Sunday, May 9, 2010

The Dilemma for Europe

One of the most important conclusions reached in modern open-economy macroeconomics is captured in what is called “The Trilemma.” The principle presented in this analysis is that governments cannot achieve all possible policy goals simultaneously.

More specifically, a government cannot, simultaneously achieve a fixed exchange rate, international capital mobility and economic policy autonomy. Only two can realistically be achieved at any one time.

Governments within the euro-zone have been attempting to achieve all of these goals at the same time. And, that is why they are experiencing the current difficulties. The euro represents the fixed exchange rate between euro-zone countries. Although an attempt has been made to bring economic policies within certain boundaries either through stated requirements to join the community or ongoing standards of behavior once a country joins the euro-zone, strict adherence to these rules have not really been observed. Consequently, nations within the community have been able to act with relative autonomy in regards to the economic policy they have followed.

Finally, membership in the euro-zone has provided all nations with greater access to international capital and this, as much as anything seems to have been one of the major attractions to countries on the periphery of Europe to join the body. Becoming a member of the euro-zone has allowed less credit-worthy countries to gain access to capital and at lower interest rates than would have been possible had they remained independent. In this, the creation of the euro has been a great success.

However, that very success is undermining the community. Ken Rogoff, the co-author of “This Time Is Different,” agues in the May 6 edition of the Financial Times, that “Europe Finds that the Old Rules Still Apply,” (See It seems as if people, and governments, living well beyond their means ultimately have to “pay the piper.”

Martin Wolf in his of May 4 raises the question, “Must All Capital Inflows Always End In Crisis?” ( One conclusion is that if a country has a large capital inflow and it cannot allow for a change in the value of its currency in the foreign exchange market then it must adjust its internal economic policy. If it is not willing or cannot do so in a sufficient magnitude then a financial crisis must take place.

And, this brings us right back to the Trilemma dilemma. A country cannot have a fixed exchange rate, run an autonomous economic policy, and enjoy the fruits of international capital flows. So, the question boils down to the problem of how is this going to be resolved?

The International Monetary Fund has now moved to approve a three-year, €30 loan to help the Greek government. Also, French President Nicolas Sarkozy and German Chancellor Angela Merkel Sunday said they are in complete agreement with measures to be unveiled later on Sunday by the Ecofin, the group of the European Union's 27 finance ministers.

NOTE: Exit polls predict Merkel defeat in federal state election (see making it more difficult for Ms. Merkel to effectively govern in Germany.

So, the euro-zone seems to be moving toward some combined help for Greece and possibly others within the European community. But, there seems to be an absence of real leadership. And, that is a problem, for people really don’t like a leadership void. How this void is going to work itself out is anyone’s guess right now.
The problem is, as I see it, that in situations like this one the drift goes one of two ways. Either the community moves toward the country that is most fiscally sound, in this case Germany, or the community moves toward those that are the weaker links: Greece, Portugal, Italy, and Spain.

If left alone, I would bet that the countries that are more in control of their finances would come out on top! Why? Well, because the less disciplined ultimately have to get their act together in order in order to be able to compete with those countries that are in better shape than they are.

One can easily use a sports analogy in this case and that is why sports can be so popular because it can be used to explain life. Usually, the most talented and most disciplined player or teams come out as the winner or champion. Other individuals and teams know that they must practice and train and discipline themselves if they are going to have a chance to compete. Those that don’t have the attitude to commit themselves to this regimen are not kept around.

But, we have another model to work with. In this model, those that are weakest and least disciplined draw on others so that they can keep playing the game. Here, the weakest links become a drag on the performance of others and define the nature of the relationship.

Why are Greece…and Portugal…and Spain…and Italy…having such a difficult time? Their economies are as undisciplined as are their finances. They still, according to Rogoff in the article mentioned above, are emerging nations, if not worse. Their entry into the European Union provided them with an opportunity to move beyond the “emerging” classification more rapidly than the amount of time usually needed to achieve this maturity. The problem is that these countries have “wasted” the opportunity. They have used their access to capital to “buy off” voters with social programs and benefits and have devoted very little attention toward developing a more competitive economy.

Bailing these countries out only exacerbates the situation. Can these countries really deliver the fiscal discipline needed to move into the modern world? The rioting in Greece does not give us much hope for such an outcome.

One further problem seems to be that European banks have purchased too much of the debt of these countries. And, in this respect, the difficulty is not just the Greek debt, but the debt of these other countries that people are now raising questions about. Of course, this is the problem when something turns out worse than thought. Thus, questions arise about others with similar difficulties.

Coming to the support of the Greek government may be a signal of the extreme concern that exists over the safety of the European banks.

Few officials want to talk about a debt restructuring. The problem again seems to be the feeling that if the Greek debt is restructured then this will have to be followed by a restructuring of the debt of other European nations. Then the problem just becomes that much more severe.

Yet, the economics of the situation give little hope that the Greek government, and possibly other governments, will be able to resolve their situations through massive changes in their governmental budgets. That is why many analysts are betting that, sooner or later, a write down of the debt will have to occur. The picture is something like that enacted by Argentina who wrote down their debt by 50%.

I would argue that this is the only real way to begin the move beyond the solvency crisis.

As far as the fate of the euro and the euro-zone? According to the “Trilemma” analysis, the only way the euro and the euro-zone can survive without recurring “political” difficulties is to coordinate the economic policies of the member nations. That is a lot to hope for at the present time…or, maybe at any time.

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