Monday, March 18, 2013

Missing the Forest For the Trees: Cyprus Edition

The Cyprus bank heist has received a lot of coverage, but in most cases the analysis is missing the forest for the trees. The real problem facing Cyprus and the rest of the Eurozone periphery is more fundamental than who will be bailed out, who will be bailed in, and how it will happen. For these concerns are the result of a flawed monetary union--a currency area that does not meet the optimum currency area criteria--that if not fixed will continue to haunt the Eurozone.  Figuring out how to deal with Cyprus without addressing the flawed nature of the Eurozone is just kicking the can the down road. More radical reforms are needed. 

One reform is to alter ECB policy so that it actually tries to stabilize nominal spending for the entire Eurozone, not just Germany. Since it inception, ECB monetary policy has been biased toward Germany at the cost of destabilizing the Eurozone periphery. This could be fixed by having the ECB abandoned its flexible inflation target and adopt a NGDP level target. Another complementary reform, would be to create meaningful fiscal transfers in the Eurozone similar in scale and scope to the United States. Both of these options, however, would face stiff opposition from Germany. For the former would require temporarily higher inflation than Germany desires and the former would require large fiscal commitments for the Eurozone from Germany. Neither is likely to happen.

That leaves the final reform option: break up the Eurozone into austere and non-austere currency unions. This ideas has been suggested before by Ramesh Ponnuru and Ambrose Evans-Pritchard. Here is Pritchard:
My solution - like that of Hans-Olaf Henkel, the ex-head of Germany's industry federation (BDI) - is to split EMU into two blocs, with France leading a Latin Union that keeps the euro. This bloc would devalue but not by 60pc, yet uphold its euro debts intact. The risk of default and banking crises would decrease, not increase.

The German bloc could launch their Thaler, recapitalizing banks to cover losses from rump euro debt. Disruptions could be contained by capital controls at first. None of this is beyond the wit of man. My bet is that aggregate losses would be lower than the status quo, and the long term outcome much healthier. The EU might even carry on, unruffled.
This reform is very radical, but there really is no other viable alternative. The German response over this crisis has given us no reason to believe the other options of improving the existing Eurozone monetary and fiscal structures will ever happen. So why keep pretending otherwise? The current Eurozone approach is the equivalent of an economic whack-a-mole game that never truly solves the problem. The Cyprus crisis is just the latest mole to stick up its head.

Fortunately, Matthew C. Klein reports that there already is some movement in Germany to create two new currency blocks. This is a start. But there is a long way to go and there needs to be a greater sense of urgency. Who knows how long the whack-a-mole game can continue before it turns ugly. Martin Feldstein warned in 1997 that the EMU could lead to conflict. I hope he is wrong. 

P.S. Matthew Yglesias is one observer that does consider the larger Eurozone context behind the Cyprus crisis.  

P.P.S. Just how big are fiscal transfers in the United States? Here is one data point from Paul Krugman
[I]f Florida suffers an asymmetric adverse shock, it will receive an automatic compensating transfer from the rest of the country: it pays less into the national budget, but this has no impact on the benefits it receives, and may even increase its benefits if they come from programs like unemployment benefits, food stamps, and Medicaid that expand in the face of economic distress.
How big is this automatic transfer? Table 2 shows some indicative numbers about Florida’s financial relations with Washington in 2007, the year before the crisis, and 2010, in the depths of crisis. Florida’s tax payments to DC fell some $33 billion; meanwhile, special federally funded unemployment insurance programs contributed some $3 billion, food stamp payments rose almost $4 billion. That’s about $40 billion in de facto transfers, some 5 percent of Florida’s GDP – and that’s surely an understatement, since there were also crisis-related increases in Medicaid and even Social Security, as more people took early retirement or applied for disability payments.


  1. Until EZ adopts a federal structure that allows or provides equalization payments between states, a true Schengen Plan of trans-EZ employment mobility, a trans EZ social safety net and a trans -EZ deposit insurance plan - Europe will simple crumble.

    A two currency zone would simply become three becomes four become.... until a 17 currency zone of total devolution.

    Krugman is simply describing normal equalization payments - as in Canada or Switzerland or tehe USA or any federalist structure. Yglesias is v a very naive view of a confederate system told with great style but really telling you nothing useful, stating the obvious. A confederate state which is causing the crisis (but not Cyprus), a state that for the EZ is hopefully only transitional.

    The "thaler" idea is simplistic and shows no understanding of the purpose and reason for the EZ project in the first place. To let Germany go their own way would be a disaster, not to say simply not doable. The "thaler" would undoubtedly lead to the end of NATO and a general re-armament of Europe. War.

    Europe's only fate, but for absolutely crippling catastrophic breakdown - including Germany - is to evolve further, well past this hodge podge confederacy or then "fiscal union" and to true federal political Hamiltonian union.

    There is no other choice so as 330 million avoid ruin.

    At least Draghi is not even paying attention to such silliness as Pritchard et al; but it is still dicey to have the ECB the only validated federal EZ institution and therefore the only legitimate institution in all of the EU.

    But by following along the initial way set by Trichet, step by step, Draghi is developing and defining federal devices and policy and thereby federal authority for the ECB, leading the way to true union. Draghi is simply defining the United States of Europe template by creating federal functionality for the ECB. Amazing and historical.

    Finally Cyprus has nothing to do with the crisis in the rest of the EZ, caused by massive imbalances with the epicenter as to cause being Germany. Cyprus is a pirate den and a criminal enterprise. The ECB action and bailout are addressing an imbalance sourced from non_EZ/EU money that is being laundered or being hidden or in flight, nesting in Cyprus. The crisis kernel has nothing to do with German intra-Europe trade but has everything to do with Russia. There simply is not enough people or industry in Cyprus to reach the amount cited via imbalances with the rest of the EU.

  2. "One reform is to alter ECB policy so that it actually tries to stabilize nominal spending for the entire Eurozone, not just Germany. Since it inception, ECB monetary policy has been biased toward Germany at the cost of destabilizing the Eurozone periphery. This could be fixed by having the ECB abandoned its flexible inflation target and adopt a NGDP level target."

    Do you have a source where this is explained more in the detail?

    There is a big problem for ECB since 2008-9, because it perceives the interest rate channel as the main way to influence eurozone economy. When sovereign bond yields are diverging, ECB sees this as a problem with transmission mechanism being influenced by the crisis, and that ECBs crisis "fighting" measures are not equally signaling monetary policy to all parts of the eurozone. Even trough 2007 and 2008 ECB was mostly concerned with stabilizing the overnight rate and believed this is sufficient. It is basically the main feature of ECBs operating framework.

    Also, heres a comment I left at Mr. Nunes's post
    I read a paper a couple of years back where authors tried to compare monetary policy of ECB with the individual national banks. It was a sort of counterfactual, and they used interest rates as the indicator. The result was that ECBs monetary policy for peripheral countries was equivalent of national banks setting short term interest rates that are negative. If I remember correct, i think it was even -6% for Portugal. The rates were right for Germany, Austria and Finland if I remember correctly.

    Heres a thought,and maybe you can give me feedback. Lets say ECB adopts NGDPLT with NGDP futures. Now, according to a rule the movement of NGDP futures determine the monetary base.
    Does ECB still have to target short term interest rate to fulfill its goal?
    I still didn't have time to take a closer look into the way NGDP futures regime would work, but I guess the (short term) interest rates could be left for market to determine?
    Interest rates wouldn't necessarily need to converge in order for Eurozone to hit its targets? As I remember, Milton Friedman believed rates would stay different reflecting risks of respective countires. And that is fine - offcourse everything gets messed up when ECB lets NGDP to fall drastically. My point is that under NGDP futures targeting regime, diverging interest rates wouldn't be such a problem(?) Offcourse, probability of huge NGDP drop would be lower.

    Also, another idea is having national NGDP futures, since ECB is essentialy decentralized Eurosystem and only important thing is that there is no differentiation of rules in conduct of monetary policy across all the NCB-s and their counterparties. Another good thing would be that eurozone would have to rely less on banks in conduct of monetary policy?

    Whad do you think?

  3. This is ivory tower academic theorising - the euro is a political project, not an economic one. What is needed now is a tougher approach from the Germans, who never wanted the euro in the first place. They should get together with some like-minded northern European countries (ie excluding France) and establish a blueprint for a strong euro, and simply say to the rest, we are doing this, with or without you. The rest will wail and struggle, and then nearly all with go along, because, having experienced the failure of soft money before the euro, they all know the value of reliable money, and none of them want to be thought of as a second class nation. Optimal currency theory is nice, but not strictly necessary, in the same way as competing firms with different fortunes get along with the same currency.

    1. The Germans and other northern Europeans were indeed behind the Euro. They wanted it............badly.

      Your post reeks of ivory tower thinking.

    2. No, check out the history, eg in "the Euro", by David Marsh. EMU was a quid pro quo for German reunification. The French even went so far as to describe the Deutchmark as the German "nuclear weapon", and they wanted to share control of it. The Germans understood the dangers and tried to protect against them with measures such as Maastricht article 123 and the stability pact, but they were unable to stop the PIIGS from subverting such measures - eg Italy's oversized debt was excused, the Greeks falsified their statistics etc.

    3. By the way, I hardly think accepting hard money handed down by an independent bank and getting on with it is ivory tower thinking - that is what individuals, households and businesses do every day inside a monetary union. If the EMU countries had never had their own moneys, then they might not consider introducing national currencies as a solution to their problems now, any more than, say GM might consider devaluing against Ford.

  4. A transfer union with *significant* transfers would likely be unacceptable for German people as long as Europe is not a democracy with a one-man-one-vote principle for the European Parliament and there is no similarly significant homogenity in taxes (levels and effectiveness of actually getting the money) and social security rules. For a German, it would appear unfair, that he has to pay higher taxes and social security and gets his pension later to be able to transfer money into the periphery where laxer rules prevail. Keeping the Eurozone and changing it into a political union would therefore imply for the other member states to give up parts of their autonomy, which they do not appear to be prepared to do.

    Thus, the political union is a perfect solution which will not be seen for the time being.

    Monetary unions without a political union have shattered throughout history. It appears unlikely that it will be different this time.

    Indeed, the political priority by now should be how to manage this shattering without giving rise to so strong frustrations that they will cause a war now or over the next generation or so.

  5. "The "thaler" idea is simplistic and shows no understanding of the purpose and reason for the EZ project in the first place. To let Germany go their own way would be a disaster, not to say simply not doable. The "thaler" would undoubtedly lead to the end of NATO and a general re-armament of Europe. War."

    This post lends credence to RebelEconomist's "the euro is a political project, not an economic one" point. Although the eurozone leading to the dissolution of NATO is laughable. Also members of NATO include the U.S., Canada, the UK, and Turkey.

    If Europe wants to have a common currency, they're in about year 5 of a mess and still haven't figured out how to solve it under the confines of a common currency. Telling the Greeks you're going to be poor for the next couple generations and telling the Spanish to emigrate is not a solution, so they better get started.

    1. What ought to happen is that the banks and countries that are unable to meet their obligations should go bankrupt, and the losses be realised by those who took the risk. That would no doubt cost German banks and consequently the German taxpayer lots of money, but at least they will understand their responsibility. NGDPLT is a trick to transfer much of the financial crisis losses to the easier target of unsophisticated investors in simple nominal savings products like bank deposits. It might work once, but will saddle future debtors with paying an elevated risk premium for years.

  6. The real problem is not the "monetary union" -- it is excessive fiscal spending by the irresponsible PIIGS gov'ts, as voted for by the (gullible? misled? greedy?) voters. Usually strongly supported by a big-gov't biased media promoting "quick" and visible gov't solutions to problems that are better solved more slowly by peaceful, private methods.

    Unless irresponsible gov'ts stop excess irresponsible spending, there will be continuing crises until ... a) the PIIGS leave, or b) Germany leaves. (There is already a party in Germany calling to restore the Deutschmark, not some silly new "Thaler". Each crisis will see that party getting more votes.)

    My own suggestion is (c), all gov'ts should begin borrowing from their own people, with 1-year 0% interest Bearer Bonds. The gov't should pay all domestic salaries, benefits, and contracts, with a portion of these bonds. The gov't should also accept these bonds as tax payments, at 100% value, immediately.

    Cyprus, Greece, Spain, Italy -- even Germany, all can and should have such Bearer Bond programs to borrow from the current recipients of gov't spending. Those who benefit most directly should have their benefits cut first.

  7. We, the citizens, refuse to allocate our own funds in any form to bailout the gambling debts incurred through the financial speculation of investment banks.

    Sign :

  8. Why not they allow Cyprus to leave EU ? That would be the best solution

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  10. Mohamed El'Erian said it best in his book "When Markets Collide", stating that the Eurozone does not have the formulas it needs to solve the intricate capacity issues we see in countries like Greece. Creating such formulas require such fragile testing, and it has been years since the fear of contagion has painted market headlines. Cyprus is nothing more than a containable guinea pig for austerity plans and "tests" that would fare far too dangerous if tested elsewhere.