A brief note on the Euro Symposium

"I would prefer not to"

Bartleby, the Scrivener: A Story of Wall Street", Herman Melville

Tonight representative of the 27 members of the EU will sit together around a dinner table to discuss a report, appropriately titled for the occasion "Towards a Genuine Economic and Monetary Union". The report was prepared by the four presidents of the European council, the Eurogroup, the Commission and the ECB; it identifies four essential building blocks for a "stable and prosperous" EMU to be put in place over the next decade (decade: a period of ten years).

They are, 1) An integrated financial framework, 2)An integrated budgetary framework, 3, An integrated economic policy framework and 4) ensuring the necessary democratic legitimacy and accountability.

 Let me focus on the first and most urgent block to be put in place over the next semester (semester: a period of six months), namely the integrated financial framework (from now IFF). For all practical means it consists in the creation of EZ-banks. The steps to transform euro-members banks into EZ-banks are to institute a single European banking supervision and a common deposit insurance and resolution framework. The motivation found in the report is totally correct: "the financial crisis has revealed structural shortcomings in the institutional framework for financial stability" and the IFF will "ensure financial stability in the euro area and minimize the cost of bank failures". Many commentators agree that the IFF will sever the incestous links between euro members banks and sovereigns, will increase confidence and stop deposits outflows, will help relax the consequent credit tightening. Fundamentally I think adopting a IFF goes beyond checking a list of shortcomings.

A while ago (the analysis is outdated and today would probably be more focused) I came to the conclusion that the architects of the Euro had focused on the necessary conditions to make it work. For example think of the competitiveness problems of the periphery from the financial angle. As long as the euro-members commercial banking system was working as one, the current accounts were intermediated. Then came the crisis and what was necessary turned out to not sufficient to make the Euro work. There are other important parts of the euro institutional infrastructure that can work with euro-member banking and financial sectors, and they worked before the crisis, but are likely to work less well, to say the least, than with a IFF. In normal times, we are entitled to think that the ECB would want to achieve a quasi-uniform transmission of its monetary policy across the EZ and along the EZ yield curve.

I really hope the room is green.

Portuguese Public Finance Council

Created in february 2012, the Portuguese Public Finance Council has published the first review analysis. It can be found in http://www.cfp.pt. There is a version of the report in English. The report is overall positive with the budget policies, but still finds room for recommendation about further improvements.

Guest author: U. Schuetz: Unintended Consequences

Unintended Consequences. Challenges for Portugal’s “Arranged Liberalization”
Ulrich Schuetz, University of Lucerne, Political Sciences (ulrich.schuetz@stud.unilu.ch)

Introduction
   After Ireland and Greece, Portugal was the third eurozone country to receive financial aid within the European Financial Stabilisation Mechanism (EFSM) framework of the so-called “troika”, composed of the European Union (EU), European Central Bank (ECB), and International Monetary Fund (IMF). In May 2011, the Portuguese socialist government, with support of the conservative opposition (which came to power one month later), accepted a reform plan conditional to the disbursement of financial assistance. The plan aims to improve Portugal’s economic competitiveness and performance through structural reforms towards a more liberal system. At the same time, it requires the state to substantially reduce public debt to regain fiscal solvency. Criticism of the reforms mostly reflects different macro-economic standpoints and comes mainly from economic observers. A frequent evaluation states that instead of fiscal austerity, expansionary monetary policy would lead the way out of the crisis (e.g. Krugman 2012). Because of the pro-cyclical nature of their conditions, past IMF programs were blamed for pushing countries into recession (Soros 2002:120). Missing from the debate on the effectiveness of the troika reform plan is the question if the reforms are embedded in an environment favorable for liberalization. A generalized “one size fits all” liberalization program might not produce the expected results, especially if non-economic factors are considered. Analyzing the separate aspects of the reform plan and trying to predict potential shortcomings in their application is necessary to be able to assess the chances of success. This essay is an attempt to do this by starting from the following assumption: If institutional complementarities and non-market relationships such as corruption and clientelism are ignored, the outcome of liberal reforms will be negatively affected.
   The first part of this paper provides a short overview of the troika reform plan. Subsequently, institutional complementarity and the Varieties of Capitalism approach are discussed regarding the Portuguese case. Finally, the impact of corruption and clientelism on a liberal reform process is addressed before summarizing the findings in a conclusion.

Troika Reform in Portugal
Details of the reform program were agreed on by both the old and new Portuguese government and troika. The agreed measures had broad political support as a result of a basic consensus on European issues between the country’s two biggest political parties, conservative Partido Social Democrata and socialist Partido Socialista (Fischer 2011). The two main pillars of the program relevant to this discourse are (1) increasing competitiveness and growth through liberal reforms and (2) regaining fiscal solvency through a substantial reduction of the public deficit (IMF 2012:4)1. Disbursement of financial assistance is subject to troika’s review of the implementation of the reforms. Portuguese authorities also committed to consult with troika on legislative changes that were not part of the agreement (European Commission 2011:1). As a consequence, the Portuguese government sends a quarterly letter of intent to the IMF and ECB with a review of the progress made so far and documenting the next steps, closing with a request to transfer the next installment. This is standard procedure for IMF-supported programs. The Fund itself argues that “conditionality can serve as a valuable commitment device that complements and enhances ownership of structural reforms” (IMF 2003:12).

1 year of troika

17 May 2011 - one year ago - the Memorandum of Understanding was signed and Portugal entered the financial rescue mode.

A year after we have
- new government, and a relatively large political consensus on the complying with the commitments set in the Memorandum, including the main opposition party
- lower wages - both in civil service, as the Government imposed a wage cut, and private sector (either negotiation of lower wages or through unemployment spells, taking lower paid jobs
- unemployment at historically high levels
- emigration rising again to levels unseen in peaceful
- public budget cuts
- price increases (transports, electricity)
- tax increases (both income and VAT) (tourists can still have back VAT, under certain conditions)
- give away 4 holidays (two historic dates + two religious dates)

but we also have
- sun and 30º C in May
- good roads and highways (though, rather empty ones, but hey, they are there to use)
- summer music festivals - Bruce Springsteen, Bryan Adams and Stevie Wonder will be at Rock in Rio
- good food, even if we take smaller portions
- waves
- exports growing, and to non-traditional markets
- GDP fall was smaller than expected this term (though one number is not yet a change in trend).

And if you want to keep tracking some key numbers in main areas of change under the memorandum of understanding, follow what our students are doing here.

What adjusts when a country deleverages

Normal blogging should soon come back. For the moment I continue the advertisement campaign on seminars: Friday we have (at Nova 12am) Pierpaolo Benigno presenting "Deleveraging and the real exchange rate"

A lecture on managing the fragility of the Euro Zone

Next Thursday (19th) here in Lisbon, Paul De Grauwe will give the second of Nova's "Lecture Series in Macro and Finance". link

New empirical evidence on fiscal devaluations

A very neat and insightful paper, here is the summary in a Vox column

a view on the Portuguese NHS

in case you want to have a view on the current situation of the NHS in Portugal through the lens of a North-American newspaper, check here

GNP versus GDP

The Irish case
Ireland has experienced large trade surpluses and current account deficits. The data show that the income paid by Irish residents to non-resident owners of domestic factor of production (such as capital) is often larger than the trade balance surplus. (click to enlarge)



We are told that most of the foreign direct investment to Ireland was in capital intensive industries (such as pharmaceuticals). The implication is that labour compensation (Irish residents) commands a relatively small share of the product of those industries.

GNP and GDP

There are two main concepts of aggregate measure of goods and services produced: GNP and GDP. GDP covers the goods and services produced by labor and capital located in Ireland. As long as the labor and capital are located in Ireland, the suppliers may be either Irish residents or non-residents. GNP covers the goods and services produced by labor and capital supplied by Irish residents.

Portugal is well aware of the difference between GNP and GDP as in the past its trade balance deficit was mostly entirely covered by labour income remitted by emigrants. The advantage with GDP is certainly that it is more precisely measured than GNP. However when the focus is on the availability of a Nation's resources to finance itself, GNP appears to be the relevant aggregate.

It should be now clear that when it comes to the capacity of financing its external debt, the relevant flow concept is the current account. Obviously improving the trade balance is crucial but data have to be analyzed with a grain of salt. Assume a foreign export oriented futuristic motor-vehicle plant that produces and assembles vehicles in minutes and is controlled by 2 workers.Part of the value added produced (net exports) by the plant will stay in the country (the 2 workers wage) and part will flow out (income payments) to the plant owners.

The fiscal devaluation keeps coming back..

Here is a nice piece on it, following the French government announcement that they will do one. In a more modest scale, Ireland has also done it. Portugal, where this measure was first discussed and seriously considered as a response to the crisis, seems less likely every day to ever do it.

Portugal wages and unemployment

This is not a formal analysis and estimation of a wage Phillips curve for Portugal. However the figure (click to enlarge) shows some evidence of a prima facie negative relationship between compensation inflation and the unemployment rate. And the coefficient is not reassuring (although it is probably unstable during recessions such as now). Data are from Eurostat.

The Euro Area + Other Currencies Areas = World

A widely shared synthesis on the symptoms of the global economic crisis exists: unsustainable private and public debt, rapid losses of competitiveness and widening of macroeconomic imbalances within a framework of zero short term interest rates and highly volatile financial markets. These symptoms appear to afflict the whole "West" and are generally identified using as unit of analysis the existing currency areas. A notable exception concerns the euro area: there, the same symptoms, especially in what regards macroeconomic imbalances, are diagnosed to be present in individual countries that form the euro area, but are much less visible when considering the area as a single unit.
Although no similarly widely shared synthesis exists on the causes and remedies of these symptoms the proposed policy mix is a multi-year fiscal deleveraging plan accommodated by expansionary unconventional monetary policy and possibly nominal depreciation. (When it comes to the current economic policy debate, I have the feeling that we are watching the latest season of the old Hats versus Caps disputes.)

The last element of this policy mix has been suggested as a solution to the internal imbalances of the euro area: let the euro devaluate and the current account deficit euro countries will readjust by expanding exports in the other currencies areas. I find this view problematic for two reasons. First, it is a currency area membership obligation to accept that internal exchange rates are irrevocably canceled and that the value of the currency changes in the same proportion for each member. Second, as mentioned above, the euro appears to be the only balanced currency area in the World.

Scale 1:1

The second column of the Table (click to enlarge) reports the accumulated current account of the 4 major world currency areas and of oil/gas exporters.



The data show the familiar imbalance between the US and the RoW together with the high government debt of the developed economies. To close this imbalance savings will need to decrease in the ROW and increase in the US, which in turn will require an adjustment of the real exchange rate between the US and the ROW. Notice that the Euro area is much more balanced when it comes to its external position: the Euro area does not participate to the global imbalances. A euro depreciation against the other major currencies would help to improve the external positions of all the euro countries but only if the depreciation increases the euro area trade surplus against the other currency areas. The Euro area is too large and important to act as if it was exogenous to the other currencies areas and must address its internal imbalances in a manner consistent with the adjustment of the global imbalances. The reward for success is likely to be large.

Further austerity and wage cuts will worsen the euro crisis

This note argues that the solutions to the euro-area crisis proposed by the EU governing institutions in cooperation with the IMF, based on further austerity and wage cuts, will worsen the crisis. They are unlikely to reduce both sovereign and external debt ratios of countries experiencing these problems. Quite in contrary, they are likely to further reduce the real GDP growth of these countries.

This note is joint with Corrado Andini and is available here.

German Professors Unite!

The German Constitutional Court recently provided an opportunity for comic relief, perhaps as a prelude to Carnival. On Tuesday it ruled out as unconstitutional the current pay scales of academics in Germany. According to the ruling of the professors-filled court, base salaries for academics are "evidently insufficient.” At the moment academic pay scales have two components: a base salary and performance bonuses, dependent on publications and the ability to attract outside funding from research councils. However, the judges in Karlsruhe determined that the fixed base salary rates were not enough for a professor, "according to his rank, to allow for the responsibility associated with his office and the meaning of the Civil Service for the general public a decent living."

So what are German professors paid? According to the German Association of University Professors, base pay for starting academics varies between €3526 per month, in Berlin, and €3926 in the state of Baden-Württemberg. Even though about 95% of professors receive bonuses, the Constitutional Court considered that these did not compensate for the excessively low base salaries since bonuses were not a ‘right’ but only a possibility. Where have we heard this before? In a very politically incorrect comparison they even noted that lawmakers were paid adequate base salaries without the need for bonuses!

On a PPP-basis, German academic salaries are today in the mid of the range of countries covered by a large survey published by the journal Nature (see figure).

In response to the ruling, the German Federal government has already called for a 25% pay rise, which will place German professors among the best paid academics in the World. The tradition of German scholarship excellence is well known, but one wonders about the consequences of the dilution of an incentive-based pay scheme for a sector whose best university ranks in the 47^th place in the Academic Ranking of World Universities. After all, German judges and the government decided on an across-the-board pay rise unrelated to performance, whereas in countries such as the US and Canada, academic salaries are negotiated individually in the context of a very competitive market.

Maybe Germans are finally “loosening up” – a similar pay rise for the rest of the economy would do wonders for the competitiveness of the rest of the Eurozone.

Eurobonds: a Greek tale with three lessons

The ongoing negotiations between the Greek government, the troika of official institutions, and the private creditors have failed so far to produce much, apart from increasingly inflamed rhetoric. The sitting Greek prime minister calls them a ‘moment of truth,’ while Jean-Claude Juncker, the leader of the Ecofin, delivered this weekend what amounts to an ultimatum to the Greek government.

It is perhaps fitting that yet another round of bargaining should take the tones of a Greek tragedy, but both sides seem to be dangerously over-playing their cards and run the risk of getting cornered into a position from which they may not be able to back-track. All of this brings back old memories, which are still instructive to interpret the current situation.

Greece is no newcomer to sovereign default. In fact, it spent almost half of its time as a sovereign nation in a state of default – the last one settled as recently as 1964. It is also not the first time that this country has been bailed out by its northern European partners. Greece was the beneficiary of what were probably the first two Eurobonds in history. To the proponents of this solution for the European debt crisis, the record of these two bonds offers some cautionary lessons.

After a long emancipation war, Greek independence was recognised by the Ottoman Empire in 1830. The then main European powers were instrumental to this outcome by effectively insuring Greek independence by treaty. They also funded the start up costs of the new nation with a £1.6 million loan, issued in 1833 under the several guarantee of Britain, France, and Russia. Under the agreement each power guaranteed half a million of the loan separately. Thanks to the guarantee, the new Greek nation was able to finance itself at barely 1% above the cost of borrowing for the three powers. In exchange, the powers demanded that these bonds would be senior to all previous Greek debt, raised privately to fight the independence war. This structure was remarkably similar to the Delpla-Weizsäcker proposal to divide the debt of European governments between ‘blue bonds,’ jointly guaranteed by all Eurozone nations and ‘red bonds,’ which remained the sole responsibility of each nation. In the Greek case the split was 25% blue to 75% red, adding to a massive 248% of GDP. The recent proposals for the Eurozone hark back to the debt criterion of the Maastricht treaty and propose instead a 60:40 split.

Figure 1: Greek sovereign yields, 1832

The vertical line marks the announcement of the guaranteed loan

Unfortunately, and as feared by the critics of the Eurobond proposal, one of the first consequences of the 1833 guaranteed bond was to make the remaining Greek debt unpayable. After almost a decade of war, the Greek government had no intention of pressing ahead with the tax increases needed to make good the payments on its debt. This was reflected in the yields of the old red bonds (Figure 1). After falling, in expectation of a comprehensive debt agreement, the yields rose back again to close to 20% once the details of the guaranteed bond were known. The Greek government would remain in default on its red debt until 1879! The first lesson from history is therefore that no Eurobond has a chance of success without a private sector involvement (PSI), a point only admitted since last October at German insistence, and after two failed bailout plans.

By 1839 the Greek government had also defaulted on the official blue debt, despite its supposed senior status. After a long series of efforts by the guaranteeing powers, that involved a revolution, a naval blockade, and a change of ruling dynasty, a final settlement was reached in 1864. By then the UK had paid £1.2 million of service for its share of the Greek debt, against a contribution by the Greeks of no more than £100,000. The second lesson is that just because no country ever defaulted on IMF debt that does not mean that defaults on official debt are impossible.

Thirty years and another war later, the Greek state defaulted again on a pile of debt worth 224% of GDP. The same powers intervened again and granted another guaranteed loan, issued in 1898 at the very low 2.5% interest rate. This time, however, they had learnt the lesson of moral hazard and insisted on the involvement of the private sector, which accepted a 61% cut of the original debt obligations, a value halfway between the 50% originally negotiated last October and the 70% now apparently being considered in Athens. This resulted in a drop of the total debt to 170%, split 55:45 between blue and red bonds (Figure 2). More significantly, the creditor nations forced the Greek government to limit its borrowing from the central bank and to accept the imposition of an ‘International Control Commission’ (ICC) which managed a series of domestic taxes and revenues to ensure that foreign creditors were paid before any other claims on the public purse. This deal was a relative success. Under the supervision of the ICC, Greek finances were reined in, and foreign capital was attracted back to the country, which helped with a rapid economic recovery in the years leading up to World War I. The German insistence for an independent ECB and the suggestion last week to introduce a ‘state commissioner,’ representing the European Union in Greece and with veto power on fiscal policy, clearly seem to echo the 1898 settlement.

Figure 2: Three defaults compared (government debt/GDP)

Perhaps, instead of “the product of a sick imagination,” as the Greek Education Minister defined it, the most recent German plan may be a consequence of the high degree of historical awareness in that country! If so, the history-conscious Germans should take heed of the dangers in using wrong historical analogies as a guide for policy. And this leads me to the third lesson. In 1898 Greece only accepted to surrender its fiscal sovereignty to the ICC as a counterpart to the settlement of a disastrous war and at a time when Ottoman troops still occupied the north of the country. In other words, the value of the status quo was very negative and the Greeks had no real choice but to accept the deal imposed by the guaranteeing powers. Today, the successive rounds of austerity imposed on the Greeks as counterpart for the release of outside help risk eroding the internal option of remaining within the framework of the troika negotiations.The temptation of going their own way correspondingly increases.

The Greeks might be recalled of the trials of Sisyphus and imagine themselves as being compelled to roll a heavy rock up a hill, only to watch it roll back down, and having to start again. Will they wait until eternity?