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Archive for the ‘Sustainability’ Category

Why does the Spanish government pay significantly more to borrow than the UK government – despite having a smaller deficit and lower overall debt? This column argues that the reason lies in the Eurozone’s fragility. Its members lose their ability to issue debt in a currency over which they have full control. The column discusses ways to deal with this weakness.

A monetary union is more than just a single currency and a single central bank. Countries that join a monetary union lose more than one instrument of economic policy. They lose their capacity to issue debt in a currency over which they have full control.

This separation of decisions – debt issuance on the one hand and monetary control on the other – creates a critical vulnerability; a loss of market confidence can unleash a self-fulfilling spiral that drives the country into default (see Kopf 2011). The economic logic of this is straightforward.

Suppose that investors begin to fear a default by, say, Spain. They sell Spanish government bonds and this raises the interest rate. If this goes far enough, the Spanish government will experience a liquidity crisis, i.e. it cannot obtain funds to roll over its debt at reasonable interest rates.1 The Spanish government cannot force the Bank of Spain to buy government debt and although the ECB could provide all the liquidity in the world, the Spanish government does not control that institution. This can be self-fulfilling since if investors think that the Spanish government might reach this end point, they’ll sell Spanish bonds in a way that turns their fears into a reality.

It doesn’t work like this for countries capable of issuing debt in their own currency. To see this, re-run the Spanish example for the UK. If investors began to fear that the UK government might default on its debt, they would sell their UK government bonds and this would drive up the interest rate.

After selling these bonds, these investors would have pounds that most probably they would want to get rid of by selling them in the foreign-exchange market. The price of the pound would drop until somebody else would be willing to buy these pounds. The effect of this mechanism is that the pounds would remain bottled up in the UK money market to be invested in UK assets.

Put differently, the UK money stock would remain unchanged. Part of that stock of money would probably be re-invested in UK government securities. But even if that were not the case so that the UK government cannot find the funds to roll over its debt at reasonable interest rates, it would certainly force the Bank of England to buy up the government securities. Thus the UK government is ensured that the liquidity is around to fund its debt. This means that investors cannot precipitate a liquidity crisis in the UK that could force the UK government into default. There is a superior force of last resort, the Bank of England.

This different mechanism explains why the Spanish government now pays 200 basis points more on its ten-year bonds than the UK government despite the fact that its debt and deficit are significantly lower than the UK ones. This contrast is shown vividly in Figures 1 and 2.

Figure 1. Gross government debt (% of GDP) – Spain and UK

Source: AMECO

Figure 2. 10-year government bond rates Spain and UK

Source: Datastream

Because of the liquidity flows triggered by changing market sentiments, member countries of a monetary union become vulnerable to these market sentiments. These can lead to “sudden stops” in the funding of the government debt (Calvo 1988), setting in motion a devilish interaction between liquidity and solvency crises. For the liquidity crisis raises the interest rate which in turn leads to a solvency crisis. This problem is not unique for members of a monetary union. It has been found to be very important in emerging economies that cannot issue debt in their own currencies. (See Eichengreen, et al. 2005 who have analysed these problems in great detail).

There are important further implications of the increased vulnerability of member-countries of a monetary union. (In De Grauwe 2011 these implications are developed in greater detail; see also Wolf 2011). One of these is that members of a monetary union loose much of their capacity to apply counter-cyclical budgetary policies. When during a recession the budget deficits increase, this risks creating a loss of confidence of investors in the capacity of the sovereign to service the debt. This has the effect of raising the interest rate, making the recession worse, and leading to even higher budget deficits. As a result, countries in a monetary union can be forced into a bad equilibrium, characterised by deflation, high interest rates, high budget deficits and a banking crisis (see De Grauwe 2011 for a more formal analysis).

These systemic features of a monetary union have not sufficiently been taken into account in the new design of the economic governance of the Eurozone. Too much of this new design has been influenced by the notion (based on moral hazard thinking) that when a country experiences budget deficits and increasing debts, it should be punished by high interest rates and tough austerity programmes. This approach is usually not helpful in restoring budgetary balance.

In addition, a number of features of the design of financial assistance in the Eurozone as embodied in the European Stability Mechanism will have the effect of making countries even more sensitive to shifting market sentiments. In particular, the “collective action clauses” which will be imposed on the future issue of government debt in the Eurozone, will increase the nervousness of financial markets. With each recession government bondholders, fearing haircuts, will “run for cover”, i.e. selling government bonds, thereby making a default crisis more likely. All this is likely to increase the risk that countries in the Eurozone lose their capacity to let the automatic stabilisers in the budget play their necessary role of stabilising the economy.

A monetary union creates collective problems. When one government faces a debt crisis this is likely to lead to major financial repercussions in other member countries (see Arezki, et al. 2011 for evidence). This is so because a monetary union leads to intense financial integration. The externalities inherent in a monetary union lead to the need for collective action, in the form of a European Monetary Fund (Gros and Mayer 2010). This idea has been implemented when the European Financial Stability Facility was instituted (which will obtain a permanent character in 2013 when it is transformed into the European Stability Mechanism). Surely, when providing mutual financial assistance, it is important to create the right incentives for governments so as to avoid moral hazard. Discipline by the threat of punishment is part of such an incentive scheme. However, too much importance has been given to punishment and not enough to assistance in the new design of financial assistance in the Eurozone.

This excessive emphasis on punishment is also responsible for a refusal to introduce new institutions that will protect member countries from the vagaries of financial markets that can trap countries into a debt crisis and a bad equilibrium. One such an institution is the collective issue of government bonds (for recent proposals see Delpla and von Weizsäcker 2010, De Grauwe and Moesen 2009 and Juncker and Tremonti 2010). Such a common bond issue makes it possible to solve the coordination failure that arises when markets in a self-fulfilling way guide countries to a bad equilibrium. It is equivalent to setting up a collective defence system against the vagaries of euphoria and fears that regularly grip financial markets, and have the effect of leading to centrifugal forces in a monetary union.

A monetary union can only function if there is a collective mechanism of mutual support and control. Such a collective mechanism exists in a political union. In the absence of a political union, the member countries of the Eurozone are condemned to fill in the necessary pieces of such a collective mechanism. The debt crisis has made it possible to fill in a few of these pieces. What has been achieved, however, is still far from sufficient to guarantee the survival of the Eurozone.

Paul De Grauwe
10 May 2011

References

Arezki, R, B Candelon, and A Sy (2011), “Sovereign Rating News and Financial Markets Spillovers: Evidence from the European Debt Crisis”, IMF Working Paper, 11/69, March.
Calvo, Guillermo (1988), “Servicing the Public Debt: The Role of Expectations”, American Economic Review, 78(4):647-661
De Grauwe, P, and W Moesen (2009), “Gains for All: A Proposal for a Common Eurobond”, Intereconomics, May/June
De Grauwe, P, “The Governance of a Fragile Eurozone”,
Delpla, J, and J von Weizsäcker (2010), “The Blue Bond Proposal”, Bruegel Policy Brief, May.
Eichengreen, B, R Hausmann, U Panizza (2005), “The Pain of Original Sin”, in B Eichengreen, and R Hausmann, Other people’s money: Debt denomination and financial instability in emerging market economies, Chicago University Press.
Gros, D, and T Mayer (2010), “Towards a European Monetary Fund”, CEPS Policy Brief.
Juncker, J-C and G Tremonti (2010), “E-bonds would end the crisis”, The Financial Times, 5 December.
Kopf, Christian (2011), “Restoring financial stability in the euro area”, 15 March, CEPS Policy Briefs.
Wolf, M (2011), “Managing the Eurozone’s Fragility”, The Financial Times, 4 May.


 1. Additionally, the investors who have acquired euros are likely to decide to invest these euros elsewhere, say in German government bonds. As a result, the euros leave the Spanish banking system. Thus the total amount of liquidity (money supply) in Spain shrinks.

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By George Soros. Published: June 24 2010.

Germany used to be at the heart of European integration. Its statesmen used to assert that Germany had no independent foreign policy, only a European policy. After the fall of the Berlin Wall, its leaders realised that German reunification was possible only in the context of a united Europe, and they were willing to make some sacrifices to secure European acceptance. Germans would contribute a little more and take a little less than others, thereby facilitating agreement.

Those days are over. The euro is in crisis, and Germany is the main protagonist. Germans don’t feel so rich any more, so they don’t want to continue serving as the deep pocket for the rest of Europe. This change in attitude is understandable, but it has brought the European integration process to a halt.

By design, the euro was an incomplete currency at its launch. The Maastricht treaty established a monetary union without a political union – a central bank, but no central treasury. When it came to sovereign credit, eurozone members were on their own.

This fact was obscured until recently by the European Central Bank’s willingness to accept the sovereign debt of all eurozone members on equal terms at its discount window. As a result, they all could borrow at practically the same interest rate as Germany. The banks were happy to earn a few extra pennies on supposedly risk-free assets and loaded up their balance sheets with the weaker countries’ government debt.

The first sign of trouble came after the collapse of Lehman Brothers in September 2008, when the European Union’s finance ministers decided, at an emergency meeting in Paris that October, to provide a virtual guarantee that no other systemically important financial institution would be allowed to default. But German chancellor Angela Merkel opposed a joint EU-wide guarantee; each country had to take care of its own banks.

At first, financial markets were so impressed by the guarantee that they hardly noticed the difference. Capital fled from the countries that were not in a position to offer similar guarantees, but interest-rate differentials within the eurozone remained minimal. That was when countries in eastern Europe, notably Hungary and the Baltic states, got into trouble and had to be rescued.

It was only this year, when financial markets started to worry about the accumulation of sovereign debt, that interest-rate differentials began to widen. Greece became the centre of attention when its new government revealed that its predecessors had lied about the size of the 2009 budget deficit.

European authorities were slow to react, because eurozone members held radically different views. France and other countries were willing to show solidarity, but Germany, traumatised twice in the 20th century by runaway prices, was allergic to any build-up of inflationary pressures. (Indeed, when Germany agreed to adopt the euro, it insisted on strong safeguards to maintain the new currency’ s value, and its constitutional court has reaffirmed the Maastricht treaty’s prohibition of bail-outs.)

Moreover, German politicians, facing a general election in September 2009, procrastinated. The Greek crisis festered and spread to other deficit countries. When European leaders finally acted, they had to provide a much larger rescue package than would have been necessary had they moved earlier. Moreover, in order to reassure the markets, the authorities felt obliged to create the €750bn European Financial Stabilisation Facility, with €500bn from the member states and €250bn from the International Monetary Fund.

But the markets have not been reassured, because Germany dictated the terms of the rescue and made them somewhat punitive. Moreover, investors correctly recognise that cutting deficits at a time of high unemployment will merely increase unemployment, making fiscal consolidation that much harder. Even if the budget targets could be met, it is difficult to see how these countries could regain competitiveness and revive growth. In the absence of exchange rate depreciation, the adjustment process will depress wages and prices, raising the spectre of deflation.

The policies currently being imposed on the eurozone directly contradict the lessons learnt from the Great Depression of the 1930s, and risk pushing Europe into a period of prolonged stagnation or worse. That, in turn, would generate discontent and social unrest. In a worst case scenario, the EU could be paralysed or destroyed by the rise of xenophobic and nationalist extremism.

If that were to happen, Germany would bear a major share of the responsibility. Germany cannot be blamed for wanting a strong currency and a balanced budget, but as the strongest and most creditworthy country, it is unwittingly imposing its deflationary policies on the rest of the eurozone. The German public is unlikely to recognise the harm German policies are doing to the rest of Europe because, the way the euro works, deflation will serve to make Germany more competitive on world markets, while pushing the weaker countries further into depression and increasing the burden of their debt.

Germans should consider the following thought experiment: withdrawal from the euro. The restored Deutschemark would soar, the euro would plummet. The rest of Europe would become competitive and could grow its way out of its difficulties but Germany would find out how painful it can be to have an overvalued currency. Its trade balance would turn negative, and there would be widespread unemployment. Banks would suffer severe losses on exchange rates and require large injections of public funds. But the government would find it politically more acceptable to rescue German banks than Greece or Spain. And there would be other compensations; German pensioners could retire to Spain and live like kings, helping Spanish real estate to recover.

Of course, this is purely hypothetical because, if Germany were to leave the euro, the political consequences would be unthinkable. But the thought experiment may be useful in preventing the unthinkable from actually happening.

The writer is chairman of Soros Fund Management

FT.com / Comment – Germany must reflect on the unthinkable.

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Growth-Strategies-After-the-Crisis

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21 hours

The vision

Moving towards much shorter hours of paid work offers a new route out of the multiple crises we face today. Many of us are consuming well beyond our economic means and well beyond the limits of the natural environment, yet in ways that fail to improve our well-being – and meanwhile many others suffer poverty and hunger. Continuing economic growth in high-income countries will make it impossible to achieve urgent carbon reduction targets. Widening inequalities, a failing global economy, critically depleted natural resources and accelerating climate change pose grave threats to the future of human civilisation.
A ‘normal’ working week of 21 hours could help to address a range of urgent, interlinked problems: overwork, unemployment, over-consumption, high carbon emissions, low well-being, entrenched inequalities, and the lack of time to live sustainably, to care for each other, and simply to enjoy life.

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