Sunday, November 20, 2011

Two (or three) speed Europe

As the crisis has reached its peak,  the division between the core and the periphery of Europe becomes more acute. Neither the European councils nor the G-20 summit have triggered confidence in the economic governance system that was put in place with great difficulties. Tensions over Italy and Spain have in fact led to the idea of a two speed Europe with a hardcore around France and Germany while tensions between the euro area and the UK are revived. The prospect of a deep recession, as warned by the ECB, feeds the economic pessimism over the current possibility to deal with the crisis within the confines of the Lisbon treaty.

P. Krugman  argues that the euro crisis is about 'original sin' (in the economic sense), meaning that countries like Italy, by joining the euro, converted its status of economic power, as a country issuing its debt in its own currency into a situation with debts in euro, which makes it more vulnerable to financial crises. This principle was inherent in the European monetary union, but no governance rules were  introduced to help address possible financial crisis due to the financial orthodoxy imposed by Germany. 

Beyond this apparent contradiction,  N.Roubini explains that the structural causes of the eurozone crisis are much deeper and do not lie in a fiscal crisis. The divergence in real exchange rates and the strength of the euro - which introduces a competitive shock on weaker economies- largely explain the current crisis. Over the past ten years, the southern economies , which include Cyprus, Greece, Italy, Ireland, Portugal and Spain- were essentially consumers ' of first and last resort', with budget gaps exceeding their respective incomes. In addition, the private sector had also accrued considerable debts, fueled by the housing bubbles, especially in Spain and Ireland. On the other hand, the other countries- Germany, France, Austria and the Netherlands- were producers 'of first and last resort'  resulting in a growing surplus in current account balances, which was exacerbated by the strength of the euro. So, the large current account deficits, due to excessive consumption, led to loss of competitiveness and economic stagnation.

N. Roubini's argument points to the following option:  "Symmetrical reflation is the best option for restoring growth and competitiveness on the eurozone's periphery while undertaking necessary austerity measures and structural reforms. This implies significant easing of monetary policy by the European Central Bank; provision of unlimited lender-of-last-resort support to illiquid but potentially solvent economies; a sharp depreciation of the euro, which would turn current-account deficits into surpluses; and fiscal stimulus in the core if the periphery is forced into austerity". 

This solution is vigorously opposed by Germany and the ECB as it would have (modest) inflationary effects in core countries relative to the periphery. The bitter medicine that they are imposing on the 'peripheral' countries is deflation with recessionary effects: fiscal austerity, structural reforms and real depreciation. Austerity policies reduce output in the short term, due to lower demand and productivity effects linked to structural reforms and reduction of nominal wages and prices. This will become socially unsustainable, and if peripheral countries remain caught in a deflationary debt trap, they might be tempted to default and exit the euro area. In this scenario, "coercive restructurings of debt will come first, and then exits from the monetary union that will eventually lead to the eurozone’s disintegration".

Alternatively, the possibility of a break up of Europe, especially with Italy too big to fail or to save - and the contagion of the debt crisis to France, could lead to a closer political Union, which would require new forms of economic governance. The Netherlands Bureau for Economic Policy Analysis pointed out in a recent report that the debt burden of southern countries is not only the consequence of lax fiscal policies, but that  banks from the northern euro area have lent too much money to Greece and other troubled countries without any effective supervision in the banking system. It also believes all euro area countries should give up some national sovereignty when it comes to bank supervision, the EFSF, the deposit-guarantee scheme and budget supervision.

The German-French 'Directoire' no longer works and may be extended now to Italy - with the Monti government close to European affairs - with a view to build  more effective supranational institutions, in particular more economic powers to the ECB as a functioning lender of last resort, fiscal integration (with permanent fiscal transfers from the core to the periphery) and a common sovereign debt with the emission of euro-bonds. This project seemed unrealistic only a few weeks ago, now, with the opening of a strong divide with the UK and non euro-countries, it may even sound plausible in a few years time with a revised EU treaty.

P.S: Last week, José Manuel Barroso, President of the European Commission, warned that the collapse of the euro area would destroy half of the value of European economy, which would swamp the region to depression similar in scale to that of 1930. 

Sunday, November 6, 2011

Tell the Truth

Adam Smith wrote in his "Wealth of Nations"* (1776) : "the violence and injustice of the rulers of mankind is an ancient evil for which, I am afraid, the nature of human affairs can scarce admit a remedy. But the mean rapacity, the monopolizing spirit of merchants and manufacturers, who neither are, nor ought to be, the rulers of mankind, though it cannot perhaps be corrected may very easily be prevented from disturbing the tranquillity of anybody but themselves". The father of economic liberalism, who also was a professor of moral philosophy reckoned that although the economic system was profoundly unfair, there was little to do to correct the current state of affairs. The 'laissez-faire' can only be offset by wise behaviour of men. In fact, since its foundation, capitalism needs rules to limit and control the functioning of markets and the State has the responsibility to design these rules and to enforce them. For this reason, the current crisis is also a political crisis that we should understand as a crisis of the State as well as a moral crisis where ethical values are substituted by electoral promises.

Our political leaders should tell citizens that global crises require global, wide ranging solutions. They decide on limited, short term measures which will not allow us to get out from the current mess. They often lie to hide the gravity of the situation: most countries claimed that they had the most solid financial system and they end up saying that they need to recapitalize banks. But they avoid arguing about the true causes of the global crisis.

The G-20 summit in Cannes (3-4 November) was, in that respect, very disappointing given the high expectations raised , in particular on strengthening the international financial system . The final declaration is extremely vague: for example, it calls for a global strategy for growth and jobs and refers to a vague commitment to take "discretionary measures to support domestic demand, should economic conditions materially worsen" . In substance, the summit has failed to provide a coordinated response to the sovereign debt crisis and all big questions (for instance the financial supervision and regulation issues) remain unresolved. Moreover, it shows the inability of nations with different interests, and often ruled by political coalitions, to take collective actions to transform the rules and structure of the world economy.

In a speech held in September 2008, Sarkozy pledged " laissez faire is over (...) The financial crisis is not the crisis of capitalism. It is the crisis of a system that has distanced itself from the most fundamental values of capitalism, which betrayed the spirit of capitalism".He called banks to develop credit rather than speculation and limit traders' remuneration. In 2009 and 2010, despite joint calls with Merkel, little has been done to regulate the European financial market and ban high risk practices (derivatives, credit default swaps, short term selling, etc.) In August 2011, the aggression of financial speculation against sovereign debt shows that financial markets can still act freely, forcing European leaders to strengthen economic governance of the euro zone.

At global level, binding rules on capital requirements have been introduced for banks to limit their profits but in return they create an incentive to generate more profits, which restricts credits to enterprises. In the aftermath of the financial crisis in 1929, the Glass-Steagall Act introduced a strict separation between investment banks and commercial banks to regulate the US banking sector and avoid conflicts of interest and fraud. this provision was removed in 1999 (with a law signed by Bill Clinton !) which led to re-establishing conflict of interest in the financial sector and fostering 'too big to fail institutions' that led to the housing market collapse and the sub-prime crisis. Subsequently, heavily indebted banks were rescued without asking anything in return, no incentives to provide credit to the real economy and no ban on high risk financial activities.

Despite the gravity of the crisis and its consequences on the vast majority of citizens, most political leaders are still reluctant to introduce effective measures to tax the rich, ban tax havens or limit trading bonuses. Adam Smith wrote : "Wherever there is great property, there is great inequality". For the first time in the last two centuries, the new generations living in western countries do not have any hope of a better future than their fathers. They express discouragement and fear of being the victims of a historical regression in western civilization and values. They only have indignation to demand global change and put an end to enormous privileges of a tiny fraction of the population. But this is a legitimate fear that we must overcome if we are capable to return to genuine politics that the political leaders have lost, its capacity  to represent the interests of all, the profound aspirations and needs of the citizens to live in a better world. This is possible if they just start telling the truth.

* A.Smith. An Inquiry into the Nature and Causes of the Wealth of Nations. Ed. R. H. Campbell and A. S. Skinner. 2 vols. Glasgow Edition of the Works and Correspondence of Adam Smith 2. Oxford U. Press, 1976.