The Euro and the Weimar deflation: why efforts to regain market confidence in the Euro so far have failed

It is clear to most analysts by now that the reason no comprehensive solution for the European sovereign crisis has been found so far is the German nightmare of a repeat of the hyperinflation that crushed the Weimar republic and delivered the State in the hands of the Nazi party.

This seems to be the only possible reason an exporting country could impose austerity all over its main export markets: irrationality bordering on madness.

It is not a repeat of hyperinflation of the Weimar Republic Germans should be worried about, but the serious deflation experimented by the same Republic.

If creditors are worried that European Sovereigns will struggle to repay their debts, it is not because the debt is high in itself, but rather because it is high as a percentage of GDP. The focus of rational investors in the credit markets is therefore on growth as much as it is on debt.

Addressing a Debt/GDP ratio imbalance can be likened to shooting a moving target, with the notable difference that the shot can move the target. The issue with using only, or prevalently, austerity measures is that the benefits on debt can be offset by damage to GDP. If the State increases taxes , that very act may depress growth so much that the effective tax revenue is lower than the one the State would have had without a tax rise. This way what economists call a debt spiral can be started. Once started, exiting a debt spiral can be very difficult.

Measures undertaken in Greece so far have indeed offered the perfect example of a debt spiral. The Government enacts only, or prevalently, austerity measures with little structural reforms or serious cuts to government expenses. That leads to economic contraction which ultimately ends up decreasing tax revenues. Play again in loop. In the end, this created a strong deflation in Greece.

If Italy goes down the same route problems will be compounded on a much larger scale, which might lead to multiple defaults of sovereigns, banks and firms all over Europe and the world and, in turn, money printing and hyperinflation.

This, dear fellow Germans, is the right recipe for a repeat of the Weimar troubles, not printing money now.

The reason printing money now would only lead to a moderate rise in inflation is very simple: money transmission mechanisms are not working properly because the banking system is not functioning. If this were not the case the massive injections of liquidity in the banking system by the ECB would have created already inflation way above 5%. In economist jargon, money velocity is very low. If it were to increase again at normal levels and risk creating inflation, it would be relatively easy for the Central Bank to decrease that liquidity once again. If it is not clear how to do it in Frankfurt, dear smart people in the Eurotower, pray e mail your fiend in Tuscany. Come think about it, you might prefer to come and visit: it is entirely up to you.

Money printing, therefore, would not be a solution in itself. Other measures are necessary: some progress has already been made in helping the banking system function again (which proves Draghi knows already what he is doing, although he still might want to come down to Tuscany for a meal) but more needs to be done to increase growth, and this is the job of politicians.

It must be noted first that there are studies (e.g. by Harvard’s Alberto Alesina) showing how decreasing government expense is much more effective to re-establish a healthy debt/GDP ratio than increasing taxes. Therefore the austerity mix should be tilted much more towards cuts and less towards taxing. So far at least it has been the other way around in Europe, except perhaps the UK. Italy has announced a series of liberalisations and sales of central and local government owned assets but has not delivered any yet. We shall see whether the economist Mario Monti finally succeeds where all others have failed.

With the resources thus available it is imperative not to listen to those who will suggest to increase government spending again but to use them to repay the debt. Those who suggest Keynesian interventions are not considering that those cannot work when the State can only finance itself at punitive rates. On the other hand the State must reduce red tape to encourage private investments in much needed infrastructure upgrading. All the government has to do is sell the concessions: free market can do the rest. This is the way European railways were built in the 19th Century, so why can it not work again?

The combination of these interventions would be highly stimulative, especially if coupled with actions that increase labour force participation rates. This means sending people into retirement later (which is being done) and encourage higher employment among women and young people. If such measures succeed in increasing participation rates, trend growth will edge higher.

At the same time, however, it is necessary to re-establish well-functioning money transmission channels.

At the time these are not working because banks prefer hoarding cash instead of lending it to other banks. This is due to uncertainties regarding haircuts on sovereign debt (which is being removed in Europe mainly thanks to French intervention) and about capital reserve requirements. If Europe wants to avoid a credit crunch, it has to make it clear what the requirements are and when they will be required. The sort of uncertainty created by politicians on this issue is detrimental even to the efforts of the excellent ECB to introduce liquidity measures.

Italian journalist Beppe Severgnini recently wrote on the Financial Times asking the Germans to stop being irrational about inflation, rightly noticing that Southern Europeans hoping Germans stop acting irrationally contradicts some clichés.

Chancellor Merkel has the duty to explain the consequence of austerity without growth (i.e. deflation) to her constituents, otherwise she might be re-elected only to oversee the break-up of the European Union (and hyperinflation too).

Dear Germans: nobody wants your money. All you have to do is be reasonable. Let’s see now if they finally get it!

Reductio ad absurdum: why the Euro will not disappear

Originally published in Italian on www.lettotralerighe.it; November 28, 2011(direct link to post:http://lettotralerighe.blogspot.com/2011/11/reductio-ad-absurdum-perche-leuro-non.html)

Many people keep asking whether the Euro can really cease to exist. Although everything is possible, we try to show ad absurdum why the demise of the Common Currency is at least unlikely.

Let us first say that, given very bad crisis management from the French, but chiefly German side the cost of keeping the Euro together has risen , obviously exponentially (How Chancellor Merkel with her PhD in physics could not foresee it remains a mystery). Because of previous choices risks have been reintroduced within the monetary union. First credit risk (it is not obvious anymore that a Euro country cannot default: see previous post), then currency risk. The latter point requires an explanation. When France and Germany, in a press conference following one of their many (too many?) bilateral meetings, declared that staying in the Euro was for Greece to decide, they implicitly admitted the possibility to opt (or be forced) out. Markets, logically, started pricing the possibility of an exit, measured as the percentage of devaluation in case of exit multiplied by the probability that the event occurs. Since the possible devaluation would be according to many, around 30-40%, even a not very high likelihood of exit, say 10%, implies a 3-4% premium: a huge number.

All spreads have since started rising, In particular, short-term spreads have risen more than long-term ones, That means it costs more to countries to finance themselves at 2 years than at 10. Although it cannot be proved, it cannot be excluded that the increased cost is due to the possible exchange rate of a new (old) currency. This on one hand is more likely to happen in the short than in the long term (if the Euro survives the next 2 years, it is probable that it will survive another 8). On the other hand, in any case, the effect would mainly be short term. The time would be similar to the duration of government debt, which in the Eurozone periphery is just around 2 to 3 years.

Given all the above, the crisis of the Euro is resembling more and more a crisis of emerging countries that pegged their currency to a stronger one. There are several examples of such crises in South America in the past decades. In these cases, mostly currencies were pegged to the US dollar. There are obviously differences between these cases and the Euro, in that in South America currencies have remained separated (at all times a dollar was a dollar and a peso a peso). Risks involved, though, were similar, i.e. credit and currency risk for the weaker Country.

Looking at the previously mentioned examples, let us see how a break-up would occur. Before someone gets scared: this scenario is by far the least probable; reading until the end it will be clear why.

People wake up one morning, almost invariably a Sunday (banks are closed) to learn that from today 1 Euro has become X new Liras, Dracmas etc. Most people will have worked out this but failed to consider the consequences, inevitable unless other measures are put in place at the same time. On Monday morning there are queues in front of bank branches as everyone wants to take money out and/or exchange it for another currency (this can also occur on bank internet severs).

In fact people would think, and with good reason, that the new (old) currency would quickly lose value against the other stronger currencies. This would very probably mean the collapse of the banking system even before debt in stronger currency could break it. The only way to avoid collapse would be to announce at the same time of the introduction of the new (old) currency limits on withdrawals and, above all, controls on capital and people at the borders. Such limits would be against the basic treaties of the European Union.  A collapse of the Euro would therefore be inevitably linked to implosion, or at least suspension with possible strong downsizing, of the Union itself. All the above measures could not probably save the banks, which would need massive capital injections form the State.

Before thinking this would be desirable, please consider that consequences, in particular for exporting Countries such as Italy, would be dire. The Country with most to lose from a failure if the Euro is of course Germany, the strongest intra Eurozone exporter, which would be hit by a double whammy of a drastic revaluation of its currency and the new limits to free movement of people and trade. This already explains why a Euro collapse is improbable: it would cost Germany much more than keeping it going (see ‘Germany and the apprentice sorcerer).

Consequences of a break-up, however, would not be limited to those just described. Those on companies would be even greater. In fact, many commercial transactions even of small firms are now international.  For example, a Spanish firm having to pay a French supplier in Euros would see its debt increase because of the fall of the Peseta against the Franc. Interconnections are such and so many that a chain of default would be probable. Obviously this would lead to increased unemployment all over Europe. In the end the only way to avoid chain defaults would be for Countries leaving the Euro to print money. That would start an inflationary spiral which would end up not being able to contain failures but would bring even greater value destruction.

Given all the above it is therefore very improbable that a Euro break-up be allowed, not least because it would disadvantage most just the Country which now opposes drastic monetary measures, i.e. Germany.

At this point one could ask whether German politicians know all this. The answer is they probably do, but perhaps they think they can hold on until the elections in 2012 before enacting the inevitable. We doubt they will have this luxury, as the exponential function (yes, still that) is already weighing heavily on events.

The importance of the alternative: possible implications of the lack of the risk-free rate

Originally published in Italian on www.lettotralerighe.it; October 23, 2011(direct link to post: http://lettotralerighe.blogspot.com/2011/10/limportanza-dellalternativa-possibili.html)

In a well pondered choice various alternatives are analysed; then, the best with respect to the others  is chosen. So we make decisions choosing the best available alternative.

This simple process, besides being common sense, is also the base of economic and portfolio choices. Investment choices are in fact usually well pondered and not taken on the spur of the moment.

The risk-free rate represents the return an investor can expect to earn if he or she wants to take no risk. On average that should be in line with the rate of inflation. The risk-free rate has always been represented by the rate of return on government bonds, as it could be taken for granted that the probability of default of a state was so remote as to be negligible.

The risk-free rate becomes then the basis of investment decisions, the one that can allow to decide what risks to accept according to the expected return associated to those risks The lack of a risk-free rate creates confusion among those willing to take risk and suggest those not willing to keep their money (figuratively speaking) under the mattress. Mostly this means keeping cash in the bank, with very low returns but immediate availability if need arises.

The effect becomes extreme in the event of a crisis, as uncertainty pushes many to avoid risk. The consequence, lacking a risk-free rate, is an increase of funds in bank current accounts.

In times of a well-functioning economy, this would translate in higher investments as banks would then lend the money to those willing to take risks. Now, however, banks are reluctant to lend to companies because of a combination of increase in bad loans and uncertainty over capital rules (politicians seem to change their minds every week on how much capital banks should keep as a guarantee for their loans).

At the same time, entrepreneurs are themselves reluctant to increase their debt as they fear their investments will not be remunerated because of a bad economy. One of the effects of the crisis has been the disappearance of the risk-free rate. Yields on government bonds have started to include a part of credit risk (the probability the State will not pay its debts). This effect could look unimportant, but has, as we have seen, very strong implications.
The problem is not limited to Italy or the Euro area. It is in fact known that on one hand the United States lost its AAA rating, and on the other Germany is starting to worry and get worried in that it has to back-up the Euro (it is by far the biggest beneficiary), but to do so it risks having to use so many resources that buyers of German bonds will ask for higher yields just because of a perceived increase in credit risk (the latest Bund auctions in fact have shown weak demand and yields above 2%. The signal is alarming, as it may mean convergence of Euro area yields in view of a common treasury being perceived as more and more likely).

It is necessary for politics to start again from here: re-establish that government debt is really risk-free means re-creating a basis of trust necessary for economic expansion.

At present, unfortunately, it looks like European leaders are far from this awareness. On one hand they are offering bridge loans to countries in difficulty, but that can at best solve a temporary liquidity crisis, not a solvency crisis. On the other hand they seem to be pushing for a recapitalisation of the banking system. The latter risks sending out the dangerous signal that some countries are expected to default. For what other reason would reserve have to be increased? If in battle one reinforces the second lines, it is rational to think one is readying for a retreat. In Europe the enemy is within, not in the speculators who, according to politicians who have brought us in this crisis because of their incompetence and incapacity to solve problems, are the cause of all evils.

Speculation is at best a comfortable scapegoat to throw to electors who do not have the cultural, critical, but above all self-critical capabilities (they voted in the present lot) to get to the right conclusions.

Germany and the Apprentice Sorcerer

Originally published in Italian on www.lettotralerighe.it; September 9, 2011(direct link to post: http://lettotralerighe.blogspot.com/2011/09/la-germania-e-lapprendista-stregone.html)

Before getting to the point of the lack of German leadership, the main subject of this post, it is useful to note the following: the shortcomings of others do not excuse the incapacity of Italian politicians in the last 40 years. They have failed to check public spending and did not put in place necessary reforms to enhance growth. The graph below is from a study of the Bank of Italy, an obviously non-partisan organization (Francese, M, Pace, A. ‘Il debito pubblico italiano dall’Unità a oggi. Una ricostruzione della serie storica’, Ottobre 2008. The full article can be downloaded for free here: http://www.bancaditalia.it/pubblicazioni/econo/quest_ecofin_2/qef_31/QEF_31.pdf).

It can be clearly noted that debt rises above 40% of GDP around 1971. At that time Italy was ruled by the so-called ‘governments of national solidarity’, headed by Democratic Christians with the external backing of the Communist Party. Since the Communists could not have ministers, presumably because of the nervousness this would have created in Washington, they obtained spending concession which made their constituents happy at the expense of their own children and grandchildren, who now have to foot the bill (see previous post). Thus, centre-left search for consensus of the 1968 kind, started with Andreotti and continued by Craxi, started the spiral of spending, debt and lack of reforms that would have cost in electoral terms but of which now the payment is required. Let us hope that the ‘spending generation’ going to retirement will stop this negative feedback loop.

Therefore, it is clear that anything that is decided in Berlin or Brussels will not delay the time of unpopular reforms. Failure to do so would result in punitive yields with the potential of sending public finances out of control. And now to Germany.

When Goethe wrote his famous ballad Der Zauberlehrling (the Apprentice Sorcerer) he did not imagine that the moral contained in it would be ignored by the same Germany which reveres him so much as a poet.

Germany seems trapped in the curse of the apprentice sorcerer: his desires becomes reality but he has to live with the consequences of his power and face the wrath of the Master Sorcerer on the latter’s return.

Germans have in fact created a system of high added value exports with which emerging economies cannot easily compete. This system, however, has turned in a huge success with the critical help of monetary policy.

With introduction of the Euro, the main trading partners of Germany started absorbing German exports without the automatic stabiliser of a stronger Mark. In the past, when a Frenchman bought a German car, he had to sell Francs and buy Marks at the same time, thus making the next car more expensive in Francs.

After introduction  of the Euro this does not happen anymore: the Frenchman buys the car but the next car is not more expensive as France and Germany share the same currency.

E second positive effect for Germany comes from ECB monetary policy which has, at least so far, yielded to Berlin’s influence on everything. The ECB in fact is mandated to control inflation but in the first decade of the new millennium peripheral countries were booming (particularly Ireland and Spain). At that time monetary policy remained accommodating, just as Germany was not growing much.

Now that peripheral countries have put in place a restrictive fiscal policy ( the State spends less and taxes more) they would need an expansive monetary policy (the combination used in Britain), but Germans live with the nightmare of the 1 million Marks stamp because of the inflationary spiral which caused the end of the Weimar republic and the rise of Nazism. Therefore the ECB cannot create inflation.

So far goes the first part of the story of the Apprentice Sorcerer. The second is starting just now.

About 2/3 of German exports go to the Eurozone. The amount is around 650 billion Euros per year. Having forced a fiscal retrenchment in their export markets, Germans face a decrease in demand for its goods, which is already resulting in lower exports.

What can the Berlin do?

Essentially it has to make up its mind as, simplifying as usual, it has 2 possibilities:

1-     More fiscal integration. If Germany is to continue enjoying the benefits to its exports (which we try to estimate below) it has to accept this, which in the end is what the Euro was created for. This would cost Germany, in the worst case, 1.5-2% of GDP, or about 48 billion per year, in increased interest costs. This estimate by German institute IFO is pessimistic, in that it is just a weighted average of borrowing costs of all Eurozone countries. This does not take into account the benefits that could result from increased liquidity and, in the best hypothesis, the rise of the Euro as world reserve currency.

In the second case it is probable that yields would be in line with those paid by Germany if not lower.

2-     Germany leaves the Euro, probably with Austria, the Netherlands, Finland and perhaps France, but Paris would probably say ‘no thanks’, as it has certainly run the numbers.

In this case Germany would have to immediately recapitalise its banks: the estimated cost is of 21 billion. However, this would be just a one-off payment, while the worst would be the impact on exports.

In fact, German trade surplus is around 150 billion Euro per year (Eurostat data for 2010). Many economists think a new Mark would appreciate 30-40% against the Euro. If this is true, there would be enough to send the German trade balance to negative territory, counting the appreciation of the new Mark against the dollar too with a clear disadvantage on all world markets. So Germany would have to do what it should have done already: consume a higher percentage of what it produces, thus further reducing its trade surplus. The damage would be, according to our estimates, in the region of 190 billion for the first year. A reduced competitiveness, however, would still linger. Correcting it would take time, which would probably increase unemployment in  Germany: it would not be unreasonable to assume an unemployment rate double than that enjoyed in Germany now.

At that point there would be little choice to contain the damage: Berlin would have to step up government spending (supporting both German production and exports) or expand the monetary base with probable inflation creation. For the 1 million mark nightmare, Berlin can rely upon a pan-German export of great success: psychoanalysis (in fact Freud was Austrian and Jung Swiss but both were German speakers).

Of course, there is the option that has been followed until now: do nothing and wait for better times.

This option, however, is disappearing as the market understood the structural imbalances at play and demands to ‘see the bluff’.

Chancellor Merkel, with a PhD in Physics, should understand the effects of compounding interests, as they are strictly related to the exponential function that she cannot ignore.

Let her take the decision she thinks best but show a bit of leadership before the Master Sorcerer comes back and punishes the Apprentice.

The current crisis through defects of representation

Originally published in Italian on www.lettotralerighe.it; August 17, 2011(direct link to post: http://lettotralerighe.blogspot.com/2011/08/fattori-determinanti-dellattuale-crisi.html)
One would probably expect from an economist a number of analyses of current market conditions with many graphs and tables.

Those are coming (in fact they are already done) but at the moment I think it is more relevant to clarify two important factors which, in combination, have taken the current European situation to a point which will be difficult to disentangle without a radical change in mentality.

The motto of American colonists during the War of Independence was  ‘no taxation without representation’. Americans were not complaining, as many believe, because for high tax rates. Indeed, they were paying much less than English citizens. They wanted, instead, to elect representatives in Westminster: not in a local parliament but that of the motherland. The English refusal brought to the War of Independence.

Many other wars and revolutions have happened because those who paid most into the system could not take the most important decisions, either because they were kept out of the decision-making process altogether or because they were a minority with respect to those segments of society that they were in fact supporting.

What does this have to do with the current situation in Europe?

Well, there are two defects of representation which could undermine the social equilibrium, as they have already done so with the economy.

The first defect is common with most of the developed world, and is linked to universal suffrage. In a world which is growing older, young generations which produce the most part of wealth are a minority with respect to older generations which receive the most from the State. The result is a growth of entitlements. Clearly, in order to maintain and grow the level of entitlements, which for the most part benefit the elderly, it is necessary to increase the income of the State. This can be done by increasing taxes or issuing government debt. The rise in debt levels has been the consequence of political parties searching for votes among a populace growing progressively older.

Increasing debt today, however, inevitably means having to raise taxes tomorrow if borrowed money is used to pay for entitlements and growth of the state apparatus handing those over, instead of being invested in projects which could increase wealth.

This is the main reason debt in several Stated has grown exponentially after WWII (I past times governments were contracting debt mainly to wage wars). This analysis owes much to those by Niall Ferguson, especially those contained in ‘The cash nexus’ and ‘The ascent of money’. A more typically Italian sort of entitlement is represented by various advantages owned by state-owned or politics-friendly monopolists and oligopolists. This is also a privilege of which few take advantage at the expense of everybody.

The second defect of representation is instead typical of Europe, where important decisions are more and more taken in Brussels and then ratified at national level, while electors chose mainly national and local governments. In fact, if it is true that the European Parliament is elected, it is also true that the Commission (more and more a Government) is not elected directly, but nominated using also criteria of national interest. In a power vacuum during the crisis, then, the European Central Bank had to make important decisions more than once, as political decision mechanisms in Europe are cumbersome and ill fit for crises which require immediate response. Obviously the ECB is not an elected body.

The latter defect of representation is creating frustration towards Europe within a growing portion of the public opinion in the Old Continent.

There are ways to overcome the two defect which we saw before without radical solutions such as a reduction of suffrage, but with very strong political implications.

In order to solve the generational problem, the introduction of a budget clause is needed. This, however, cannot be limited to balancing the budget, as could be done by introducing new taxes. In fact, new taxes reduce growth while maintaining entitlements, essentially penalizing the young. The clause that is needed is that a generation cannot leave more debt that it has found (as said by Laurence Kotlikoff about USA: http://www.bloomberg.com/news/2011-08-03/generational-balance-not-budget-balance-laurence-kotlikoff.html). There are methods in economics that allow to measure these numbers: those methods revolve around the concept of Generational Accounting. The only way forward which is fair to everybody is to reduce entitlements and competition advantages, of which in the end only a minority takes advantage but everybody pays for. In Italy in particular the defect of representation of the young extends, for similar reasons, to Trade Union representation. CGIL, the main Italian Trade Union, reports (http://www.cgil.it/tesseramento/default.aspx) that in 2010 the percentage of pensioners with Union card was 52.1%. Furthermore, the category of active workers with the highest percentage of members was civil servants, with 7.1%. Essentially, almost 60% of all those with a Trade Union card are either receiving entitlements or working in the entitlement system. A way to resolve this defect of representation would be moving contract from nation to firm level. Encouraging steps in this direction have been taken recently. The above data could explain the strong resistance to change from Trade Unions.

To solve the second defect, if a European Union still is to exist, is to accelerate political integration, giving at the same time the possibility to citizens to elect a European government directly. What is needed, in other words, is a lessening of the national decision level and the emergence of European parties which can put forward coherent programmes for the whole Union.