Stefan Karlsson
A machine counts Euro bank notes in a counter of a bank in Dresden, Germany. Despite the burdens of the unified currency, Germany is unlikely to leave the euro. (Matthias Rietschel/AP/File)
What if Germany exited the euro area?
A Swedish reader asked with regard to my post on the practical difficulties surrounding Greece or some other country with high deficits leaving the euro area for the purpose of competitive devaluation/depreciation, about a hypothetical scenario I didn't discuss, namely if Germany instead exited the euro area so that Greece and the others could lower the value of their currency without exiting the euro area.
I was well aware of this idea, as Ambrose Evans-Pritchard recently advocated it. I didn't address it because for one thing I thought that the post was on the verge of becoming too long, and because it is completely unrealistic, in many ways even more so than the scenario of the weak countries leaving.
First of all, the practical difficulties would be virtually as large. Assuming German deposits and bonds would be converted into New Marks, then this too would create a run against the financial systems in the rest of Europe. Why would anyone want to hold accounts or bonds in the rest of Europe if they're practically guaranteed high returns (the whole purpose if this operation is to raise the value of German currency) if they hold German accounts or bonds?
This problem could be eliminated if German accounts and bonds remained denominated in euros even after the introduction of a "New Mark" (or whatever the new currency would be called). But that would create other disruptions. Just as domestic currency depreciation is bad for borrowers with foreign currency debts, domestic currency appreciation is bad for creditors with foreign currency debts. German savers and banks would suddenly lose much of their assets as they drop in value along with the euro. And this wouldn't be limited to just assets in Germany, their holdings elsewhere in Europe would also lose value.
The effect for German savers and banks would be a partial default on all of their fixed income assets, creating much more trouble for them than if Greece or some other state had a partial default.
The second big problem is that there is absolutely no reason why Germany would want to do so. Germany is not under any market pressure, quite to the contrary as their bonds have gained "safe haven" status within the euro area. While they could possibly maintain such a status, some of the safety for other euro area residents consists in the lack of exchange rate risk, something which would go lost if Germany had a separate currency. And with an independent currency, "safe haven" status will mean that the value of your currency will be driven up, causing disruptions and problems for your exporters. This could partly be compensated in the short term by the reduced debt burden for the German government, but because the value of the safe haven status would be significantly reduced, and because of the losses for German investors in other parts of the euro area, this gain will be much smaller than the losses for German investors.
Furthermore, this scheme would greatly damage the German export industry, both because of lost exchange rate stability and because of the higher value, causing great job losses in Germany. The 43% of German exports goes to and 46% of German imports comes from the rest of the euro area (with a few more percentage points being with Denmark and others with fixed exchange rates to the euro)would suffer the most, but as the "New Mark" would probably appreciate against other currencies as well (though probably by less than against the euro as the euro would presumably depreciate), exports to other parts of the world would also decline.
Why should Germany even consider such a scheme given the damage it would inflict on both its financial sector and its foreign trade? There is no way Germans would want to make such large sacrifices just because it would allegedly help foreigners with fiscally irresponsible governments.
Some might say that they would do so because they don't want to bail out these other governments. But that doesn't hold. First, because the proposed scheme would itself be a form of bail-out, and a very costly one for Germany. And secondly, there is nothing in EU treaties that compels Germany to bail out the governments of other euro area countries. EU treaty in fact explicitly forbids the ECB or the EU from doing so, and any bail-out would therefore have to carried out directly by other national governments and that would be voluntary for them.
Germany is unlikely to agree to any hand-outs (as in gifts) to Greece or others. And any loans would likely come only if Germany felt it would be beneficial to them, for example if they got paid say two percentage points in premium compared to Germany's own cost of borrowing (under such a "bail-out", Germany would thus actually earn money) and were also coupled with increased external supervision and the implementation of further fiscal austerity measures.
In short, the idea that Germany would exit is even more unrealistic than Greece exiting, because it would be more obviously damaging to the country that is supposed to leave.
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A row of refrigerators were on sale this week in a home-appliance and electronics store in New York. Core inflation for the 12-month period ending in January was down. (Natalie Behring/Reuters)
Core inflation down? It's really just a blip.
Many analysts, and also Wall Street which escaped the sell-off that the Fed's discount rate increase otherwise would have caused, made a big deal out of the small drop in so-called "core inflation" in America in January. However, that was likely a blip caused by temporary factors.
Compared to 12 months earlier, "core inflation" was 1.6%, compared to 1.7% in January 2009.
However, what few have noticed is that this is entirely the result of a big drop in the rate of increase in rents and "owner's equivalent rents". Indeed, excluding this factor, "core inflation" has risen significantly.
Rents are about 7.5% of the "core" index, while "equivalent rent" is 32.5%. In the year to January 2009, rents increased 3.4% and "equivalent rents" increased 2.2%. In the year to January 2010, these increases had dropped to 0.5% and 0.4% respectively. Excluding these factors, "core inflation" was 1.2% in the year to January 2009 and 2.35% in the year to January 2010.
One example of this was apparel prices, which decreased 0.9% in the year to January 2009 but increased 1.7% in the year to January 2010.
Now, I really don't believe in the "core inflation" concept, so I wouldn't make much of this increase in what one might call "core core inflation". I do however consider the increase in all-items inflation from 0.0% in January 2009 to 2.6% in January 2010 to be of interest. The point is instead that particularly given how rents and "equivalent rent" is affected by relative preference for owned housing relative to rented housing and given how they have such a big influence on the "core" index, one shouldn't make much of the movements in "core inflation".
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The US dollar is rising once again. (Jake Turcotte / The Christian Science Monitor)
US dollar strength will reduce US corporate profits
During much of the stock market rally, one factor driving the rally was the weak U.S. dollar, which was likely to boost corporate profits both by increasing margins or competitiveness of U.S. exporters and by increasing the dollar value of the profits of foreign subsidiaries of U.S. companies (while higher import costs for U.S. companies would partly offset this, the net aggregate effect was clearly positive).
Now that the U.S. dollar has again started to rally this will negatively affect corporate profits. As the rally has been particularly strong against the euro (+12% from the November lows) and the pound (+9%) and as euro area and the U.K. aren't among the biggest trade partners, but do have large domestic markets where subsidiaries of U.S. multinationals earn much of their profits, the negative effect will mainly come in the form of reductions in the dollar value of the profits of foreign subsidiaries.
The markets haven't appeared to notice this yet, but ultimately they will as profits falls as a result.
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Federal Reserve Chairman Ben Bernanke (shown here awaiting to testify last year at a Senate committee hearing) raised the central bank's discount rate Feb. 18. (Jason Reed/Reuters/File)
What does the Fed's discount rate increase mean?
So the Fed unexpectedly decided to raise the discount rate. What implications will this have?
The direct effect is neglible. The discount window is used so rarely that a discount rate increase won't have any effect on real world interest rates worth mentioning.
However, as the market reaction illustrates, this increase will have the indirect effect of increasing expectations that the Fed will increase the rates that really matter – the Fed funds rate and the interest that the Fed pays on bank reserves – sooner rather than later.
While the Fed claims that this is meant to normalize the spread between the funds rate and the discount rate, and that they intend to keep the funds rate low for an extended period, and while this may actually be true, many people will nevertheless interpret this as a signal that the more important rates will be raised sooner than people earlier thought, something which will increase bond yields, and thus have a tightening/deflationary effect. The effect will however probably only be very small.
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A Spanish flag flutters near the dome of the Bank of Spain in central Madrid Feb. 15. While hit hard by unemployment, Spain is seeing rising productivity. (Sergio Perez/Reuters)
The Spanish reversal
Contrary to what you may believe when reading Paul Krugman and many others on Spain, Spain has actually had a relatively moderate drop in output during the latest crisis. Of the four other major Western European economies, only one (France) has had a smaller drop in output, while the other three (Germany, Italy, the U.K.) have had bigger drops in output.
While the drop in domestic demand has been bigger than elsewhere, this has been largely compensated for by a big drop in the Spanish trade deficit.
Yet if you look at unemployment, Spain has fared worse than other Western European countries, much worse in most cases in fact. It has the highest unemployment rate in Western Europe and has also seen the biggest increase (in percentage points).
How can this discrepancy be explained? While it is possible that there might be some statistical error (with either the Spanish drop in output being underestimated or the Spanish drop in employment being overestimated, or both), the main cause is that productivity has increased faster than elsewhere.
But haven't we often been told that Spain has a problem with productivity? Yes, we have, and while that was true in the past, it hasn't been true recently.
If you look at the more detailed national account numbers released today, you can see that nominal GDP has dropped 2.8% (nominal domestic demand is down 7.6%, the difference being of course the result of a big drop in the trade deficit) in the latest 2 years, while the domestic demand price deflator is down 1.5%, implying a cumulative 1.3% drop in the real value of output.
Yet employment has dropped as much as 9.1% in two years, with the job losses being particularly dramatic in the construction sector, where employment has dropped as much as 34.5%.
This implies a productivity increase of more than 8% in 2 years. Meanwhile, compensation per employee increased more than 10% in real terms, the difference being accounted for by stagnating profits and a sharp drop in net taxes on production and imports. So, while employment has dropped dramatically in Spain, average real wages for those that have been able to hold on to their jobs have soared.
The current story of rapid increases in productivity and rapid drops in employment contrasts with the opposite story during the boom years when employment grew rapidly, while productivity dropped.
The most likely explanation for this is that during the boom, labor supply increased rapidly due to massive immigration (and to a lesser extent an increasing number of women entering the work force). However, since the new workers had lower productivity than the male native born Spanish workers, output increased a lot less than employment.
With the bust, that hit the construction sector (where low productive foreign workers were over represented) disprortionately hard, causing unemployment to increase. While employment of native born Spanish workers dropped 5.1% in the latest year, employment of foreign workers dropped 11.75%. The unemployment rate of foreigners have now reached nearly 30% (compared with 16.8% for Spaniards). Because job prospects remained dismal in their countries of origin, few have wanted to return.
So, Spain had for years a boom with particular emphasis on low productive foreign workers in the construction sector, causing it to have higher growth in employment than in GDP, but now the current bust partially reverses this, as these low productive workers disproportionately loses their jobs, causing employment to drop more than output.
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U.K. posts first January deficit
Traditionally, the British government has a large surplus in its finances in January as January is the time when corporations make a large part of their tax payments. In January this year the surplus was only £1.2 billion, down from £10.2 billion, reflecting both a big drop (7.6%) in revenues and a big increase (9.8%) in spending. If you take the high inflation rate into account, the drop in government revenues were even greater while the increase in spending was smaller.
And it is even worse if you use the normal accounting principles for government finances. The U.K. government has the unusual principle of not counting spending it calls investments as spending, despite the fact that these "investments" do not generate any visible return for the government. If you had also included borrowing for "net investments" (which most government accounts do), then the surplus of £5.3 billion in January 2009 swung to a deficit of £4.3 billion.
For the first 10 months of the fiscal year, the official deficit rose from £36 billion to £90.7 billion, while the deficit using normal accounting methods rose from £58.4 billion to £122.4 billion.
While government revenue is partly a lagging indicator, the fact that it keeps falling is clearly a sign that the recovery is very weak at best, something that is confirmed by other indicators as well (see here and here).
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Right and wrong from Eichengreen about euro area breakup
Barry Eichengreen writes in a good way about the procedural problems associated with Greece or anyone else exiting the euro area. There have been many cases of currency areas’ breaking up in the past, but in those days capital was less mobile and/or the motive for doing so wasn't to lower the value of money.
"The insurmountable obstacle to exit is neither economic nor political, then, but procedural. Reintroducing the national currency would require essentially all contracts – including those governing wages, bank deposits, bonds, mortgages, taxes, and most everything else – to be redenominated in the domestic currency. The legislature could pass a law requiring banks, firms, households and governments to redenominate their contracts in this manner. But in a democracy this decision would have to be preceded by very extensive discussion....
...One need only recall the extensive planning that preceded the introduction of the physical euro.
Back then, however, there was little reason to expect changes in exchange rates during the run-up and hence little incentive for currency speculation. In 1998, the founding members of the euro-area agreed to lock their exchange rates at the then-prevailing levels. This effectively ruled out depressing national currencies in order to steal a competitive advantage in the interval prior to the move to full monetary union in 1999. In contrast, if a participating member state now decided to leave the euro area, no such precommitment would be possible.The very motivation for leaving would be to change the parity. And pressure from other member states would be ineffective by definition.
Market participants would be aware of this fact. Households and firms anticipating that domestic deposits would be redenominated into the lira, which would then lose value against the euro, would shift their deposits to other euro-area banks. A system-wide bank run would follow. Investors anticipating that their claims on the Italian government would be redenominated into lira would shift into claims on other euro-area governments, leading to a bond-market crisis. If the precipitating factor was parliamentary debate over abandoning the lira, it would be unlikely that the ECB would provide extensive lender-of-last-resort support. And if the government was already in a weak fiscal position, it would not be able to borrow to bail out the banks and buy back its debt. This would be the mother of all financial crises."
It could be argued that one way of getting around the massive capital flight would be to outlaw capital outflows during the discussion about exiting. But apart from the many practical problems associated with that, including the possibility of bank runs of people wanting to switch to euro notes, that would likely simply ensure that capital flight would happen during the discussion to introduce the controls.
Another way of getting around this problem would be to say that bank deposits and bonds would still denominated in euros. But that would create the problem of debt traps. If say the Greek debt burden is 105% of GDP, and a new drachma falls 30% in value, then the debt burden would immediately increase to 150% of GDP. If the drachma falls 50% the debt burden rises to 210% of GDP. It should be clear that with this solution, the debt problem of Greece wouldn't be solved. It would in fact likely get worse, just as the big devaluations of Ukraine and Iceland only worsened their debt problems. Trying to inflate your way out of debt doesn't work if the debt is denominated in a foreign currency.
While Eichengreen is basically right that the practical or procedural problems makes a euro area break up extremely unlikely (notwithstanding the wishful thinking from certain British and American pundits to the contrary), he is wrong about the economic pros and cons about an exit:
"the country would be forced to pay higher interest rates on its public debt. Those old enough to recall the high costs of servicing the Italian debt in the 1980s will appreciate that this can be a serious problem.
But for each such argument about economic costs, there is a counterargument. If reintroduction of the national currency is accompanied by labour market reform, real wages will adjust. If exit from the euro area is accompanied by the reform of fiscal institutions so that investors can look forward to smaller future deficits, there is no reason for interest rates to go up. Empirical studies show that joining the euro-area does result in a modest reduction in debt service costs; by implication, leaving would raise them. But this increase could be offset by a modest institutional reform, say, by increasing the finance minister’s fiscal powers from Portuguese to Austrian levels. Even populist politicians know that abandoning the euro will not solve all problems. They will want to combine it with structural reforms."
Assuming that the transition problems discussed earlier could somehow be solved (or assume that Greece had never entered the euro area), would exiting (or not entering) the euro area really make debt service more costly? Quite to the contrary under the current circumstances if the government issues debt in its own currency. The reason for that is that with your own central bank, you can have the central bank hold down interest rates by monetizing or threatening to monetize the debt. A comparison of Greece, which pays a real interest rate of 5% on long term securities, and the U.K which pays a real interest rate of 0.5% on its long term securities, despite the fact that the Greek and British deficits are equally large, illustrates this.
And Eichengreen is also wrong on structural reform. There is no reason at all to assume that Greek politicians would have been more willing to for example cut government spending if they could devalue and have a central bank partly monetize its debt. Quite to the contrary they would be a lot less likely to institute reforms resisted by government sector employee unions and others benefiting from the status quo. If there was little cost of borrowing more money then it would have little incentive to take the heavy political price of fighting government sector employee unions and others. It is only because of the current pressure from the bond markets that the Greek government has the political will to do so.
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Greek Party(ing) Is Over?
As part of its fiscal austerity program to reduce its large budget deficit, the Greek government plans to raise taxes on alcohol and tobacco. So not only can one say that the Greek party is over figuratively speaking, there will be less partying in Greece for its citizens. At least it will be so using alcohol and tobacco bought legally in Greece. Higher alcohol taxes have a tendency to encourage moonshining, smuggling and purchases in other countries. Because of that, this tax increase might not generate as much extra revenue as the Greek government hopes.
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Bank Of England Is Responsible For High U.K. Inflation
U.K. inflation rose again, from 2.9% to 3.5%. Together with the 3% increase we saw in January 2009, this pushed the cumulative 2 year inflation rate to 6.6%, compared with 2.1% in the euro area and -1.3% in neighboring Ireland.
The Bank of England tries to pretend that it has nothing to do with this, saying the higher inflation rate was due to the reversal of the VAT hike, higher commodity prices and the weak pound.
While the Bank of England may not have caused the VAT hike that is a bad excuse since this hike was a reversal of the previous year's reduction, and inflation stood at 3% even after that cut. The same goes with commodity prices which had fallen significantly in the year to January 2009. Moreover, the Bank of England (like all inflating central banks) is partially responsible for the increase in commodity prices.
And blaming the weak currency is of course no excuse at all, since they are responsible for that.
For the Gordon Brown government, the high U.K. inflation is good, since it means that in real terms they borrow much more cheaply than almost everyone else, including Germany, despite running a deficit as large as that of Greece relative to GDP. There's nothing like having your own printing press for deficit spending politicians.
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