If you read one thing today... (and you are interested in the EZ)

The President of the Council of Europe has published his proposals ahead of the European summit this Thursday and Friday.

The document does present a roadmap to further integration that should underline the strength of the union in the long run.

It mentions explicitly integrated financial, budgetary and economic policy frameworks.

There is no time frame but it is suggested that this could be agreed in December.

I suspect that the markets are getting impatient for something concrete and will not react with enthusiasm.

But the EZ leaders have shown that they do not want to be (seen to be) swayed by the financial markets' short term reactions.

Democratic accountability and legitimacy also mean that the proposals will have to be sufficiently discussed and approved at the national level.

I think that these proposals are in the right direction.

Of course a lot (all) depends on what Germany thinks it can do.

And further integration presents a challenge not only for those who want to be part of it but also for those who are sceptical or hostile (e.g. the UK).

Does the EZ have time to contemplate these proposals?

I think it does, as long as Italy can borrow at reasonable rates.


Just in case you missed it the document is here.

Greece's Memorandum of Understanding with the "Troika"

For those who haven't had the chance to browse through the MoU that Greece has signed with the troika (ECB, IMF and the European Commission) here is a link to a document (IMF Country Report No. 12/57) that includes it (page 152 onward).

The actual document is entitled "Greece: Request for Extended Arrangement Under the Extended Fund Facility—Staff Report; Staff Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Greece" and contains more or less everything one needs to know about the greek economy, its assessment by the IMF staff, and the MoU that has been signed.

It will, of course, be interesting (and consequential at so many levels) to see whether the greek people decide to renege on, or abide by, their commitment to the terms of the bailout at the elections of June the 17th, 2012. 

They really have to choose between a rock and a hard place... 

Rock: Sticking to the terms of the bailout, achieving some concessions from the troika, staying in the EZ. Recession continues for 2-3 more years, ceteris paribus. 

Hard place: Reneging on the MoU, missing the next loan instalment, defaulting on debt, returning to the drachma. Massive uncertainty.

Problem with the Rock: this option is favoured by the same old parties that have been ruling Greece since the end of the civil war (except for seven years of military rule), and are responsible for the current drama.

Problem with the Hard Place: this option is favoured (implicitly) by a radical Left party that has never been in government, let alone having the responsibility of steering a nation to safe waters during a cataclysm. 

Today the greeks progressed in the euro 2012 football competition's quarterfinals against all expectations. Can they produce another surprise by returning to some sort of economic and social normality? It will take much more than the 90 minutes of a football game but it requires the same kind of spirit.

Greece must hang on?

Exploring the possible economic effects of Greece's election.

Phone interview with Dukascopy TV. Click here for Dukascopy's page or, for a direct YouTube link, click here

Exchange Rate Regimes: What Do Countries Do?

Participating in a currency union is a choice about an economy's exchange rate regime. The exchange rate is fixed -supposedly irrevocably, but of course never say never- and the old currency is abandoned for the crispy notes and shiny coins of a new one.

That's what the eurozone countries chose to do a while back, partly for economical and partly for political reasons.

As economists know, the decision of what exchange rate regime to adopt is not straightforward. It depends on a variety of factors, such as

• what kind of shocks tend to hit the economy 
• what effects the variability of exchange rates has on trade 
• to what extent the country's monetary policy is credible 
• what trading partners and competitors do 
• and so on.

In turn, this decision will determine the effectiveness of particular macroeconomic policies, among other things.

What is interesting is that sometimes countries say that they operate a different exchange rate regime than they actually do. This is the difference between the official de jure regime and the actual de facto one.

So, what do countries actually do?

It turns out that almost everyone intervenes in the foreign exchange market either to maintain a peg, or to prevent the currency from moving too much. For the period, 1998-2007, only 4% of observations fall in the freely floating category.

In the chart above I have used data on de facto exchange rate regimes from Ilzetzki, Reinhart and Rogoff (2008) to show the percentage of observations in their sample that falls in different regimes. They assign a value from 1 to 6 to different types of exchange rate regimes followed by governments:

1. No separate legal tender, Pre announced peg or currency board arrangement, Pre announced horizontal band that is narrower than or equal to +/-2%, De facto peg                       

2. Pre announced crawling peg, Pre announced crawling band that is narrower than or equal to +/-2%, De factor crawling peg, De facto crawling band that is narrower than or equal to +/-2%

3. Pre announced crawling band that is wider than or equal to +/-2%, De facto crawling band that is narrower than or equal to +/-5%, Moving band that is narrower than or equal to +/-2% (i.e., allows for both appreciation and  depreciation over time), Managed floating

                       

4. Freely floating           

           

5. Freely falling                       

6. Dual market in which parallel market data is missing.

Lost Competitiveness for Greece and Spain - Is There a Way Out?

Using ECB data the chart below shows the substantial loss of competitiveness for Greece and Spain since 2000. With flexible exchange rates against Germany there is no doubt that the countries would have allowed their national currencies to depreciate against the mark. That would have allowed an improvement in the external balance.

With the euro straightjacket, however, the only way to restore competitiveness and give hope for future economic growth is to reduce unit labour costs by following austerity programs and implementing supply side changes that could promote investment and the return of confidence. Of course, the unpopularity of such programs is directly proportional to their severity, making their advocacy by politicians difficult. And the actual implementation can be even trickier...

Does this mean that abandoning the currency union is the only way out? Recent history teaches us that 'artificial' pegs (i.e. pegs that involve significantly dissimilar economies) are indeed prone to disintegration. Think of the UK's exit from the ERM mechanism in 1992 and the Argentinian abolition of the peg with the US dollar in 2002 - is there another spectacular peg disaster in store for 2012? 

The problem is that de-pegging in a disorderly way is bedevilled by dangers. High inflation, the collapse of the banking system, violent income redistribution, deep recession and social disorder are some of the possible scenarios for the day after. So, whenever there is a choice policymakers normally prefer the (costly) status quo than the (potentially disastrous) alternative.

So what should Greece and Spain do? 

I think more or less what they are already doing. Fighting tooth and nail to stay in the eurozone (EZ). If the Germans are serious about the viability of the euro experiment (and I think they are) they will eventually have to consider a more accommodative monetary policy (leading to a higher inflation that would erode the real value of existing debt), some form of eurobonds to allow countries in difficulty to borrow at lower rates and potentially more debt write-downs for the criminally indebted nations. The EZ banking system will need to be reinforced as well.

As long as Greece and Spain implement the necessary structural changes (the Greeks have been given a handy MoU with detailed instructions by their creditors), such changes would eventually allow these countries to grow again. No doubt, this is politically explosive stuff in Germany and that's why time is needed to prepare the public for the price they need to pay. (For the Greeks that time is now.) Unfortunately, the markets are pressing hard and a clear roadmap to an "ever deeper union", fiscal and political, will need to be presented sooner rather than later. 

Too much is at stake and everyone should do their bit. The rich EZ "North" should help the poorer "South", and the South should undertake painful but necessary economic adjustments. It is in the interests of everyone involved -and the rest of the world.

You can read more about the harmonised competitiveness indicators at the ECB's website.

Why Exiting the Euro is a Bad Idea for Greece

A number of world leaders, including the UK PM, have made it clear that the forthcoming election in Greece on the 17th of June will decide whether the country stays in the Eurozone (EZ) or returns to the old national currency, the drachma. Some greek politicians, however, would have you believe that the country can disentangle itself from the terms of the bailout and remain in the EZ at the same time. They argue that the potential cost of a greek exit to the world's economy is so high that Greece's creditors (the IMF, EU and ECB) would be willing to do anything to avoid it.

This is a miscalculation. The markets have already discounted the greek departure to a certain extent. A return to the drachma is not as unthinkable as it was a year ago and it is naive to think that behind closed doors EZ policymakers have not devised damage limitation strategies. Given that a unilateral greek withdrawal from the terms of the bailout would eventually -and quite quickly- lead to a voluntary return to the drachma, it would be honest for the politicians that support such unilateral action to admit that what they, in effect, advocate is the abolition of the euro.

So what can we expect to happen if the electorate votes an anti-bailout government in? Here is a likely (but not the only) scenario for the short run:

• The newly elected government declares that it wishes to renegotiate the terms of the bailout 
• Greece's creditors either give little way or none at all
• The government pulls out of the bailout agreement, misses the next loan instalment and defaults in its debt repayments
• Greek banks find themselves unable to borrow from the ECB, which no longer accepts greek debt as collateral, and there is a bank run
• Restrictions are placed on deposit withdrawals 
• The government nationalises the banks and starts printing money to recapitalise them
• A new exchange rate is set for the EURDRS (euro-drachma)
• Imported goods become (much) more expensive and greek tradable products and services gain competitiveness
• The greek government places rationing on the purchase of petrol and medicines
• The primary budget deficit cannot be financed through borrowing so the government resorts to inflationary finance (money printing)
• High inflation erodes stable incomes of pensioners and employees 
• Greece's output collapses and unemployment increases further

In the longer term, it is likely that net exports will improve due to the more favourable exchange rate but the outlook for consumption and investment is more uncertain.

• High inflation and interest rates will not help
• Necessary supply-side reforms will not have taken place and this will further hinder investment
• Public spending will be limited by the inability of the government to access the debt markets

A return to the drachma will not destroy Greece. But it will make it poorer.

Greek fiscal crisis

It would not take an expert to see that the greek economy was headed for serious trouble even when most greeks were celebrating the country's accession to the eurozone back in 2001. 

A few years later, in the summer of 2004, I wrote a short article arguing that the abolition of the drachma meant that the country should concentrate on reducing its public debt. 

The basic idea was that with an 'excessive' debt ratio (i.e. the level of debt owed by the government as a percentage of the size of the economy) and no independent monetary policy Greece was depriving itself from economic policy tools that could be deployed during a potential recession. 

Any economic downturn would be seen by the markets as extremely difficult to tackle (in the absence of fiscal leeway and with no ability to soften monetary policy any structural response would be longer-term in nature) and this would lead to an increase in interest rates paid by the government to borrow in the international bond markets.

I think that this is a clear example of myopia: governments seeking re-election concentrate on short-term economic targets neglecting the country's longer-term needs. 

The current situation where the greek economy is effectively ran by the IMF, the ECB and the EU is a loss of national sovereignty and is, obviously, a very heavy price to pay.

A useful lesson perhaps for those who think that countries can increase their borrowing ad infinitum -the day of reckoning always comes! 

For the greek economy, however, it may be a blessing in disguise as structural changes avoided for decades by timid politicians are now taking place.

My original paper from 2004 (in greek only -sorry!)