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Friday, June 14, 2013

Mervyn King on the solutions to the eurozone crisis

The FT has just posted an interesting and lengthy interview with outgoing Bank of England Governor Mervyn King (pictured), conducted by the FT’s Martin Wolf. Many pressing topics are covered but the short discussion about the eurozone caught our eye (as might be expected).

When asked about the solutions to the eurozone crisis, King sums up the options very succinctly and without the usual qualifying statements needed by those directly involved in the crisis:
 “I think there are four [solutions]. One is to continue with mass unemployment in the south, in order to depress wages and prices until they’ve become competitive again. The second is to say, ‘Well, we have to get rid of this imbalance in competitiveness, so we need inflation in Germany.’ That seems unattractive, certainly to the Germans.

“The third is to give up on this question of restoring competitiveness quickly and accept that this is an indefinite transfer union. That requires two things: one is for people in the north to give money to people in the south; the other is for people in the south to accept the conditions imposed on them, which will limit the size of the transfer.

“The fourth is to change the membership. Now, I don’t know what the right answer is, and it will depend on their political objectives, but economics tells you that you have to have one or some combination of these.”
A very concise and accurate summary we’d say. Obviously each option can be tinkered and altered but the broad truth is all there.

However, we might go so far as to narrow the options down even further. Option one (which is currently being employed) seems unlikely to be politically or socially acceptable – countries such as Greece, Portugal and Cyprus in particular would struggle to regain competitiveness this way. It would also leave the structural flaws of the eurozone untouched, leaving it incredibly vulnerable to future crises.

Option two also seems unlikely to be sufficient, even if it were an option politically. We would say some element of it is probably necessary for the eurozone, but far from sufficient to solve the crisis. It could also create the ‘uncompetitive union’ which Germany fears most, as although internal imbalances in the eurozone may be eased the actual competitiveness of the bloc as a whole would be much worse than previously. There are also questions about how much such an approach would spillover into growth in the struggling eurozone countries - as we discussed in detail here. Again it also does not tackle the institutional flaws.

Therefore that leaves us with options three and four – something we have noted before.

Before the crisis can ever be solved the true choices facing the eurozone need to be realised. Let us hope that this weekend some of the eurozone leaders read King’s interview.


Anonymous said...

He's not mentioning one important solution (the most importone one IMO), which is debt relieve. A restructuring of PIIGS debt would lead to a direct improvement in their balance of payments (less income paid to foreigners) Their net external investment position is unsustainable and there has to be a really huge amount of income transfers to solve this.

The wage share in Germany is at historically lows. So higher wages wouldn't be a bad thing and will probably mean the end of sectors which should have been gone away anyway through creative destruction.

Jesper said...

I'd have though the British would have discovered the difference between cost-inflation and wage-inflation by now.... Monetary policy has generated cost-inflation and it does not seem to have generated any wage-inflation.

Option 2 would require wage-inflation in Germany.
German wages have been kept down through the threat of moving jobs abroad. How would it be possible to generate wage inflation in these conditions? I.e. how would that threat be nullified?

Option 3? Money to be transferred indefinitely has been tried and is currently being done through the EU. Sending more money through an opaque organisation to another opaque organisation (not trusted by its citizens, the supposed end-beneficiaries) and hoping that things will improve.... Hoping for improvements is not a strategy.

Option 4? Changing the currency will not solve problems of governance. The few cases where devaluations have been involved in successfully solving a crisis it has always been in well governed countries.

Wage-expectations in the problem countries are a lot lower than in other euro-zone countries. Might the problem with competitiveness come from something else than wages for working people?

Open Europe blog team said...

@ Anonymous

Many thanks for the comment. You make a fair point, although we would note that a lot of PIIGS debt is now owned by the eurozone (from bailouts), the ECB (through bond buying) or other eurozone banks. A write off would therefore amount to some form of transfer in our view, either by the other eurozone countries agreeing to take a loss on their bailout loans or by having to recapitalise their banks on their losses from the write downs. Either way we would say this falls into Option 3 to a large extent. As we said, the adjustment in Germany will likely be necessary and help somewhat but isn’t enough on its own.

@ Jesper

Many thanks for the comment as always. Fair points and all the options have shortcomings, but then there is no easy solution to such a deep crisis. On option 4, we would simply note that in this instance it no longer remains a ‘eurozone crisis’. We’d agree that many of the countries would have national problems and devaluation is far from a panacea for their woes – but it may at least allow some economic and political breathing room to make the changes (accepted it may also discourage them but then we’re back to no perfect option discussion).

Rik said...

Germany is now in line for outsourcing (well the midsize/ family owned part of its industry).
As you say in such a climate (plus low growth) increasing wages is not going to happen. Better lower paid jobs than no jobs. Nobody will be doing away with even bad jobs under the current circumstances (as somebody here suggested), completely unrealistic.
Basically Germany, Finland and Holland have the same problem. In Holland it is probably most clear. Export oriented economy with already a huge trade surplus but no growth. With rising wages you would help the internal consumption but rubbish the export sector at the same time. Will not happen no export country rises wages or wagescosts in a low growth enviroment.
It is indeed a demand problem but a worldwide one. The wages should be increased in the export sector of the EMs. Works from an economic pov but will take a few decades at the earliest. No help in this crisis. Seems that the division of income between labour and capital will be rebalanced in favour of capital. Something we probably have to live with (and likely not good for growth). The whole thing is full of imbalances.

My guess has from the beginning been that a 'systemfailure' will 'solve' the issue. What I mean is that at some time within a likely short timeframe a solution for a problem will be required, but simply the rubbish set up and/or lack of political platform will make that impossible.

Anyway huge transfers likely require a referendum in Germany and look like political suicide in Fin- and Holland. Not a realistic option therefor. And as Mr Holmes says, if the rest is not possible ...... So 4 is the only thing left.
My guess likely with an attempt again to buy time via the ECB. But in no way they can buy enough time to make countries like Spain and Greece functioning again. So a delayed 4 is my best guess.

Rik said...

Watch the IMF Greece issue.

My guess is that the IMF are clearly planning some things. My guess is as well that they will (not in public at first btw) play their cards not too far from now (because of the German election). Merkel is trying to keep everything quiet the reason why she didnot make a big fuzz about the 'not an end to the not austerity'.

Barrosso is as usual rubbishing the relation and unnecessary. And opens his big mouth before making a round with the other people involved. As if the EU will decide when and how the IMF will act and stop.
As said a completely one dimensional person. Completely predictable always going for his standard solution (more powers for the EU and own resources) and hardly ever successful in that.
Anyway going for a fight with the IMF is hardly something Merkel wants (as her parliament will make problems about that) and certainly not just before an election.

Denis Cooper said...

It's really too late for Option 4 in the case of Greece. What should have happened over three years ago was Greece being eased out of the euro back to drachma with all the government bonds re-denominated in drachma and with transitional assistance from the other Eurozone states. That way Greece would have had a devaluation and bond holders would have had the default that they've since had in any case, but through getting repaid in drachma not euros. Now that the new bonds are written in English law there is no possibility of the Greek parliament changing their terms, as I understand, and so whatever the Greek government has promised to pay bond holders, including the ECB, in euros must be paid in euros. It would have been a breach of the EU treaties for Greece to leave the euro, but instead the EU treaties have been breached to keep Greece in the euro with a worse outcome. But then the decision was driven by politics, much more than economics.

Jesper said...

@Open Europe,


We seem to be in an agreement that there are no easy and painless solutions. I'm still reluctant to call national crisis a crisis of the currency.

I'd make the claim that option 4, introduction of a new currency and devaluation is a practical impossibility. In addition I'd say it would not generate any new economic nor any new political breathing room.

The above might be seen as bold claims that are not being backed up, however, properly backing them up might require more space than could/should be given to anonymous posters.

What I can say briefly is:
I've not read a detailed plan for how introducing a new currency can be done in situations like the one we have now, if there is such a plan I'd be happy to read it.
One effect of devaluation is to make imports more expensive. I've not seen any studies explaining how countries that import a lot of energy, medicine etc and having a trade deficit could generate more economic breathing room for those countries by making those essential things more expensive.

However, maybe I misunderstood your point? If the problem is that we are having an incorrectly named crisis, euro-zone crisis, then we can easily resolve the problem of the incorrect name by naming it to reflect what it is: Banking and poor governance crisis.

jon livesey said...

One thing is clear, and that is that no solution will emerge as long as people remain so deep in denial about what's going on.

A rose is a rose, no matter what word games you play with its name. What happened in the eurozone isn't exactly a deep mystery.

You just have to look at charts of interest rates from 1990 to today to see the peripheral countries make a round trip from high interest rates to low and back to high.

In the same way, they made a round trip from high unemployment to low and back to high.

I suppose in some dream World it could be claimed there is no connection, but in the real World there is a pretty obvious one.

A country like Spain started with high interest rates and high unemployment, then the euro brought about a decade of cheap and plentiful credit. But Spain is a semi-developed economy with a poor education system, so it could not absorb that credit by creating high-tech industries, and instead it launched into a real estate building bubble, which was the only way it could used up the unemployed low-skill labour that was available. Wait long enough, and this excess housing remains empty, developers default on loans, and unemployment goes back to 25% and beyond.

When an economy is only semi-developed, a wave of cheap credit is absolutely toxic.

And then what? You are still faced with the same four choices, but if you are least honest about how the problem came about, you won't be so quick to dismiss half the choices using bogus excuses.

Instead, you will look at the solutions that have been tried so far, and ask how successful they have been. For example, how successful can an unemployment rate that has been steadily climbing since January 2008 be said to be? If forcing down wages and Government spending was going to be successful, would you now expect to see some sign of recovery after five years?

Here is an idea. Remember Sherlock Holmes - when you have eliminated the impossible, then what remains is probably the answer.

Another hint. Common currencies have broken up before, and the difficulty of returning to national currencies was very low.

christina speight said...

Mervyn King omits the fifth option - unless he considers it as the ultimate end of option 4 on membership - the ending of this madcap venture. Despite all the warnings they went ahead with a framework that was bound to fail - and it did. Reducing its membership to [say] Germany, Finland and Austria night work and save 'face' but little short of that has any hope.

Vanity - not economics - is stopping our puffed-up eurocrats from understanding the stark facts - They've wrecked the eurozone and are dragging the rest of Europe down too as well as hindering world recovery.

Rik said...

You miss an important point on 4.
4 is indeed very difficult to do. Legally not possible, your banks likely go bust (and/or a bankrun) and you will be in for a large inflationshock. Just to name the 3 most important.
However it is in human nature when they get frustrated about a thing (in this case another/the present solution) they want to try something else. Which leaves basically only option 4 open as that is the one on which they can largely decide themselves.

Not that will be a solution in the sense that it solves the problem. A lot more will be required for that. The reason for austerity and bail out fatigue likely to set in (or better likley to get more until somewhere it determines the decisionmaking.
Like the CBs. They not really oversee what they are doing but are still in 'action mode' nevertheless. As action is perceived better than inaction. Of course that is non-sense, but that is how people especially in the West tick.

Rik said...

Do you really think that any Greek government in case of an exit would have been able to make the other necessary changes. Btw for a situation that in countries that do that create roughly for the first 2 years a much worse situation than the kicking the can scenario does now in Greece.
I fully agree that if you have to do it anyway do it asap. But Greece and all other PIIGS CS (plus France and Belgium) simply appear not to have the stomach for that. They first need a real crisis. Which is simply a when and not an if.

Greece has no choice on a free market than to apply English law. No normal foreign or even local investor will lend them money otherwise. Nobody does business with a totally unreliable party that can change the rulkes as well.
Simply the EU lost out of sight. They make the rules under the assumption that they set the conditions for future borrowing. They were wrong. For Greece there will be no other option than English law and for alot of the rest it is English law or a higher yield.

Anonymous said...

So, we have an unashamedly Eurofascist gang -- Open Europe -- citing am openly criminal central bankster as an argument for "Europe's" economic salvation.


Doesn't inspire much trust among the neutrals, does it?

jon livesey said...

Here is how you re-introduce a national currency.

The Government announces that to save euros for essential purposes - ie trade - it will pay domestic wages and salaries in a new IOU.

Gresham's law ensures the people spend the IOUs and hoard whatever euros they have.

Businesses are reluctant at first but they eventually start accepting IOUs because they can spend them on domestic goods.

After a few months you announce that taxes can be paid in IOUs and you gradually replace whatever IOU certificates you issued with properly printed Banknotes.

Of course, the new currency will devalue, and there will be capital flight, but that's a consequence of where we are. The alternative is how many years of 27% unemployment?

Rollo said...

Yes, only 2 solutions: total colonisation of the weaker states; or freedom out of the Euro and out of the EU. Which one would we choose, given politicians that care more for our country than for their careers?

Jesper said...

@Jon Livesey,

I'd agree with most of what you say on how to introduce a new currency except for:

-I believe that the IOU (beginning of new currency) has to be accepted as payment of taxes from day one

As is today, the invoices issued to the government can be sold or used as collateral for loans and thereby converted to cash easing cashflow problems. No need for a new currency for that. The cost/price of raising cash on invoices now might give an indication how much a new currency would be worth.
However, even that valuation might be too high as the full value wouldn't be realised until taxes are paid. Countries with low taxes and where tax-evasion isn't uncommon will get a currency that is worth even less.

The major obstacle in introducing a new currency might in some cases be that the ones who are responsible for introducing the new currency will after its introduction be rewarded by getting paid in a devalued currency. In other words, the goal of the organisation will be the complete opposite of the goal of the people employed in the organisation. Opposing goals usually ends up in very little progress anywhere.

I doubt that any of the countries currently in trouble can overcome that particular obstacle.

The currency isn't causing unemployment, poor governance is causing unemployment.