Eurozone

Milton Friedman is having the last laugh on euro

Portrait_of_Milton_Friedman
The euro came into being on January 1, 1999. On this day, 11 countries in Europe joined together to form what came to be known as the Eurozone or countries which use the euro as their currency. Greece joined the Eurozone on June 19, 2000, and gave up on its own currency, the drachma.

Fifteen years on Greece is in a terrible economic state. More than 50% of its youth population is unemployed. The economy has contracted by 25% since 2010. And its debt to gross domestic product (GDP) ratio has jumped to 175% from 129% in 2009.

Also, the country has voted against a referendum which essentially asked the citizens whether they were ready to face more austerity measures in return for a third bailout by the economic troika of the International Monetary Fund, the European Commission and the European Central Bank.

The country owes around 240 billion euros to the European Commission, the European Central Bank (ECB) and the IMF. The troika has been lending money to Greece for a while now. As Mark Blyth writes in Austerity—The History of a Dangerous Idea: “In May 2010, Greece received a 110-billion-euro loan in exchange for a 20 percent cut in public-sector-pay, a 10 percent pension cut, and tax increases.”

Every time the troika lends money it demands more austerity measures from Greece. The troika wants to ensure that the budget of the Greek government enters into a positive territory so that the country is finally able to start repaying the debt it owes, instead of borrowing more to repay what it owes.

The troika wants the Greek government to run a surplus i.e. its revenues should be more than its expenditure. As Blyth writes that the idea seems to be to: “Cut spending, raise taxes—but cut spending more than you raise taxes—and all will be well.” The trouble is that the austerity that has accompanied Greece has hurt rather than helped Greece. As the GDP has contracted, the debt to GDP ratio has jumped up majorly.

This vote against the referendum has made Germany more aggressive on the question of allowing Greece to continue staying in the Eurozone. While it is difficult to predict which this will go, my guess is that ultimately Greece will allowed to stay in the Eurozone and the current crisis will be postponed for a latter day, for the simple reason that the euro is ultimately as much a political idea as it is an economic one.

A major reason for which countries within Europe came together to form a monetary union and start using a common currency was to ensure closer economic cooperation and integration in order to ensure that countries in Europe did not fight any more wars against each other. The First and the Second World Wars were the deadliest wars that the world had ever seen.

As the Nobel Prize winning American economist Milton Friedman wrote in a 1997 column: “The aim has been to link Germany and France so closely as to make a future European war impossible, and to set the stage for a federal United States of Europe.”

Having said that monetary unions are not always easy to run. As Friedman wrote: “A common currency is an excellent monetary arrangement under some circumstances, a poor monetary arrangement under others…The United States is an example of a situation that is favorable to a common currency. Though composed of fifty states, its residents overwhelmingly speak the same language, listen to the same television programs, see the same movies, can and do move freely from one part of the country to another; goods and capital move freely from state to state; wages and prices are moderately flexible; and the national government raises in taxes and spends roughly twice as much as state and local governments.”

As far as countries coming together to start using the Eurozone were concerned, their residents spoke different languages, they watched different television programmes and movies and did not really move freely from one country to another. And most importantly different countries needed a different interest rate policy at different points of time.

But within a monetary union with a common currency that is not always possible. And this led to problems within the Eurozone. As Ramesh Ponnuru writes on Bloomberg View: “During the boom years a decade ago, Greece and other countries on Europe’s periphery over-borrowed because interest rates were inappropriately low for them.”

In 1992, before the euro came into being, the German government could borrow at 8% and the Greek government at 24%. By 2007, this difference had largely gone. The German government could borrow at 4.02%. And the Greek government could borrow at 4.29%. When the interest rates for the government fell, fell as dramatically as they did in parts of the Eurozone, the government as well as the private sector ended up borrowing a lot more.

And this primarily led to a huge housing bubble across large parts of the Eurozone. In a normal scenario where there was no monetary union the central bank of a country could have raised interest rates and made it more expensive for the private sector to borrow. This would have ensured that the real estate bubble wouldn’t have gone on for as long as it did.

But the European Central Bank had to keep the entire Eurozone in mind and not just Greece and other weaker countries like Spain, Italy and Portugal. Hence, it allowed the low interest rates to remain low.

In the aftermath of the crisis, the weaker countries in the Eurozone needed low interest rates. As Ponnuru writes: “During the bust, the European Central Bank’s efforts to keep inflation low in the core has led to a punishing deflation in the periphery. The European Central Bank raised interest rates in 2008 and 2011 — at both the start and the middle of Greece’s depressions.”

Even if Greece continues to be within the Eurozone in the days to come, these basic problems with the euro will continue to remain. And that would mean that euro and financial crises will continue to be closely linked.
The column appeared on The Daily Reckoning on July 8, 2015

 

Grexit: Why Amartya Sen and Thomas Piketty are right about Germany

thomas piketty
The French economist Thomas Piketty whose bestselling book Capital in the Twenty First Century was published last year, in an interview to the German newspaper Die Zeit recently said: “What struck me while I was writing is that Germany is really the single best example of a country that, throughout its history, has never repaid its external debt. Neither after the First nor the Second World War.”

In the recent past, Germany has been insistent that Greece repay the money that it owes to the economic troika of the European Central Bank, the European Commission and the International Monetary Fund. As Piketty remarked: “When I hear the Germans say that they maintain a very moral stance about debt and strongly believe that debts must be repaid, then I think: what a huge joke! Germany is the country that has never repaid its debts. It has no standing to lecture other nations.”

In order to understand what Piketty meant we will have to go back nearly 100 years. At the end of the First World War in 1918, Germany had to compensate the victorious Allies (read Britain, France, and America primarily) for the losses it had inflicted on them.

At the reparations commission, the British delegation wanted Germany to pay $55 billion as compensation to the Allies. This was a huge number, given that the German gross domestic product (GDP) at that point of time stood at around $12 billion.

The Americans were fine with anything in the range of $10 to $12 billion and did not want anything more than $24 billion. The French did not put out a number of what they were expecting but they wanted a large reparation from Germany.

This was primarily because when the French had been in a similar situation in 1870 they had paid up Germany. After France had lost the Franco-Prussian War, Germany had asked France to pay 5 billion francs to make good the losses that it had faced during the course of the war. The French had rallied together and paid this money in a period of just two years.

Given this historical back­ground, they saw no reason why Germany should not be made to pay for the losses that France had suffered. The French assumed that like they had paid the Germans 50 years back, the Germans would also pay up. As Piketty put it in the interview: “However, it has frequently made other nations pay up, such as after the Franco-Prussian War of 1870, when it demanded massive reparations from France and indeed received them.”
In May 1919, it was decided that Germany would pay the Allies an initial amount of $5 billion by May 1, 1921. The final reparation amount to be paid would be decided by a new Reparations Com­mission.

Finally, the total reparations amount that Germany would have to pay the allies was set at $12.5 billion, which was equal to the pre-war GDP of Germany. To repay this amount, Germany would have had to pay around $600–$800 million every year.

Germany was in a bad state financially and at the end of the war had a budget deficit that ran into 11,300 million marks (the German currency at that point of time). As the government did not earn enough revenue to meet its expenditure due to the high-reparation payments, it started to print money to finance pretty much everything else.

This finally led to the German hyperinflation of 1923. Inflation in Germany at its peak touched a 1,000 million per­cent. Interestingly, one view prevalent among economic histori­ans is that Germany engineered this hyperinflation to ensure that it did not have to pay the reparation amounts. The hope was that, with inflation at such high levels, the Allied countries would deal with Germany sympathetically when it came to deciding on repa­ration payments. And this is precisely what happened.

By the time the hyperinflation came to an end, the economy was in such a big mess that the repa­ration payments had slowed down to a trickle. And it so turned out that over the next few years more was paid to Germany in the form of various loans than it paid the Allies in reparations. After this, Germany regularly continued to default on the pay­ments and finally when Hitler came to power in 1933, he stopped these payments totally.
As mentioned earlier, after the hyperinflation of 1923, money had started to pour in from other nations into Germany. A substantial part of the preparation for the Second World War was financed through this money.

The Second World War started in 1939 and ended in 1945. Given the fact that Hitler had used foreign money to get the Second World War started, the directive at the end of the Second World was that nothing should be done to restore the German economy above the minimum lev­el required to ensure that there was no disease or unrest, which might endanger the lives of the occupying forces.

Eventually, the realization set in that an economic recovery in Europe was not possible without an economic recovery in Germany, the largest economy in Europe. The American Secretary of State, George C. Marshall, after having returned from Moscow in April 1947, was convinced that Europe was in a bad shape and needed help. This eventually led to the Marshall Plan. From 1948 to 1954, the United States gave $17 billion to 16 countries in Western Europe, including Germany, as a part of the Marshall Plan.

So what does all this history tell us? One is that Germany did not repay the debt that it owed to the Allied nations and hence, as Piketty said: “Germany is the country that has never repaid its debts. It has no standing to lecture other nations.”
But there is a bigger lesson here—that demanding austerity from Greece in order to be able to repay the debt isn’t exactly the answer. The German experience after the First World War precisely proves that.

The Nobel Prize winning economist Amartya Sen, writes about the German experience after the First World War, in a recent column. As he writes: “Germany had lost the battle already, and the treaty was about what the defeated enemy would be required to do, including what it should have to pay to the victors. The terms…as Keynes saw it…included the imposition of an unrealistically huge burden of reparation on Germany – a task that Germany could not carry out without ruining its economy.”

And this is precisely what has happened in Greece over the last few years. The country now owes close to 240 billion euros to the economic troika. The austerity measures have had a highly negative impact on the Greek economy. As Nobel Prize winning economist Joseph Stiglitz recently wrote: “Of course, the economics behind the programme that the “troika” foisted on Greece five years ago has been abysmal resulting in a 25% decline in the country’s GDP. I can think of no depression, ever, that has been so deliberate and had such catastrophic consequences: Greece’s rate of youth unemployment, for example, now exceeds 60%.”
Amartya_Sen_NIH
This has essentially led to a situation where the total amount of debt with respect to the Greek gross domestic product (GDP) went up instead of going down. Currently the total debt to GDP ratio of Greece stands at a whopping 175%. And this number is likely to go up further in the days to come. In comparison the number was at 129% in 2009.

The only way Greece can perhaps be able to repay some of its external debt is if economic growth comes back. And that is not going to happen through more austerity. As Sen puts it: “Keynes ushered in the basic understanding that demand is important as a determinant of economic activity, and that expanding rather than cutting public expenditure may do a much better job of expanding employment and activity in an economy with unused capacity and idle labour. Austerity could do little, since a reduction of public expenditure adds to the inadequacy of private incomes and market demands, thereby tending to put even more people out of work.”

As economic history has shown more than once, whenever people in decision making positions forget what Keynes said, the world usually ends up in a bigger mess.

The article originally appeared on Firstpost on July 7, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Greece votes an emphatic no in the Sunday referendum, what happens next?

euroVivek Kaul

“The Greeks invented democracy and, let’s not forget, tragedy,” writes Chris Allbritton in The Daily Beast. And the fact that the country invented democracy had a very important role to play in it being accepted into the Eurozone in the first place. Eurozone is essentially a term used in order to refer to the countries using the euro as their currency.
As Neil Irwin writes in The Alchemist—Inside the Secret World of Central Bankers: “Greece…was where democracy was invented, the birthplace of the European idea, the original European empire.” But all that was in the past.
Greece voted an overwhelming 61.3% no in the referendum held yesterday, to decide on the following question:
““Should the proposal that was submitted by the European Commission, the European Central Bank, and the International Monetary Fund at the Eurogroup of 25 June 2015, which consists of two parts that together constitute their comprehensive proposal, be accepted? The first document is titled ‘Reforms for the completion of the Current Programme and beyond’ and the second ‘Preliminary Debt Sustainability Analysis.’’”
The referendum essentially asked Greeks to decide whether they were ready to suffer from more austerity measures, like the government cutting back on pensions, raising taxes etc., so that the it could be bailed out again by the economic troika of the European Central Bank, the European Commission and the International Monetary Fund (IMF).
To this, the Greeks have voted an emphatic no. The question is what happens next? Will this democratic decision of the Greeks turn out to be a tragic one in the days to come? ““Greece has just signed its own suicide note” – Mujitba Rahman, head of European analysis at the Eurasia Group risk consultancy, told the Financial Times.
But the reality of the situation is not as unidimensional as that. Allow me to explain.
The Greek banks are running out of money. As former US treasury secretary Lawrence Summers wrote on his blog: “The referendum is probably the second most important event of the week in Greece. However it turns out, Greek banks will run out of cash early in the week, probably on Monday [i.e. today].”
Currently, the Greek banks are shut. Cash withdrawals from ATMs are limited to 60 euros a day and are likely to be cut further. This can’t be a good scenario for ordinary Greek citizens. Further, it would be stupid to think that those who voted ‘no’ would have not realised that voting ‘no’ would mean trouble ahead. So to that extent people are ready to bear some amount of economic pain.
Also, an economy cannot function without currency. In fact, fearing precisely this scenario, the Greeks have been stocking up on food. As The Globe and Mail reports: “Already, some basic items such as medicines were running low as cash supplies ran short and payment systems ceased to exist. Many Greeks have been loading up on food staples for fear that supermarkets will be unable to buy products.”
The Greek government employees need to be paid on July 12. How will that payment be made? Governments in the past have resorted to issuing IOUs or scrips. The Greece government could do the same as well. The problem here is that the confidence in scrips issued by a bankrupt government wouldn’t be very high.
The Greek politicians believe that with a ‘no’ vote they are in a better negotiating position with the economic troika and other leaders in Europe.  As Panos Skourletis, the Greek labour minister said: “The government can go now with a very strong card to continue negotiations [with creditors].”
The reason for this is very straight forward—with a ‘no’ vote the fear that Greece will exit the euro is even higher.  And this is something that will strike at the very heart of the euro, given that it is ultimately a political idea, which hopes to bring the entire region closer through economic integration, with the hope of preventing any future wars in the years to come.
One of the first things that is likely to happen if Greece exits is that the country will redominate all its debt in its new currency, which is likely to be the drachma. Also this will set a precedence for other countries like Spain, Portugal and Italy. And this can’t be good for the entire idea of euro.
Further, though no German politician will publicly admit to it, but the euro has tremendously helped increase the German exports. In 1995, German exports made up for 22% of the gross domestic product (GDP). By 1999, this number had run up to 27.1%. In 2004, five years after the euro came into being, the German exports to GDP ratio stood at 35.5%. In 2008, the number reached 43.5%. As the impact of the financial crisis started to spread around the number fell to 37.8% in 2009. Nevertheless, the German exports to GDP ratio has recovered since then and in 2014 stood at 45.6%.
With the euro becoming the common currency across most of Europe, the exchange rate risk that businesses had to face while exporting goods and services was taken out of the equation totally. This has benefitted Germany the most, given the productivity of its business.
And will Germans want to get rid of this advantage by chucking out the Greeks and start a process which questions the entire idea of euro? As Niels Jensen writes in the Absolute Return Letter for July 2015 titled A Return to the Fundamentals? : “Germany…actually benefit[s] from the damage that Greece has done to the value of the euro. Poor domestic demand as a result of challenging demographics have made exports the most likely way to secure decent economic growth, and a relatively weak euro has been tremendously helpful in that respect. Imagine how much stronger the euro would have been if every member country had the fiscal discipline of Germany!”
The public posture maintained by the German leaders has been very aggressive. As Sigmar Gabriel, the deputy chancellor of Germany said: “With the rejection of the rules of the euro zone… negotiations about a programme worth billions are barely conceivable.”
There are a spate of meetings scheduled between European leaders today and tomorrow. And this is where some hard decisions will have to be made. If the politicians continue to believe in the idea of euro and the Eurozone, then they will have to treat Greece with kid gloves and not push for more austerity.
On July 20, 2015, Greece has to make a payment of 3.5 billion euros to the European Central Bank for a bond that is maturing. I guess things would have become much clearer in the Eurozone and Greece by then.
So, watch this space.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on July 6, 2015

Is Eurozone trying to become a bigger Germany?

euroVivek Kaul

The US Department of Treasury publishes a semi-annual currency report. The latest report released on October 30, 2013, makes a scathing attack at Germany. “Germany has maintained a large current account surplus throughout the euro area financial crisis, and in 2012, Germany’s nominal current account surplus was larger than that of China. Germany’s anemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many other euro-area countries have been under severe pressure to curb demand and compress imports in order to promote adjustment. The net result has been a deflationary bias for the euro area, as well as for the world economy,” the report points out.
So what does this mean in simple English? Germany has been the export powerhouse of the world. It exports considerably more than it imports. This is the formula it has been trying to force onto other countries of the Eurozone as well. Eurozone is a term used for 17 countries which have adopted euro as their currency.
Some of these countries like Portugal, Spain, Italy, Greece, Ireland etc have not been in the best economic condition over the last few years, with a huge amount of private as well as government debt. This was a result of going overboard with their spending in the years before the financial crisis started.
As Albert Edwards of Societe Generale writes in a report titled Prepare for the next phase of global currency war – should we blame Germany? dated November 14, 2013, “In the run-up tothe crisis they all promoted an inappropriately loose monetary policy that caused a credit and housing bubble, runaway domestic demand growth, ostensibly sound government finances and burgeoning current account deficits, all financed by a surplus nation…predominately Germany.”
Countries like Portugal, Spain, Italy, Greece, Ireland etc went on a borrowing spree, which ultimately led to a housing bubble. When the bubble burst the banking system in these countries was in a mess. They had to be bailed out by the European Central Bank(ECB). At the same time countries were forced to follow austerity measures to control government expenditure. These measures have led to an extremely high level of unemployment in these countries. As Ambrose Evans-Pritchard of The Daily Telegraph pointed out in a recent column “unemployment is 27.8% in Greece, 26.3% in Spain, 17.3% in Cyprus, and 16.5% in Portugal.. it would be far worse had it not been for a mass exodus of EMU refugees….Greek youth unemployment is 62.9%.” 
This has led to a situation where internal demand in these countries fell dramatically. A fall in internal demand has meant lower imports. And this in turn has led to exports being greater than imports, and hence a trade surplus( a situation where exports of a country are greater than its imports). The eurozone trade surplus in August 2013 was at $9.5 billion.
Interestingly, the collapse of demand within these countries has also led to a situation where German exports within the Eurozone have fallen. “It is that actually Germany’s trade surplus within the Eurozone has collapsed to almost zero as the GIIPS(Greece, Italy, Ireland, Portugal and Spain)have plunged into depression,” writes Edwards.
This basically means that Germany is importing as much from other countries in the Eurozone as it is exporting to them, leading to a trade surplus of almost zero. But it has more than made up for this by running a higher trade surplus with other parts of the world, primarily United States and large parts of Asia.
 Hence, it isn’t surprising that the United States has a problem with Germany. While Germany is exporting goods and services to the United States, it isn’t importing the same amount back from the United States or other parts of the world for that matter. This means that businesses in the United States and other parts of the world are not exporting enough, which in turn has an impact on economic growth.
This formula of running a trade surplus by exporting more and limiting imports has worked very well for Germany. But the question is will it work for the Euro Zone as a whole? Martin Wolf of The Financial Times feels that the strategy may not work for two reasons. “First, the eurozone is far too big to achieve export-led growth, as Germany has done; and, second, the currency is likely to appreciate still further, thereby squeezing the less competitive economies all over again.”
The euro is likely to appreciate in the days to come given that both Japan and United States are printing money big time in the hope of devaluing their currencies. Also, this formula will have political complications as well, given that, exports can only happen if someone else is importing. Every country cannot be an exporter at the same time. Someone has to import as well.
And who will that importer be? Sanjeev Sanyal of Deutsche Bank writes in a report titled Bretton Woods III and the Global Savings Glut dated October 8, 2013 “Reinterpreted to present conditions, the next round of global economic expansion may require the US to revert to its role as the ultimate sink of global demand.”
Or as the French like to put it plus ça change, plus c’est la même chose.(the more things change, the more they stay the same).
The article was originally published on www.firstpost.com on November 15, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)