Lessons from the Eurozone Crisis

It is increasingly likely that the Eurozone could become the Humpty Dumpty of currency unions. If so, this is a tragedy foretold by many observers. Martin Feldstein, for example, argued back in the late 1990s that there were too many cultural, institutional, and economic differences in the EU nations for a single currency to work. He even claimed that the currency union could lead to more conflict instead of reducing it as many Euro supporters claimed it would do. His skepticism of the Eurozone was shared by many others, particularly American economists, who saw a one-size-fits all monetary policy as destabilizing to the regional economies in the EU. For all these naysayers, though, there were supporters who argued that political gains will trump any economic costs in the monetary union and that over time many, if not most, of these costs would disappear as the regional EU economies converged. Well so much for the Euro optimists. Many folks are now saying that at a minimum there needs to be a "shock and awe" bailout package as high as $1 trillion to keep Eurozone intact. Yikes.

Given the real possibility of the Eurozone ceasing to exist in its current form, it is worth taking stock of important lessons from this experience. Here are what I see as the four big lessons of the Eurozone crisis:

(1) The optimal currency area (OCA) criteria should be taken seriously ex-ante. Before any country joins a currency union it should make sure it has met some combination of the OCA criteria. These criteria tells us that members of currency union should (1) share similar business cycles or (2) have in place some combination of economic shock absorbers including flexible wages and prices, factor mobility, fiscal transfers, and diversified economies. In the former case, similar business cycles among the regions mean that a common monetary policy, which targets the aggregate business cycle, will be stabilizing for all regions. In the latter case, dissimilar business cycles among the regions make a common monetary policy destabilizing—it will be either too stimulative or too tight—for regions unless they have in place some of the economic shock absorbers. In short, if a region's economy is not in sync with the currency union's business cycle and the above listed shock absorbers are absent then it does not makes sense for a country to be a part of the currency union. Instead, the country should keep its own currency which itself will act as a shock absorber. This understanding can be graphically represented as follows (click to enlarge):
As shown in this recent post of mine and by others, several of the Eurozone countries fell inside the OCA boundary, Greece being one of them. This is not a surprise to most folks including the Euro optimists, but many hoped that these criteria would be met ex-post as the economies integrated. This leads to the second lesson.

(2) Don't hang your hope on becoming a successful currency union by meeting the OCA criteria ex-post. Some observers argued around the time of the Eurozone's inception that looking at the OCA criteria ex-ante was not warranted since the criteria themselves would emerge once a currency union was formed. This "endogenous" view of the OCA gave hope to the Euro optimists and lent support to their cause. Now there is evidence that joining a currency union does stimulate trade as transactions costs are lowered. One study found currency unions more than tripled trade among members. It is apparent now, though, that some of the Eurozone periphery did not integrate enough to justify the cost of being a member in the currency union. It is best not to base the survival of a currency union on hope.

As an aside, it is worth nothing that even if a region does endogenously meet the OCA criteria further problems can arise from being a part of the currency union. The increased trade flows and economic activity within the currency union can over time lead to regional specialization that makes the regions more susceptible to economic shocks. Paul Krugman first made this point in 1998 and the idea has become known as the "Krugman Specialization Hypothesis" (KSH). I think the best example of KSH is the United States. Despite being a currency union for many years, the United States did not become an OCA until the 1930s according to Hugh Rockoff. One reason is because there was so much regional specialization and until the New Deal reforms, many of the economic shock absorbers necessary to offset the lack of regional economic diversification were simply missing. So even if the Eurozone were a functioning OCA there is no guarantee it would stay that way.

(3) Take the real exchange rate seriously. A summary measure of a country's external competitiveness is its real exchange rate. If a country's real exchange rate is appreciating then its goods are becoming more expensive to the rest of the world. And, as a result, it will begin losing foreign earnings and the ability to meet external obligations. In a time of crisis for a country dependent on foreign funding this problem becomes more pronounced. As seen in the next figure, most of the Eurozone periphery has had a real appreciation on average since the inception of the Euro!

Now to understand why the periphery has had the real appreciation, one has to look at the three components of the real exchange rate: domestic prices, foreign prices, and the exchange rate. For Greece the problem was twofold. First, because of wage pressures domestic prices rose, more so than in the core Eurozone countries. Second, given its membership in the Eurozone, Greece had a fixed exchange rate and, thus, no chance for its currency to depreciate. To get out of this bind Greece can either have painful deflation or end its use of the Euro. Given where Greece is now, leaving the Euro may seem like lesser of two evils for Greek leaders. (Just to be clear, a depreciation will not solve Greece structural problems, but it make it easier to address them.) Any country joining a currency union should consider the implications of membership on its real exchange rate.

(4.) The central bank contributes most to macroeconomic stability by stabilizing aggregate demand (i.e. total cash spending). I have made this point before for the United States, but it applies just as well to the Eurozone. And based on the following figure, the European Central Bank (ECB) has not done a very good stabilizing total cash spending during this crisis:

As Nick Rowe notes, the sharp decline in the Eurozone's aggregate demand was avoidable had the ECB really tried to stabilize it. Instead, the ECB mistakenly looked to low short-term interest rates as an indicator of loose monetary policy and became convinced it was doing enough. A better indicator of the stance of monetary policy I have discussed before is to look at the growth rate of aggregate demand relative to the policy interest rate. Using this metric, the ECB policy rate should not deviate too far from the aggregate demand growth rate otherwise monetary policy is either too loose (the policy rate is significantly below the total spending growth rate) or too tight (the policy rate is significantly above the total spending growth rate). This next figure shows this measure for the Eurozone:

According to this measure, monetary policy in the Eurozone has been rather tight over the last year. The Eurozone's future would have been more secure had the ECB been more vigilant in stabilizing aggregate demand.

So what lessons do you see from the Eurozone crisis?

Eurozone Crisis Roundup

Here are some good articles on the Eurozone Crisis. :

The Three Stages of the Eurozone Crisis--Rebecca Wilder:

On to the Germans. What they are doing is actually quite striking: offering a bailout in order to appease markets so that international investors will pick up the Greek bill (never was going to happen anyway); and then telling markets that bond investors in Europe will take a haircut so that international investors won't pick up the Greek bill. I guess the light-bulb finally went off that there is a contagion brewing here because bunds are tight, while all Peripheries are wide...We’re in crisis mode – the calm before the storm. I see the Eurozone disaster happening in three waves:

The Holy Roman Eurozone--Nick Rowe:

It's not just Greece; I now think the Eurozone has gone. Not gone completely; it will live on in some form, just like the Holy Roman Empire, a shadow of the original, comprising maybe Germany, France, and Benelux.

Roubini on Greece and Spain--Felix Salmon:

Nouriel’s base case, then, is Argentina 2001: after all, Greece has a much higher debt-to-GDP ratio, much higher deficit-to-GDP ratio, and much higher current-account deficit than Argentina had back then. And if that’s the base case, there’s no way that Greek debt should be trading anywhere near its current levels.

Of course, this being Nouriel, it goes downhill from there: if Greece is worse than Argentina, he says, then Spain is worse than Greece. Its housing bubble and bust has left the banking sector much weaker than Greece’s; its unemployment situation, especially with the under-30 crowd, is much worse than Greece’s; and the cost of any Spain bailout would be so much more enormous than the cost of a Greek bailout as to be almost unthinkable. The only thing that Spain has going for it is that it isn’t quite at the edge of the abyss yet; if it gets its political act together and implements tough fiscal and structural reforms now, it can save itself. But clearly no one saw that happening, given Spain’s political history over the past 20 years.

There’s no good news here. The least bad course of action for Greece, in Nouriel’s eyes, is some kind of coercive yet orderly debt restructuring, which keeps the face value of the debt unchanged but which reduces coupons and pushes out maturities. And an exit from the euro. Alternatively, the ECB steps in and cuts interest rates so low that the euro gets pushed down towards parity with the dollar, which would accomplish something similar without nearly as much pain.

As Debt Fears Grow, Finance Ministers to Meet in Europe--Jack Ewing:

[I]t is becoming apparent that the international community may need to come up with a much larger sum to backstop not just Greece, but also Portugal and Spain.

“The number would be huge,” said Piero Ghezzi, an economist at Barclays Capital. “Ninety billion euros for Greece, 40 billion for Portugal and 350 billion for Spain — now we are talking real money.” Mr. Rogoff says that the I.M.F. could commit as much as $200 billion to aid Greece, Portugal and Spain, but acknowledges that sum alone would not be enough. In fact, analysts at Goldman Sachs suggest that Greece will need 150 billion euros over a three-year period.

What a growing number of investors suggest is really needed is a “shock and awe” figure, enough to convince the markets that peripheral European economies will not be left to fail.

Quote of the Day

Here is Nouriel Roubini via Felix Salmon:

[I]n a few days... there might not be a eurozone for us to discuss.

It is good to see that Dr. Doom is alive and well.

Questions about Aggregate Demand

Both Pete Boettke and Scott Sumner have mulling over the idea of changes to aggregate demand. As a result, both have asked good questions on this issue. First, Pete poses the following question:

What precisely is aggregate demand failure and how would you know if you saw it?

There were a large number of responses to his question in the comment section of his blog and of those I like best what Bill Woolsey had to say:

Deficient aggregate demand--aggregate demand less than productive capacity = excess demand for money--a quantity of money less than the demand to hold money = a market interest rate greater than the natural interest rate--saving greater than investment.

How do you know that aggregate demand is deficient? If cash expenditures have fallen below their trend growth path, and the levels of prices and wages have not fallen in proportion, then the presumption should be that aggregate demand is too low, that there is an excess demand for money, and that the market interest rate is above the natural interest rate.

Never, never, never look at market interest rates and the quantity of money and compare them with historically "normal" levels.

So does the data show any of the characteristics Bill outlines above? The answer is yes, as can be seen here and here. Next, Scott Sumner is wondering whether there is a better way to describe changes in aggregate demand:

I’ve constantly complained that there is no word in the English language for nominal shocks, i.e. unexpected increases and decreases in NGDP... So we need terms for changes in M*V, which is the sort of nominal variable the Fed should be trying to stabilize.

Here is my reply to Sumner in his comment section:

Awhile back we talked about reframing the nominal income targeting approach by saying the Fed should stabilize total cash spending. That is so intuitive and should be understood by most folks.

Consequently, in terms of what is a nominal spending shock we can simply say “There has been a sudden collapse in total cash spending” for a negative AD. Alternatively, we can say “Total cash spending is increasing at an unsustainable pace” for a positive AD shock.

Of course there is always Leland Yeager's take on this issue.

Where is the U.S. Currency?

About $450 billion or two-thirds of all U.S. currency notes are held outside the United States according to a 2006 U.S. Treasury report. This effectively amounts to an interest-free loan for the United States as it has simply exchanged at some point in the past ink-stained paper for $450 billion worth of goods and services. To boot, the purchasing power of the dollars has eroded making the eventual repayment of these interest-free loans even easier. Of course, if the dollars are never returned to the United States then it is an even better deal for the United States. This is just one of the perks to having the main reserve currency of the world.

So which countries in the world have been so generous to the United States? Here is a table from the Treasury report that accounts by country for about $250 billion of the total U.S. currency notes held abroad (click on figure to enlarge):


Unsurprisingly, most of the currency is being held by emerging and developing economies. Presumably all of these countries at some point in the past had some form of monetary instability and, as a result, their residents are now demanding a relatively safe alternative form of money, the dollar. So what denominations are these folks holding? Linda Goldberg has put together a nice chart that answers this question:

It is interesting to see the increasing demand for $100 bills and the decreasing demand for $50 and $20 bills. Maybe the dollars are being held more as a store of value than a medium of exchange and, thus, the larger bills are more in demand.

Interest Payment on Excess Reserves Smackdown

Thomas Palley provides a critique of the Fed's policy of paying interest on excess reserves:

The Federal Reserve has recently activated its newly acquired powers to pay interest on reserves of depository institutions. The Fed maintains its new policy increases economic efficiency and intends it to play a lead role in the exit from quantitative easing. This paper argues it is a bad policy that (1) has a deflationary bias; (2) is costly to taxpayers and that cost will increase as normal conditions return; and (3) establishes institutional lock-in that obstructs desirable changes to regulatory policy. The paper recommends repealing the Fed’s power to pay interest on bank reserves. Second, the Fed should repeal regulation Q that prohibits payment of interest on demand deposits. Third, the Fed should immediately implement an alternative system of asset based reserve requirements (liquidity ratios) that will improve monetary control and can help exit quantitative easing at no cost to the public purse. Now is the optimal time for this change. Lastly, the paper argues the new policy of paying interest on reserves reveals the troubling political economy governing the actions of the Federal Reserve and policy recommendations of the economics profession.

Read the rest here.

More Dependent Than Ever

Paul Krugman recently claimed we should not be concerned about whether China will continue to finance U.S. budget deficits since they are being funded by U.S. private savings:

The US private sector has gone from being a huge net borrower to being a net lender; meanwhile, government borrowing has surged, but not enough to offset the private plunge. As a nation, our dependence on foreign loans is way down; the surging deficit is, in effect, being domestically financed.

When I read this claim back in March my reaction was that it makes sense but I also wondered if it were supported by the data. The evidence Krugman showed at the time was that private sector borrowing had declined and was being offset by increased public sector borrowing. While this evidence was consistent with his view, it did not directly show the actual saving rate from each sector or the national saving rate. Consequently, I had some lingering doubts as to whether the U.S. budget deficit was being entirely financed by increased U.S. private savings.

Yesterday I had the chance to reexamine this question while I was putting together some graphs on U.S. saving rates for my class. Below is one of the graphs I created. It shows the net saving rates for the private sector (households and firms) and the public sector (state and local government and federal government) and is based off of data from the BEA's National Income and Product Account Table 5.1. (Click on figure to enlarge.)

Consistent with Krugman's claims, the figure does show that the private sector saving rate has increased with most of the gains coming from households. However, the figure also indicates the public sector dissaving is far larger than the saving gains in the private sector. If we sum up the sectors we get the net national saving rate which is graphed below over a longer period:

Here we see the net U.S. net saving rate is negative in 2009 with an average rate of about -2.5%. This net saving shortfall amounts to about $356 billion dollars that had to be financed by foreigners last year. Now to be fair to Krugman, the figures above show U.S. net savings which is equal to U.S. gross savings minus savings allocated to maintaining the existing U.S. capital stock. If one looks at U.S. gross savings in 2009 it is positive. This means the actual budget deficit was financed domestically. Note, however, that the $356 billion dollar shortfall in net savings means the U.S. economy is currently not saving enough to replace its existing capital stock let alone create new capital. The last time that happened was in early 1930s. Luckily for us, though, foreigners are still willing to invest in the United States and make up the difference. So while Krugman is correct that the concerns about China threatening not to finance our budget deficit are misplaced, it also true that the U.S. economy is now more than ever dependent on China to maintain and grow its capital stock.

P.S. Here is the net saving rate per year going back to 1929. The source, again, is Table 5.1 from the BEA:

An Insightful Talk at an Important Conference

William White, former chief economist of BIS and one of the few who foresaw and warned policymakers on the economic crisis, explains the causes of the economic crisis in a talk he is to give at an upcoming conference (hat tip Mark Thoma):

While private sector behavior (“procyclicality”) played a crucial role in this event, central banks also contributed heavily. It is likely not a coincidence that the expansion phase of the last credit cycle began with policy rates at their lowest in the major industrial countries. As well, with increases in policy rates carefully signaled, there was an open invitation to take on more leverage in response to declining carry margins as policy rates rose. Further, in emerging market countries, upward pressure on their exchange rates was fiercely resisted through both FX intervention and easier monetary policy. In this way, the problem of excess “liquidity” became truly global. Finally, it is not farfetched to suggest that many of the developments that made this crisis “different” were also encouraged by low policy rates. These led to more risk taking in ”the search for yield”, as well as efforts (off balance vehicles and new instruments) to disguise these risks. Unfortunately, disguised risk is not the same as reduced risks, as eventually became apparent.

I would summarize his three points above as follows: (1) central banks in advanced economies kept interest rates far below their neutral level which created a credit boom, (2) this excessive monetary easing in the advanced economies spread to the emerging market economies through their exchange rate policies (e.g. the dollar bloc countries imported the loose U.S. monetary policy), and (3) the low rates in the advanced economies created further distortions via the risk taking channel. All of these developments were compounded by the procyclicality of the financial system. I couldn't agree more.

White goes own to discuss the need for a new analytical framework, one the incorporates the best of Keynesian, Austrian, and Minskyian insights. This is a point he made earlier in an IMF paper. This looks to be an interesting conference with many important thought leaders participating.

Employment Change Per Industry

With today's employment report showing a gain of 162,000 jobs for March, I thought it would be useful to break these jobs gains down by industry sector. The table below does so and also shows the cumulative change in jobs over the previous three months as well as the December 2007 - December 2009 period. (Click on table to enlarge.)


A couple of things to note. First, it is interesting that the 162,000 jobs gained in March is equal to the total number of jobs gained during the past three months of January, February, and March. Second, it is encouraging to see the four industries hit hardest during the recession--construction, durable goods manufacturing, professional & business services, and retail trade--had jobs gains in March and all but one of them have had job gains over the past three months as well. Third, the financial activities sector (i.e. FIRE in NFP) continues to lose jobs and has done so over the past three months.

For a broader perspective I have graphed below the cumulative percent change in employment since December 2007 per industry sector. (Click to enlarge figures.)

Recommended Readings

• Breaking Up Banks--Bill Woolsey
• Why Texas Avoided Much of the Real Estate Meltdown--Alyssa Katz
• Do Bond Vigilantes Fear a Growing Economy?--Andrew Leonard
• Treasuy Yield Curve Spread and the Zero Bound--Paul Krugman
• The Dollar Still Dominates--Linda Goldberg