The creation of the EFSF - such gripping drama

The FT has a fantastically well researched and sourced article on the events that led to the creation of the European Financial Stability Fund, "Dinner at the edge of the abyss", written by the great Tony Barber. Really good for anyone interested in the history of European integration and about what country stands for what in that debate.

Interesting Contributions: Daniel Gros

EU or Euro-zone seat at the IMF

How to avoid trade war: A reciprocity requirement

How to deal with sovereign default in Europe: Towards a Euro(pean) Monetary Fund

The EMF - EFSF - has a website

A little note on the European Monetary Fund:

It is officially not called that. It's called the European Financial Safety Facility, or EFSF for short (created as a societé anonyme under Luxembourg's law), and there's a website that one can access here, with among many other things, a very interesting F.A.Q. PDF file.

European Fiscal Federalism (Part 3): Pigouvian taxation, and redistribution - Externalities, mobile assets, and euro interest rates

So far, I’ve been describing the economic logic for fiscal federalism. However I have not qualified it. It's all nice and easy to argue that we need to tax the richest and subsidise the poorest, but how do you do this? Which pockets should the EU reach into and what should it pay for?

In the next lines I propose the following Euro-level fiscal tools : (1)Taxes on mobile factors that cause negative externalities, (2)an Income tax, and the maintenance of a (3)common education policy as well as a (4)common defence policy, with a tendency for expansionary military R&D expenditure during recessions. Finally I also argue in favour of (5)the establishment of an European Monetary Fund (EMF) to switch from cooperation to coordination of euro-area fiscal policies. This would be the best tool to keep and improve the theoretically good monitoring devices created by the SGP, while replacing its very ineffective legalistic procedures, in order to improve fiscal stability across the board.

I believe these are the necessary tools for the EU to minimise its risks of suffering from asymmetric shocks, while endowing it with the policy tools to deal with them, should they arise, as they inevitably will. They may however not be sufficient...

European Fiscal Federalism (Part 1): Introduction to the “irrefutable”

It seems that weekends are only reserved for Lady Ashton. On Sunday 8 August, Mr Janusz Lewandowski, the (Polish) EU budget commissioner started floating around the idea of a European tax to be levied by the European Commission on banks, financial transactions, carbon emissions (permits) and air traffic. Berlin, Paris and Westminster were not amused, but Poland, Austria, Belgium and Spain seemed to not dislike the idea too much. Anyway, this is part of the ongoing process of preparation for the 2014-2019 budget which will be presented by the afore mentioned Commissioner at the end of September 2010. Most interestingly of all for me was the response that the proposal received from the Financial Times. I believe that unless you've subscribed to the ft, even if only for free, you can't read this article. It's not complicated but I assume not everybody can be bothered to do it. As such I feel compelled to report some of the comments which are rather strong:

What are PGS doing?

What are Portugal, Greece and Spain doing about their fiscal positions?

Here's an account. It is rather incomplete, but it gives some insights. For simplicity, and because it is originally in Portuguese, I include the picture below in this post. The conclusion is that they are doing something, and except the unavoidable tax hikes, the reforms seem to be quite positive for productivity, savings and growth. Hopefully some of these reforms will be permanent...

I will also try to see if I can find the links to the Stability and Growth programmes that these countries submitted to the European Commission.

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(This is a late addition to the original post)

For another overview of the situation with the PIIGS, here's what The Economist has to say.

The Southern European Problem: Not Speculation, Not Just Fiscal Profligacy, but Structural inconsistencies

Wolfgang Munchau of the FT has a very good article published online last night, about the problems in the Eurozone, particularly in its southern members. (here's a little trick for accessing restricted news reports from the FT: Copy paste the title of the relevant article on google and click on the relevant link. For some reason this grants you access to otherwise restricted articles) It says that the problem is not speculative financial attacks on the debt of these countries, nor that it is just fiscal profligacy. It argues instead that the root problem is structural, and that there is a need for economic reform of the labour market, where wages are much above productivity. As a result these countries are not competitive vis à vis its northern neighbours.

I completely agree with it. But I need data to confirm this. I'll be updating this post.

What future for the Euro after the bail out?

5 very interesting articles from www.VoxEU.org :

"Greece: The start of a systemic crisis of the Eurozone?" by Paul De Grauwe, from Leuven

"Greek lessons", by Michael Burda and Stefan Gerlach, felows of CEPR

"European Stabilisation Mechanism: Promises, realities and principles", by Charles Wyplosz, CEPR fellow

"Financial Stability beyond Greece: Making the most out of the European Stabilisation Mechanism", by Daniel Gros and Thomas Mayer, CEPS and Deutsch Bank respectively

"How to deal with sovereign default in Europe: Towards a Euro(pean) Monetary Fund", by Daniel Gros and Thomas Mayer, CEPS and Deutsch Bank respectively

uau!! €500Bn is a lot of money!!

As Jean Quatremer (notice the reference to the IMF) of Liberation writes the Eu revolutionized itself last night, by creating the puffiest safety cushion on earth:

Markets rally on €750bn EU bail-out - FT

EU Crafts $962 Billion Show of Force to Halt Crisis - Bloomberg

EU Turns to 'Nuclear Option' to Halt Euro Speculation - Der Spiegel

“Mother of all rescue plans” buys Europe time - but can it work? - Tony Barber from Brussels Blog at the FT

Wolfgang Muchau of the FT joins his colleague on a gloomy analysis of the Fiscal package. He makes two interesting points. One about fiscal union and another about national economic reform:

On the first he says that "this deal is going to be ineffective beyond the very short term, unless it is followed up by substantive reforms – the introduction of a single European bond, an agenda to co-ordinate economic reforms with specific relevance for the monetary union, policies to reduce economic imbalances, much tighter supervision of fiscal policies that kick in well before budgets have already been announced, and, in my view also a kernel of a fiscal union – in essence all the things over which the EU has been, and still is, in denial."

I guess I must take issue with this. It As I have shown in this post, there is already a single European Bond, which has existed in theory since 1988. The ECOFIN already is a forum for coordinating economic reforms, and it is expected to be revamped by the commissions' proposals to be presented in two days. This will probably see the implementation of tighter supervision.

I agree that this is not tantamount to fiscal Union, but it leads the way for it, under enhanced cooperation.

Regarding to economic reform, Mr Munchau says that "the private sector [in Portugal is and in Spain ]massively indebted. The prices of assets that serve as collateral are still falling. The Spanish government, as guarantor of the banking sector, will be lumbered with rising debts at a time of stagnating economic growth. We should remember that solvency is not primarily related to financial markets’ willingness to lend. That’s liquidity. You are solvent when you can stabilise your debt as a proportion of income. Southern Europe’s solvency position is thus unaffected by the billions."

Here I must agree with it, but according to the general argument this is a problem intrinsic to the Eurozone. Because there is only one interest rate for all 16 countries, it cannot effectively target everyone. As a result the rates are too low to contain inflation in Portugal and Spain and too high for Germany and the Benelux. However there's a problem with this argument, it completely disregards the fact, that banks as intermediators should price debt better than they do in Portugal and Spain. Just because they can borrow cheaply, it does not mean that they cannot lend more expensively. My guess is that this has been possible in Portugal because a lot of people were guaranteed to pay their debts because so many people work for the state. In Spain the mechanism must have had something to do with the economic growth and the real estate boom. However this conjuncture has been changed and with the reforms to be implemented, it should change even more. As unemployment increases, as civil servants' salaries are frozen and as other such austerity measures are implemented (please stop hiring new civil servants!!) banks should start to price risk at a higher rate and thus the cost of borrowing should increase, thus increasing the rate of savings in countries like Portugal and Spain. More over it should also force them to move their money abroad, to less risky investments. This is of course if publicly owned banks don't loan at lower rates than those of the market for political and electoral reasons. The hope is that this won't lead to a debt deflationary crisis.

Before I go though, here's the council communiqué from last night about the fund/Financial Stability Facility in question. As you can see it is sparse on details and qualitative clarity. It is very clear quantitatively though!

What do you think?

Eurozone inevitably an Optimum Currency Area (OCA)?

I posted the following comment on Prof. Krugman's blog for the New York Times. What do you think?

"

Prof. Krugman,

As you say the arguments on the shortcomings of European EMU as an OCA have been known ever since the early 1990s. If a group of economies are very open and trade in differentiated products, then as they are exposed to asymmetric shocks, they must have flexible wages and prices, high labour mobility, or alternatively, there must be some form of homogeneity and/or solidarity to ensure that transfers from one country to another balance the asymmetric shock. Otherwise one group of countries benefits from the union at the detriment of another. This is simple enough and it is what is taught in every decent manual on the economics of the EU. Moreover, it is easy to see how France and Germany might initially have benefitted from Greece's fiscal crisis. After all a cheaper € makes for more competitive exports.

What no one seems to focus a tremendous amount is on the merits of the Euro. First of all, the public and the commentators seem to have forgotten about all the exchange rate crises of the 1970s-1990s. Increased trade interdependencies expose EU member states to each other's bad governance, forcing to create arrangements to protect themselves from each other. The ERMs and the EMS were the first attempts at dealing with this issue, but proved incomplete at best, leading to the creation of the €. If the latter was to disappear, then we'd be back to the early 1990s.

Finally, speaking as a Portuguese and as a social scientist I must also admit that the euro also presents a welcomed pressure for necessary economic reform. By creating a tighter system of monitoring between the member states, it divulges more information about the quality of their performance. If for the € to work, it requires a strengthening of internal monitoring and if this increases the pressures for rationalisation of policy making and reform, then I can only conclude that the € is positive for its less efficient member states.

It seems that European integration happens through trial and error along a fairly clear integrationist path. As with any other polity, decision makers tweak and fine tune the machine. When each monetary mechanism failed after another, the argument for the € became more and more credible. Now that the consequences of the shortcomings of the Stability and Growth Pact have been brought to light, the structure will be kept with enhanced powers and institutional support, and my guess is that sooner rather than later there will be a certain amount of fiscal powers transferred to Brussels in order to fulfil the OCA.

On the USA though, by the standard of its time the country would not have been seen as any more homogenous than the Hapsburg Empire, with all its religions and languages (English, German, French). Moreover until the Civil War most Americans considered themselves first and foremost Virginians, New Yorkers, etc, and only after that Americans. Yet the dollar, fragile though it may have been, existed before the 1870s. The EU in that sense is not very different from the early USA or India, although we do not have a military threat as a catalyst for integration.

Before I conclude, I would like to add that the issue of labour mobility is limited first and foremost by language diversity. This however seems to be a decreasing problem as the vast majority of Europeans are now adopting English as their second language, thus making it the continent's "lingua Franca". This should solve the issue of labour mobility in the next 2 to 3 generations.

To conclude, just because the €zone is not an OCA, it is not automatically undesirable. Moreover just because it is now a second best option, it does not mean that it will not become a first best option in the future, as labour mobility will increase and as geographical automatic stabilizers will start to play a bigger role "

Debt markets in the next two weeks

This article is extremely insightful. However I must disagree with the analogy between Greece and Bear Stearns. This is inappropriate because Greece is getting bailed out, Bear Stearns wasn’t. If anything Greece should be compared to Morgan Stanley who was bailed out.

Moreover, the contagion to Portugal, Spain, Ireland and Italy is similar but on a much smaller scale. When Bear Stern filed for bankruptcy, the devastation was enormous because suddenly reputation was worthless. Therefore markets were unable to know who was in a good financial position and who wasn’t. Bad money crowded out good money which almost brought trading to a halt. In the present situation however markets know that Northern Europe’s credit is good. The doubt is as to whether all of Southern Europe is worse off than its northern neighbours and if so by how much.

Thus reactions are probably extremely exaggerated. Greece cooked its books for some years until it was impossible to hide the mess any longer. Portugal, Spain, Ireland and Italy for all we know have been honest in their reporting. Now of course no one is in a great place right now. Portugal has a private debt to GDP ration above 200% and requires some very fundamental changes in the way its economy works. Spain is going through 20% unemployment rates. Ireland has the EU’s largest deficit this year. So the fundamentals are not quite there, and in the long run it is both predictable and good that the financial markets are putting some pressure on these countries to fix their economies.

I would venture the guess that asymmetries of information between the governments and their lenders are causing the latter to exaggerate the extent of risk that they are exposed to. They are also increasing the effect of rumours and gossip in trading, such as Morgan Stanley's Joachim Fels' argument that the Euro-area is at risk. If this is the case, then things should either get much better or much worse for Portugal, Spain and Italy in the next 2 weeks. On May 12 data pertaining to the first quarter of 2010 about the national accounts of Portugal and the preliminary Italian and Spanish GDP values will be published. On May 19, the Spanish national accounts data will be published and the next day Italy will publish its latest industrial turnover figures.

The dissemination of this information should decrease the asymmetries of information and give a better idea of how solvent these countries are. Of course whether the new data will be favourable to the reporting nations is completely unknown. If it is, sovereign debt yields should shrink. If isn’t, then there might be yet another run on their debts and on the Euro. If the latter occurs, I would expect the ECB to start purchasing national debt on the secondary market in order to limit contagion. This should lower the prices of national debt, while maintaining some institutional pressure on EU member states to reform. All that the ECB has to do is to warn that in the absence of reform it will dump suspicious sovereign debt on the markets, causing a fairly predictable increase in their price.

Until then the markets should continue to behave a bit nervously, at least for another week, unless something new happens, like some oil shock, a or some freak revolution in Greece. Moreover, they will probably go a bit bonkers with the fact that there wont be a clear cut majority in Westminster. The Greek parliament could fail to approve EU/IMF assistance, or the upcoming summit of the council leaders could be either very successful or very unsuccessful in drafting plans for dealing with fiscal problems and reforming the Stability and Growth Pact (Hopefully they'll come up with decent plans for the EMF rather than for an actual European rating agency). Finally some rating agency might downgrade one of these countries yet again. What do you think?

EMF, German economy and EU procurement reform

In the following article, Tony barber of the FT asks Two questions. First, whether it is possible for Germany to

: 1) "no longer to be, in the broadest sense of the term, the EU’s paymaster", 2) "impose strict budget deficits in the Eurozone" 3)"remain the EU’s champion exporter and a model of business competitiveness, piling up vast current surpluses as a result"

and secondly, whether this is compatible with European (Economic, I assume) Stability.

Regarding the first question, I believe that this is a coherently proposed set of goals. Again, I go back to the basic open economics: Y=C+I+G+NX, and Y=C+S+T implies that I-S + X-M = T-G. Therefore it is not just possible, but in the absence of a short term disequilibrium between Investment and Savings, if Germany wants to be a big exporter it needs to have a low deficit. What better way to do that than to stop being the EU "paymaster". But is it really the pay master?

Now, the second question is much more tricky. As I said, I'm assuming that he is referring to economic stability. Now the thing one needs to keep in mind is the EU's procurement system. At the moment EU revenue has 4 main sources: VAT, customs and agricultural duties and direct country contributions, based on some GNP proportionality formula. Then there are some other smaller adhoc contributions, but nothing more tha 5-10%. This means that whoever consumes more, whoever participates in more external trade, and whoever has the largest GNP, will always be the EU's paymaster. So Germany is stuck. Even if the EU was to levy some income tax, it would still be germans paying the largest piece of the cake.

Ultimately the point is still that the whole story is a bit inflated. There is no problem with Germany not wanting to pay for greek debt. Moreover, just because it decides that the idea of a EMF is good because it spreads the monetary cost of rescue to everyone, it does not mean that suddenly Germany wants to decrease the bill it pays. I guess it only means it does not want it to increase! Germany is the biggest payer of EU but it is not the majority. It's not worth making a fuss

The EMF is a very good idea!! The others not so much may be...

France and German officials have voiced their support for an IMF like organisation for the Eurozone. This situation is part of the normal process of surviving a crisis. First you recognise that there's a problem (which is to say that you stop being in denial, because in economic terms the problem does not build up over night, it has been there and it has created a pretty little bubble on which people were happy to feed. Once it blows, then it is this amazing black swan that no one expected.). Then you come up with a short term solution for it (you patch things up), so that you can think of a good way to try and avoid the problem repeating itself. We are now at that stage in Europe, we have taken stock of what happened and are trying to figure what can be done to solve things. Of course it is difficult to sort through the noise of German and Greek nationalistic slur.

We have a number of things on the table:

First we have this idea by the ECB, that it should somehow possess a financial rating agency of its own. My understanding is that this was put forth by the Governor of the Austrian Central bank, but no one has really spoken out in favour or against it. Finance ministers are discussing it apparently...

Then we have also heard of the more serious proposal for a European System of Financial Supervisors (ESFS) within the framework of a European Macroprudential Supervisory Authority (EMSA?), , which has stirred enough interest for there to be hearings at the EP about it. This is a more official idea (details about it can be found here). It was put forth in the Larosière report drafted by a "High level group" on financial supervision, which is to say a group of credible and important MEPs. From what that article seems to describe the ESFS would be divided in three subcommittees:

The Committee of European Banking Supervisors (CEBS),

The Committee of European Insurance and Occupational Pensions Committee (CEIOPS)

The Committee of European Securities Regulators (CESR)

Finally, there's the EMF (European Monetary Fund) proposal, which was first put forth in recent days by the German Finance Minister Wolfgang Schäuble (analysis here). As the name indicates this would be a type of insurance company for European governments. Everyone pays an yearly premium for an "insurance" and then when the getting gets tough, the fund is there to lend money to whoever has not been able to keep its expenses in check. It is there to ensure that governments who mess up their public balance are still able to pay their debts (oddly enough by contracting even more debt, but at a nice rate) and it deflects public outcry from the affected country to the European Commission rather than to Germany

I think that the first idea is not particularly good... Getting a government agency in charge of determining who is worth what sounds too much like centralised price setting, which is inefficient. Public officials lack the self interest that private agents have in their pursuit of information. Secondly public institutions are more constrained in terms of the monetary incentives it can provide (particularly if one assumes that financial crisis will still happen, and that no single system can prevent them or guarantee that their size will be limited. That would be a little PR mess...). Thirdly, it would open the doors for a greater extent of agency capture in the financial sector. Finally, there's the opposite problem of agency capture by governments, who may try to exploit their new found influence by pushing this agency to provide their debt with inappropriately high quality ratings. In other words there would be a potential for selection bias in the value that this rating agency would attribute to government assets rather than to private assets.

So to sum up: lack of self intrest and a limited set of tools to provide incentives exacerbate, or at least fail to solve, the problem of asymmetries of information

agency capture from both private and public agents seems to create fertile grounds for future conflicts of interest and revolving doors. Regarding the second idea, I think further integration is a really good idea. I agree with the author of the Eurozone entry blog, that there is little point in creating this finacial supervisory authority if the structure is going to be overly decentralised. Of course the committees should be separate, but there should be a supervisory point where all financial sectors (Banking, Insurance and Securities) are aggregated for analytical purposes. These industries cannot be regulated separately. Over decentralisation would be tantamount to coordination under a new name, rather than actual integration/delegation of powers. Regarding the problems that I raised with the EU rating agency, these are absent here. In this sense, the ESFS would outsource financial rating to the private sector (Moodys and S&P, etc). My main problem really is about its name. Why call this a European Macro prudential Supervision? It Finance, not macroeconomics... It should be overseen at the EcoFin level, but more than that I can't quite see the Macro point of the ESFS... Finally I think that the last idea is really good. Although it has faced some opposition. Here are some links for further information> Here, der spiegel and business week ft and bbc Note that I think that the EMF would not suffer from any particular problem of Moral Hazard, as it would provide an incentive mechanism based on conditionality. This is not just insurance. It's insurance "if!". So that's good! Moreover, I believe that the risk is in the rigidity of the proposed conditionality. Too rigid and its intellectually dangerous. Too flexible and its economically useless. On the other hand it could be more targetted, taking advantage of the insider knowledge that the EU already has about the functioning of its member states economies, so that conditions could be targetted at certain economic sectors, political reforms and apply in the Longer rather than in the Shorter term, when appropriate. One of the problems of the IMF interventions has always been that its interventions don't have permanent effects. The risk is that once the EMF will be set up it will repeatedly rescue the same countries. This would be problematic, as self selection would propose that those who are not at risk would simply stop contributing, and instead decide to follow policies that minimise their exposure to their neighbours malpractice. If this logic makes sense then it would imply that poorer countries policies would crowd out foreign investment from the EU. Also check this link for some insights on the present discussions about budget and tax coordination.