Wednesday, November 26, 2014

Three New Lessons of the Euro Crisis

WASHINGTON, DC – While some observers argue that the key lesson of the eurozone’s baptism by fire is that greater fiscal and banking integration are needed to sustain the currency union, many economists pointed this out even before the euro’s introduction in 1999. The real lessons of the euro crisis lie elsewhere – and they are genuinely new and surprising.

The received wisdom about currency unions was that their optimality could be assessed on two grounds. First, were the regions to be united similar or dissimilar in terms of their economies’ vulnerability to external shocks? The more similar the regions, the more optimal the resulting currency area, because policy responses could be applied uniformly across its entire territory.

If economic structures were dissimilar, then the second criterion became critical: Were arrangements in place to adjust to asymmetric shocks? The two key arrangements that most economists emphasized were fiscal transfers, which could cushion shocks in badly affected regions, and labor mobility, which would allow workers from such regions to move to less affected ones.

The irony here is that the impetus toward currency union was partly a result of the recognition of asymmetries. Thus, in the aftermath of the sterling and lira devaluations of the early 1990’s, with their resulting adverse trade shocks to France and Germany, the lesson that was drawn was that a single currency was needed to prevent such disparate shocks from recurring.

But this overlooked a crucial feature of monetary unions: free capital mobility and elimination of currency risk – indispensable attributes of a currency area – could be (and were) the source of asymmetric shocks. Currency unions, in other words, must worry about endogenous as much as exogenous shocks.

Free capital mobility allowed surpluses from large savers such as Germany to flow to capital importers such as Spain, while the perceived elimination of currency risk served to aggravate such flows. To investors, Spanish housing assets seemed a great investment, because the forces of economic convergence unleashed by the euro would surely push up their prices – and because there was no peseta that could lose value.

These capital flows created a boom – and a loss of long-term competitiveness – in some regions, which was followed by an all-too-predictable bust. To the extent that monetary and fiscal arrangements fail to reduce or eliminate moral hazard, the risk that capital flows create these endogenous asymmetric shocks will remain commensurately high.

A second insight from the case of the eurozone, advanced by the economist Paul de Grauwe, is that currency unions can be prone to self-reinforcing liquidity crises, because some vulnerable parts (Greece, Spain, Portugal, and Italy at various points) lack their own currencies. Until the European Central Bank stepped in last August to become the central bank not just of Germany and France, but also of the distressed peripheral countries, the latter were like emerging-market economies that had borrowed in foreign currency and faced abrupt capital outflows. These “sudden stops,” as the economists Guillermo Calvo and Carmen Reinhart call them, raised risk premiums and weakened the affected countries’ fiscal positions, which in turn increased risk, and so on, creating the vicious downward spiral that characterizes self-reinforcing crises.

The most appropriate analogy is with a country like South Korea. In the aftermath of the Lehman Brothers collapse in 2008, South Korea needed dollars, because its firms had borrowed in dollars that domestic savers could not fully supply. Thus, it entered into a swap arrangement with the Federal Reserve to guarantee that South Korea’s demand for foreign currency would be met.

Of course, the euro crisis was not just a liquidity crisis. Several countries in the periphery (Greece, Spain, and Portugal) were responsible for the circumstances that led to and precipitated the crisis, and there may be fundamental solvency issues that need to be addressed even if the liquidity shortfall is addressed.

Finally, a less well-recognized insight from the euro-crisis concerns the role and impact of a currency union’s dominant members. It is often argued that the United States, as the major reserve-currency issuer, enjoys what then French Finance Minister Valéry Giscard d’Estaing famously called in the 1960’s an “exorbitant privilege,” in the form of lower borrowing costs (a benefit estimated to be worth as much as 80 basis points).

There was always a downside – previously ignored but now highly salient in our mercantilist era – to this supposed privilege. If investors flock to “safe” US financial assets, these capital flows must keep the dollar significantly stronger that it would be otherwise, which is an unambiguous cost, especially at a time of idle resources and unutilized capacity.

But, in the case of Germany, exorbitant privilege has come without this cost, owing solely to the currency union. Weakness in the periphery has led to capital flowing back to Germany as a regional safe haven, lowering German borrowing costs. But, yoked to weak economies such as Greece, Spain, and Portugal, the euro has also been much weaker than the Deutschemark would have been. In effect, Germany has had the double exorbitant privilege of lower borrowing costs and a weaker currency – a feat that a non-monetary-union currency like the US dollar cannot accomplish.

The future of the eurozone will be determined, above all, by politics. But its development so far has forever changed and improved our understanding of currency unions. And that will be true regardless of whether the eurozone achieves the closer fiscal and banking arrangements that remain necessary to sustain it.

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    1. CommentedJose araujo

      Why most of the time people fall for the Austrian explanation, without having the trouble of verifying the facts.

      There wasn't a sudden capital inflow to the periphery in 2000 because of the Euro. Interest rates were already low in the end of the 90's, and direct foreign investment is lower in the 2000's when compared to the 1990's.

      The causal nexus is all wrong, in fixed rate system, the inflows are due to the trade deficit. Its not capital inflows that produce trade deficits.

      Strong currency leads to problems in internal demand, de-localization of industries, unemployment , etc etc etc

      Regarding house bubble and all, fact is that the default on mortgages in spain is on a normal level, so there is no indication that people just bought houses because there was sudden access to cheap money, because there wasn't. Interest rates in 1999 were already low

    2. CommentedMarco Cattaneo

      The euro is an ill-conceived project. The lesson that should have been learned in 1992 is that the previous fixed-exhange rate system should have been replaced by something MORE FLEXIBLE, not more rigid (such as a monetary union). Having said that, restoring flexible on a country-by-country basis is still possible.

    3. CommentedGerald Silverberg

      The endogenous shocks (and resulting loss of competitiveness) resulting from capital mobility in a fixed-exchange rate or currency-union regime was already modeled by Rüdiger Dornbusch in the 1990s. He called it "the Latin Triangle" after the experiences of Mexico, Brazil and Argentina.

      While Germany profits from the double dividend you point out, this does nothing to solve the internal balance of payments problem at the root of the Euro crisis. Why the Germans have insisted on the route of peripheral devaluation rather than core inflation is discussed in my blog

    4. CommentedZsolt Hermann

      On one hand I agree we can learn a lot from each crisis, on the other hand we can blur and ignore what we could and should learn if we do not want to see or accept the truth.
      The main problem is that we keep thinking we need to invent new things, we are pioneers living in a vacuum creating a new reality for ourselves.
      But this is not the case.
      We exist in a vast, perfectly harmonious natural system.
      We evolved from this natural system, our biological body, our psyche, our basic human needs, desires and instincts belong to the natural system.
      And this system has laws that are binding to all that are part of it. These are laws maintaining overall balance, homoeostasis, maintaining life.
      And since this natural system is complete, it is integral, all of its elements are interconnected, and interdependent.
      Thus such notion as partial integration, partial union does not, cannot exist.
      A financial or economical union forced on different, seemingly sovereign nations, without trying to create a fully mutual, complementing, balanced union cannot work.
      How can such nations unite in one way, and compete with each other at the same time?
      We keep on going against binding, unbreakable natural laws, trying to invent our own artificial subsystems, rules and we are surprised when it does not work.
      So what we really should be learning from the Eurozone crisis is that integration has to be full.
      And since the whole global world exists in the same system it does not only concern Europe but the whole of humanity.
      We have to gradually change from the self-destructive, exploitative, profit oriented competition and build a mutually complementing, harmonious human system that is adapted to nature.

    5. CommentedFrank O'Callaghan

      Germany benefits from astrong trade surplus that would be impossible without the weakening effect of the bailout countries on the currency.