Readers Question: What policies could Germany / the EU use to help save the Euro?

The Euro has many problems. The most obvious outer problem is rising bond yields and the threat of sovereign debt default. Related to sovereign debt default is a banking default, e.g. from Spanish banks which would cause knock-on effects. But, the problems of the Euro are deeper than just the issue of bond yields and debt default.

So far the current policy involves:

1. Asking countries in trouble to pursue austerity and cut government spending – hoping that reducing budget deficits will restore stability to the bond market and avoid the need for further bailouts.
2. Providing temporary loans to help governments meet the shortfall. e.g. the Spanish government are being given bailout funds so the Spanish government can bailout the Spanish banks.
3. Structural reform and internal devaluation to help improve competitiveness in peripheral Eurozone countries

The impact of these policies have not been successful.

1. Bond yields have continue to rise. Governments, such as Italy and Spain are still at risk of default.
2. Austerity measures combined with overvalued exchange rates are pushing economies further into recession, which has harmed prospects of reducing debt to GDP.
3. Internal devaluation risks taking too long to restore competitiveness

To Save The Euro, some or all of the following are needed.

1. Joint liability of European debt. Eurobonds where debt is pooled.
2. Direct recapitalisation of European banks
3. Printing Money to buy bonds and provide liquidity for governments facing a liquidity crisis.
4. Economic growth to give countries a chance to improve tax revenues and reduce debt / GDP ratios
5. Restoring competitiveness amongst peripheral Eurozone countries who are struggling in the fixed exchange rate of the Euro.
6. Structural reform / supply side policies which improves tax collection and improves productivity and competitiveness.

Policies to Save the Euro

Public Sector debt as % of GDP

EU Debt 2007-2010

Source: EU Stat

1. Appreciate nature of crisis. Firstly, there needs to be an appreciation that the Euro-crisis is more than just profligate spending in southern Europe,  In 2007, both Spain (35% of GDP) and Ireland (22% of GDP) both had lower public sector debt than Germany (63%). Government debt is a consequence of the crisis not the cause. At the moment, German finance ministers seem to suggest that if only southern Europe cut government spending all problems will be solved. But,  the main problems in Eurozone are:

• Divergence in competitiveness causing a two speed Europe
• Stagnant economic growth and high unemployment (European recession) Rising bond yields are partly a reflection of poor prospects for nominal GDP growth.

2. Pursue Economic Growth. Germany and the ECB need a general policy to attempt to reduce debt through growth, rather than reduce spending – even if it causes recession. The ECB should be given a dual target – not just low inflation, but also maintain economic growth and avoid a negative output gap. We need to end the deflationary bias which exists in the Eurozone.

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Readers Question: Does Germany Benefit from the Euro or does it lose out from the Euro because of the cost of bailing out weaker southern European countries?

It is a difficult question to answer, but Germany has gained many advantages from membership of the Euro. There are also many costs involved.

Firstly, you could look at the traditional benefits of the Euro (lower transaction costs, greater certainty over exchange rates). But, these seem relatively minor compared to bigger issues which have emerged.

Benefits to Germany of Euro

Very Competitive Exports. A key issue of Euro membership is that German exports are more competitive than if Germany had its own currency. Germany has seen the strongest productivity growth in the Eurozone area. Germany has been successful at increasing output and keeping wage costs low. If Germany still had the D-Mark, this increased productivity and low inflation would cause an appreciation in the D-Mark. But, with Euro membership, Germany hasn’t seen this appreciation against other European economies. Also, to non-EU countries the Euro is weaker than the D-Mark would be. The consequence is that the German export sector has done well because of improved competitiveness. This competitiveness is reflected in a large current account surplus.

Germany has a large current account surplus nearly 6% of GDP – matched by a corresponding current account deficit in southern Europe.

Germany has seen a current account surplus since 2001

Without membership of the Euro, Germany would have more expensive exports, higher unemployment and lower economic growth. This is the nature of a single currency – some will be ‘winners’ some will be ‘losers’.

From one economic perspective, the Euro may be better off without the strength of the German economy. (why Germany should leave the Euro) It is something of a paradox that German economic success (improved productivity, lower wage costs) can create problems. But, within the structure of the Eurozone, one country’s current account surplus, is another current account deficit.

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Readers Question: What do you think about Argentina’s economical future, with the current presidents politics and ~v22% inflation, taken in mind?

Argentina performed relatively well since crisis of 2002 (see: Argentina Recovery and Crisis). Leaving their exchange rate peg enabled some re balancing in the economy and helped to boost exports. Importantly, it left the Argentina economy with greater autonomy. However, although devaluation and expansionary policies can provide a temporary boost to the economy, this is not a panacea and there is a danger the Argentinian economy could experience increasing difficulties.

1. Misleading Economic Statistics.

According to the economist, the government statistic body is under-estimating inflation.

PriceStats, a specialist provider of inflation rates which produces figures for 19 countries that are published by State Street, a financial services firm, puts the annual rate at 24.4% and cumulative inflation since the beginning of 2007 at 137%. INDEC says that the current rate is only 9.7%, and that prices have gone up a mere 44% over that period.

Misleading economic statistics will be a factor that discourages foreign investment because there will be a lack of trust. The fact economists can be censored for publishing inflation figures only cements this damaging reputation.

2. Inflationary Growth Unsustainable.

I have written a lot about the need for Europe to promote expansionary policies in the middle of a recession. But, the situation in Argentina is different. Nominal GDP is growing quickly, (if we believe GDP statistics) and inflation is a persistent problem. People increasingly fear a higher rate of inflation in Argentina. This is because:

• Government willing to print money
• Expansionary Fiscal policy. The government have increased spending with no obvious plan to meet deficit shortfall. Recently, government funded higher spending through using pension fund in social security.

Roberto Lavagna — the former economy minister under Nestor Kirchner who is credited with resurrecting Argentina’s economy after the country’s 2001 default on its foreign debts — estimates that government subsidies for transportation and energy soared from U.S. $1.2 billion at the end of 2005 to U.S. $19 billion last year. (link)

Argentina National Debt

Argentina have a history of debt default. The 2001 default was largest sovereign debt default on record £80bn Official statistics show national debt of only 48% of GDP. However, S&P give Argentina a credit rating of B. There is danger of higher borrowing reducing credit rating and leading to future debt defaults. There are still disputes over the default from 2001 (Economist link)

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Readers Question: With talk of a Greek exit from the Euro, the situation is almost always compared to Argentina in the 1980s and 90s. Can you explain what happened there and how it was resolved.

In the 1980s, Argentina built up substantial debt and also suffered from periods of very high inflation. To stabilise inflation, Argentina set a peg of the Argentina Peso against the dollar – the peg was one Peso to one dollar (this was enshrined in law).

The aim of this fixed exchange rate was to give people greater confidence in the Argentinian currency after periods of inflation.

• The fixed exchange rate meant that inflation was stabilised and encouraged capital flows into Argentina. These capital flows led to a rise in wages and living standards
• It also made imports cheaper, so the value of imports increased,
• Exports became less competitive, leading to lower demand for exports.
• This fall in exports and rise in imports lead to a current account deficit which was initially financed by these international capital flows.
• However, the over-valuation of the currency contributed to a fall in domestic demand, and from 1998, Argentina experienced fall in GDP.
• Also from 2001, international capital flows to Argentina dried up as investors were worried about the state of the global economy and the state of Argentina finances.

In particular, Argentina was adversely affected when the dollar rose against the Brazilian Real in 1999. This meant that the Argentina currency experienced a strong appreciation against its main trading partner – Brazil. This appreciation led to rapid fall in exports.

This appreciation in the Argentina currency was a key factor in pushing Argentina economy into a deep recession. Domestic demand fell. Unemployment rose to a socially crippling level of over 15%.

Government Debt

During 1999-2002, the Argentina government debt became unmanageable. This was because:

• Legacy of debt from 1980s
• Poor tax collection and corruption
• Rise in government spending
• Fall in tax revenues from recession.

International investors lost confidence in Argentinian bonds and interest rates rose to over 30%. Argentina relied on loans from the IMF to meet its shortfall.

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