does it? Why, in those circumstances, they describe themselves as a “proud nation” is beyond me.

[Kevin Donoghue]

Ralph Musgrave,
It's not just the Greeks. There's a widespread belief that devaluation always results in an inflationary spiral. It's quite hard to convince people that there have in fact been numerous examples of successful devaluation (as well as numerous failures it must be admitted). Back in the 1990s the reason many people looked forward to the creation of the Eurozone was that we would have German rates of inflation and German nominal interest rates. It seemed likely to work and with better bank regulation it maybe could have.

[Nick Rowe]

[Ralph's duplicates aren't Ralph's fault. I'm just training TypePad.]

I'm gonna be off-air for a few days. Play nice.

[Avon Barksdale]

"The Euro was a mistake. I hoped (and still hope) to see the Euro dissolved."

It's sad to see an economist say this. It is an utterly ignorant position.

The US dollar has been great for the US states and territories. Puerto Rico is at serious risk of default, but notice how it's not really that big of a deal. Banks are not closing, accounts are not being seized, and there is no threat that Puerto Rico will be kicked out of the "dollar-zone".

The Euro is a wonderful idea. All that needs to happen in the currency union is that individual member states can default. Treat the sovereign debt like any other corporate debt. Stuffing banks with sovereign debt in a government managed banking system is the problem - not the Euro itself.

[Scott Sumner]

Excellent post. And nice example of the importance of money as a medium of exchange.

[David Andolfatto]

Nick,

I think you'll find this piece of interest: http://www.interfluidity.com/v2/5965.html

David

[Patrick]

25% unemployment, and 60% unemployment among youth is unstable. Even if one doesn't care about the suffering it causes, it's bound to lead to bad things. I've been pleasantly surprised that it has become really violent and chaotic.

However they got to this point, it seems to me (as a rank amateur observer) that Greece will never be able to repay ever more loans with an ever shrinking economy. When this happens to individuals or businesses, we have bankruptcy laws to clean-up the mess in an orderly fashion, put the debtor on a short leash, but also let them and let them start-over. Greece needs something along these lines.

If Greece can somehow manage to get some debt relief and get out of the euro and issue New Drachma - and actually get people to use them - that would seem to be the best option for everyone. They'd be able to set their own monetary policy and the Germans wouldn't need to deal with them anymore (and vice versa). But from what I've read, it also seems to be the most unlikely.

I'm sympathetic to Syrizah desire to end the suffering, but I can't see how they can move ahead after a 'no' vote, and a 'yes' vote probably means a snap election.

And the Germans et. al. should be careful what they wish for. AFAIK, there is no means to kick someone out of the EU, even if they are effectively forces off the euro, so if Greece becomes a failed state, the Germans (and French, etc) soon find themselves with a flood of refugees - after all, as EU citizens Greeks have freedom of movement within the EU.

[Roger Sparks]

Here is an interesting comment on the Greek banks by John Cochrane

http://johnhcochrane.blogspot.com/2015/07/greece-vs-puerto-rico-and-whats-systemic.html

[Jordan Charbonneau]

Thanks for responding, Nick. I understand those arguments, but my counterargument is the same as Avon Barksdale's: how is this any different than the currency union of a country? My understanding is that Alberta and Ontario have different preferences for the value of the Canadian dollar, but we've managed to survive as a country despite this. Why is the Euro different?

rsj, you are right about the role of computers. The reason I put the bit about the perspective of a consumer in my comment, however, is that most travelers don't benefit from that power: we still have to convert Canadian dollars into American dollars, for example, every time we want to travel between those two countries. This is to say nothing of importers and exporters who aren't able to take advantage of computing power to facilitate trade they would like to conduct between two countries using different currencies.

[rsj]

Jordan,

The banks have "computing power". Last time I was in Europe, I paid with my credit card for most things (like I do in the U.S.) and the currency conversion happened automatically. In those cases when I wanted to pay with cash, I did exactly what I do when I want to pay with cash at home -- I went to a bank/ATM and withdrew cash, except it was in the right currency for the location of the bank/atm.

I just don't see the overhead costs here...

If a small business has no access to a payment system such as a credit card vendor account, an online account such as paypal, or a bank account to which customers can make payments by writing checks or wiring money, well, they will need to schlep over to the bank to deposit their hoards of foreign currency cash into their account, just as they would need to do if they were depositing their hoards of domestic cash. But they should consider using a modern payment system offered by a large bank. The bank will have a correspondent account in other nations and will be able to clear international payments made by your foreign customers.

Really, this is like complaining that we should form a united world government because of the difficulties of international postage. Cross border financial flows are a solved problem and does not need any form of monetary unification.

[Determinant]

Driving Greece into a Great Depression is nothing short of criminal. Default, print the New Drachma and get on with it. It is another form of insolvency; the creditors take a haircut and move on. On the flip side, the debtor should not expect any more loans in the future. Greece cannot pay and I do not see the sense in beating a dead horse for something that will not come.

And having Germany as the party responsible for this debt collection witchhunt is beyond irony, considering the shenanigans that Germany pulled with respect to both inflation and deflation in the 1920's and 1930's (self-inflicted, I might add), and the considerations that were extended to them to enable them to have the economy they now have.

[Bob Smith]

Jordan,

It's certainly true that different parts of Canada (and the US) have different preferences for monetary policy. But if anything those examples illustrates precisely why the Euro was a terrible idea.

Canada and the US have fiscal unions (to a degree) with cash transfers from different parts of the union to others. The EU doesn't have the same degree of transfers (and what they do have tend to for ill-conceived projects such as subsidizing agriculture, rather than macro-economic stabilization).

Canada and the US have true national identities and institutions. The EU doesn't. Americans complain about the government bailing out American banks, the don't complain about bailing out California banks or Florida banks or Michigan car companies. I'd suggest to you that the 2008 recession would have played out very differently if American identified principally with their state, rather than as Americans. I suspect only a distinct mminority of citizens of EU countries identify primarily as EU-ers rather than Greeks, Germans, French,etcm.

Canada doesn't have Ontario banks or Newfoundland banks (since banks are federal jurisdiction - we do have provincial credit unions, but they're generally small). The Greek situation would be totally different if the EU had a Canadian style banking system with EU-wide banks. They don't.

Moreover while the EU may have some attributes of an optimal currency union, namely labour mobility, it's easy to see why that's not likely o be as effective as it is in Canada or the US at absorbing asymetric shocks. Americans and Canadians (at least outside Quebec) share a common language. A Newfoundlander can readily move to Alberta to find work if need be (or vice-versa - and frankly many Quebequers speak English well enough to find work in English Canada if neccesary). Ditto for Americans. How many Greeks speak German? Or French? Or Dutch? I'm willing to bet that few Greeks speak all three (to say nothing of all the the other EU languages). It's all well and good to say the EU has labour mobility, but in practice the linguistic and cultural differences between the EU member countries are so radical (relative to the same differences in Canada or the US) as to make such mobility far more costly relative to Canada or the US.

As for the purported benefits of a currency union, I don't see it. The reality is that the transaction costs associated with different currencies are nominal and can readily be managed by importers/exporters. To be sure, it may well be worth eliminating those costs in a optimnal currency area, but not in the EU.

The only other purported benefit of a common currency is that it might impose fiscal discipline on those countries used to inflating away their problems - clearly that benefit was never realized in Europe.

[Lord]

It takes more than a currency union to make a country and more than diktats to rule.

[Bob Smith]

Looks like the Greeks voted "No" - this should be "interesting" (in the sense of the old Chinese curse "may you live in interesting times").

[Avon Barksdale]

Bob Smith,

A currency union does not require a fiscal union. The euro is a fantastic idea. We just need to let individual states default with no bailouts.

[Bob Smith]

Avon,

Can you name a currency union other than the EU which doesn't have substantial fiscal transfers between its constituent jurisdictions? It's all well to say that you can have a currency union without a fiscal union, but the one example of such a creature is busy imploding.

I'm happy to concede that it's theoretically possible to have a currency union without a fiscal union, but in a democratic society such a union is likely to prove unstable, since the average monetary policy is unlikely to be optimal for all the component jurisdictions (unless you have a highly homogenous economy, a very high degree of labour mobility,etc.). The reality is that every country with its own currency is a currency union of a sort, they are almost all fiscal unions of some sort or another. Only the EU has tried to have a currency union without a corresponding political and fiscal union (the EU level of government lacking legitimacy in most EU member states).

[Avon Barksdale]

Bob Smith,

Why is there an interest rate spread between bonds issued by different American states?

[Frank Restly]

Avon,

"Why is there an interest rate spread between bonds issued by different American states?"

http://www.pewtrusts.org/en/research-and-analysis/blogs/stateline/2014/06/09/sp-ratings-2014

Because there are economists from various states (Illinois?) that think it is a good idea for states (and countries) to default on their loans. All joking aside, policy makers at the state and federal level get a fair amount of their economic policy ideas from academia, some good, some bad.

If a state internalizes it's own debt, then their is no net benefit to defaulting. States that rely heavily on external financing tend to pay higher interest rates and are considered a larger credit risk.

[Frank Restly]

Avon,

Also, interest income from municipal and state bonds is often non-taxable on the federal level when purchased by a resident of the state where the bond was issued. Meaning that a person choosing between a bond from his / her home state versus an out of state bond would require a higher nominal interest rate on an out of state bond to receive the same after tax income.

Again, this lends credence to states relying heavily on external financing being forced to pay a higher nominal interest rate.

[Bob Smith]

Avon,

I'm not sure what you think you're implying.

Someone has previously posted the bond yields for Canadian provinces and what is remarkable is how little variation there is amongst them despite very real differences in provincial debt levels and each provinces' intrinsic fiscal capacity. If the US numbers are different, please post them, but given the rating information posted by Frank, I'd be surprised if the differences are radical.

[Avon Barksdale]

Bob and Frank,

Learn something, read more. Stop making things up to explain away facts that you don't understand.

The US federal government is not necessarily going to bailout Puerto Rico, any state, city or municipality (technically it's the creditors who get bailed out). The same is true for Canada. The market knows this. As a result, investors demand extra yield for debt that has a higher chance of default. Higher interest rates reflect higher risk. Each borrowing unit in North America has a credit rating - it's not just a carbon copy of the American or Canadian federal government's credit rating. If Illinois defaults, Illinois bond holders will not get paid back.

People keep saying that a currency union needs fiscal union, but it is simply not true.

[Majromax]

> The US federal government is not necessarily going to bailout Puerto Rico, any state, city or municipality (technically it's the creditors who get bailed out).

Stop thinking of a fiscal union in terms of bailouts -- think of it in terms of baseline spending.

The individual US states represent a far lower share of spending than do EU states. Look at tax collection, where the bulk of taxes collected go to Washington rather than individual state capitols. Even if a state defaults, the absolute level of public austerity will be significantly less than in the Eurozone, because this federal funding will continue.

We also see this in the deficit numbers. Illinois's default-risking deficit is about $6.5bn, or less than 1% of state GDP.

If Greece's ongoing fiscal woes represented just 1% of the nation's GDP, they would be newsworthy.

Canadian provinces are bigger than their US counterparts, but the nation also has a history of explicit financial transfers, both for operational expenses (the health transfer being the biggest) and for general revenues in the form of equalization. Again, both of these (combined with Federal backing of the financial sector) act as partial stabilizers.

A situation like Greece's is simply not possible in the US or Canada.

[Majromax]

> If Greece's ongoing fiscal woes represented just 1% of the nation's GDP, they would be newsworthy.

Addendum here: I clearly meant to say "they would not be newsworthy."

[Frank Restly]

Avon,

The question you asked:

"Why is there an interest rate spread between bonds issued by different American states?"

My answer:

In part because of the federal tax treatment of interest received on those bonds based upon who holds that debt.

I don't deny that state debt carries credit risk with it. However, measuring that credit risk by simply looking at interest rate spreads between bonds issued by different states will not be an accurate measurement.

Your implication is that interest spread is a function of credit risk. My answer is that interest spread is a function of a number of variables, credit risk being one of them.

[Bob Smith]

"The US federal government is not necessarily going to bailout Puerto Rico, any state, city or municipality (technically it's the creditors who get bailed out). The same is true for Canada. The market knows this. As a result, investors demand extra yield for debt that has a higher chance of default. Higher interest rates reflect higher risk. Each borrowing unit in North America has a credit rating - it's not just a carbon copy of the American or Canadian federal government's credit rating. If Illinois defaults, Illinois bond holders will not get paid back."

A couple of points.

First, don't be a d!ck.

Second, you haven't provided any evidence to support the proposition that borrowing costs vary significantly amongst US states and Canadian provinces. Frances posted the following study a few years ago which suggests that the gap is much smaller than I would have thought, based on the intrinsic economic capability of Canadian provinces: http://www-2.rotman.utoronto.ca/~booth/Provincial%20debt.pdf.

Third, is it your contention that Canada and the US aren't fiscal unions? That other countries with their own currencies aren't fiscal unions (inherently a unitary state is a fiscal union in the sense that the unitary government does everything), and most federal states have some degree of federal fiscal policy)? Bold statement.

Finally, a fiscal union doesn't neccesarily imply that a federal government will bail out subnational governments. The US clearly has a fiscal union (and Puerto Rico is clearly part of it, given that a significant portion of its spending is funded by US federal grants and subsidies), and has consistently not bailed out various bankrupt subnational governments (mostly at the city level, New York, Detroit, etc. - come to think of it, New York and Michigan state can also be thought of as fiscal unions, but haven't bailed out their cities).

What a fiscal union does imply, however, is that government spending in a particular subnational region is not solely a function of local government revenue (basically Majromax's point). Even if Detroit can't pay its civil servants, federal and state civil servants still get paid, state and federally funded health care or education still gets provided, old people still get their social security checks. Moreover, the existence of a fiscal union, even if it doesn't eliminate the risk of default, at least reduces it, since federal transfers to subnational governments allow subnational budgets to ride-out local economic disruptions (witness the very narrow spreads in bond yields between Canadian provinces). A fiscal union provides a shock absortion mechanism which replaces monetary policy as a means of dealing with economic shocks. The Euro members have neither mechanism at their disposal, so it was only a matter of time before one of them crashed. I suspect Greece won't be the last.

[Bob Smith]

"People keep saying that a currency union needs fiscal union, but it is simply not true."

No one is saying that a currency union NEEDSa fiscal union. Had you "read more" of my comment, you would have noted that I happily conceded that you can have a currency union without a fiscal union - we have one in the EU. What people do say, dating back to Robert Mundell's work on optimal currency areas, is that a currency union without a fiscal union is likely to be unstable. That's particularly true in a currency union (such as the Euro zone) which lacks other attributes of an optimal currency area (inter-regional wage flexibility, significant labour mobility, a similar business cycle, a common identity) The EU experience is bearing that prediction out.

[donald]

Nick, that's quite a states-as-single-entities rules-are-rules kind of a way of looking at things which implies important value judgements which you don't bother to discuss or justify but which you really should because this is important stuff and your blog probably has some small influence over how people think about this.

[Declan]

"If this is what an exit from the Euro looks like, who would want to follow Greece in exiting the Euro?"

This isn't what an exit looks like, this is what staying looks like. You'd need at least a year or two after exit occurs to see what an exit looks like.