Credit Downgrades and Europe

The problem is the free flow of capital throughout most of the world. 

When capital flows freely you cannot escape the consequences of your actions.

What is called the “trilemma” problem of international economics makes this very clear.  The “trilemma” problem states that a country can only choose two of the following three options.  The three options are to be a part of world capital markets where capital flows freely; have a fixed exchange rate; or, be free to run an independent economic policy.

If there is a free flow of capital internationally, then the choice is reduced to just one of the two remaining options.  But, there are consequences to either choice.

First, if a country choses to run its economic policy independently of all other nations, then it must let it currency float in the foreign exchange markets.  Generally, a nation that wants to run an independent economic policy has particular domestic economic goals it wants to achieve and so wants to be able to choose an independent economic policy that supports these goals.

The goals most often chosen in the latter part of the twentieth century have been full employment and social welfare programs like government jobs, early retirement, substantial amounts of vacation, and high pension levels.  The means of achieving these goals has often been a policy of public sector credit inflation. 

If a country chooses the path of credit inflation then the price of its currency in foreign exchange markets must be allowed to float.  And, if credit inflation becomes extreme, the value of the currency in the foreign exchange markets will decline.  And, this will bring on other problems. 

This is one reason John Maynard Keynes wanted restrictions on the international flow of capital in the 1920s and 1930s. (http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell)   A limited flow of capital internationally was a reality when Keynes helped to craft the Bretton Woods agreement that created the rules for the post-World War II international monetary system.  This agreement also included fixed exchange rates between the currencies of the participant nations. 

The purpose of this system was to allow member countries to follow their own economic policies aimed at achieving high levels of employment in their own country.  Therefore, a policy of credit inflation could be followed in each country without disrupting changes in foreign currency rates.

The Bretton Woods system fell apart as international capital markets opened up in the 1950s and 1960s and the credit inflation created in the United States in the 1960s resulted in a situation where the United States could not maintain its fixed exchange rate.  On August 15, 1971, President Nixon choose to float the value of the U. S. dollar.

A second choice, given the unrestricted flow of capital internationally, is to choose a fixed exchange rate.  But, if a nation chooses a fixed exchange rate then it must give up its sovereignty with respect to running an economic policy that is independent of other nations. 

This is what the European nations did when they choose to form a monetary union based on a single currency, the euro: in essence, they choose to have a fixed exchange rate between member nations.  But, the nations forming the union did not want to give up their sovereignty with regards to the formation of their government budgets. 

Oh, they allowed for budget deficits to be run, but they were to be limited in scope.  This, they felt, gave the included nations some flexibility in creating their budgets, but, they were not supposed to exceed the set limits.  The problem was that these limits were unenforceable. 

Which brings us to the current time.  Budget limits have been grossly exceeded and the nations forming the European currency union and these eurozone nations are unable…or unwilling…to give up the sovereignty of running their own economic policy or abiding by the rules of the union.

The “trilemma” analysis states very clearly that in circumstances like this the monetary union must be broken up and the countries must form a central budgetary unit or must once again establish their own currency units whose price will be floated against the other currencies of the former eurozone countries. 

The ultimate cost of running independent economic policies and trying to run a single currency monetary union will be the destruction of the sovereign political bodies as we know them in Europe or the euro, as we know it now, will have to become history.

Current events now relate to the break down of solvency talks, which had been taking place between the Greek government and private investors in Greek debt.  An “unrealistic” proposal has been rejected by the debt holders.     

Furthermore, the credit downgrades of France and other nations, which took place over the past week, were expected, yet no one really exhibited any sense of urgency.   Now that the downgrades have taken place a downward spiral seems to be starting.

“Both events are important because they show us the mechanism behind this year’s likely unfolding of events.  The eurozone has fallen into a spiral of downgrades, falling economic output, rising debt and further downgrades.  A recession has started.  Greece is now likely to default on most of its debts and may even have to leave the eurozone.  When that happens, the spotlight will fall immediately on Portugal, and the next contagious round of downgrades will begin.” (http://www.ft.com/intl/cms/s/0/987fd2fe-3ddc-11e1-91ba-00144feabdc0.html#axzz1jd5VycTs)

The European Financial Stability Facility has also been downgraded and this means that its effective lending capacity has been reduced.  The ability to “bailout” distressed countries has declined.  And, the European Central Bank cannot resolve the longer-term issues.  There is very little still available to the European officials to “kick the can down the road” any more.

I just do not see the European countries at this time getting over their resistance to form “a strong central fiscal authority with power to tax and allocate resources across the eurozone.”  Hence, I don’t have much confidence for the continued existence of a common currency for Europe, except maybe, on a much more limited scale.  Right now, I don’t see alternatives to the downward spiral mentioned above.

The bottom line is that the conditions of the “trilemma” problem seem to hold.  Given that capital is flowing freely throughout the world nations cannot just totally ignore the consequences of their choice of economic policy.  And, if the consequences of that economic policy are not realized immediately, the evidence shows that they will be realized sooner or later.  This is a lesson in macroeconomic decision-making that all countries need to take into account when determining what economic policy they should be following.  Are you listening America?     

The Euro is "Bad News" for Spain!

Paul Krugman says it all this morning in the New York Times: “If Spain still had its own currency, like the United States—or like Britain, which shares some of the same characteristics—it could have let that currency fall, making its industry competitive again. But with Spain on the euro, that option isn’t available.” (http://www.nytimes.com/2010/11/29/opinion/29krugman.html?_r=1&hp)

It’s that Trilemma thing again!

The Trilemma problem in international financial theory is that a nation can only achieve two out of the following three objectives: it can participate in the international flow of capital; it can have a fixed exchange rate; or it can conduct an economic policy that is independent of every other nation.

Spain, and other nations in the Euro-zone, is constrained by the first two of these objectives. Being a part of the Euro-currency-system, Spain has, in effect, a fixed exchange rate with all other nations in the Euro-zone. Spain also benefits from participating in the international flow of capital.

Given that these two conditions exist within the Euro-zone, Spain, and all other nations within the Euro-zone, cannot conduct its economic policy independently of every other nation within this currency area.

If Spain could conduct its economic policy independently of every other nation within the Euro-zone it could inflate its debt and currency all it wanted to and just suffer the injustice of seeing the value of its currency decline in the international financial markets. But, this would be “good” according to Krugman because the falling value of its currency would make its industry competitive again.

The problem in Europe, according to this fundamentalist Keynesian preaching, is Germany. Germany is the most disciplined country within the Euro-zone and hence is causing all sorts of problems for Greece, Ireland, Portugal, Spain, and possibly Italy and France. And, when times get tough, discipline wins.

This situation highlights the difficulty in attempting to build a currency area. A currency area has a single currency. So, by definition, a “fixed” exchange rate exists within the area. Unrestricted capital flows are very desirable within a currency area because everyone benefits when capital can flow to its most productive uses.

That leaves one prong of the Trilemma hanging…independent economic programs.

This has always been the “hidden bump” along the road to the formation of a currency area. Governments within the currency area need to conduct economic policies that are consistent with one another. But, governments don’t like to give up this independence.

And, if you have a nation like the Germans who believe in self-control and fiscal discipline, it becomes hard for nations who chaff at self-control and believe in credit inflation to continue upon their path forever.

Keynes realized this problem in attempting to construct his economic model in the 1920s and create the post-World War II international monetary system. Keynes knew that his proposals for debt inflation depended upon nations having the ability to conduct their economic policies independently of one another. And, he was, during this time period, very adamant about having a system of fixed exchange rates. Thus, Keynes advocated controls on the international flow of capital.

Unfortunately for Keynes’ view of the post-World War II environment, international capital flows increased, particularly in the 1960s and have accelerated ever since.

What then has to give? Fixed exchange rates or the ability of a nation to conduct its economic policy independently of other nations?

The United States, in August 1971, chose to do away with fixed exchange rates. The Euro-zone came into existence in 1993 and on January 1, 1999 opted for a one-currency system by introducing the euro to the world. The Euro-zone created a single central bank for the area, the European Central Bank which began business in 1998, but allowed national governments to still conduct their budgetary policies independently of one another.

Thus, countries in the Euro-zone could maintain self-control and discipline, if they so desired, or, they could creates mounds of debt and live way beyond their means, if that was what they wished to do. Governments did not want this choice taken away from them.

Times went well for the Euro-zone and most seemed happy with the existing arrangements. Then, the bond markets got antsy. And, we had the first “debt crisis” in the Euro-zone earlier this year. Band-Aids were felt to be appropriate.

Now, we are in the second “debt crisis” and the bill is coming due. Wouldn’t it be nice, as Krugman suggests, to keep on inflating and just let the value of the currency declining? Remember in the economic model Krugman uses there is no debt and no penalty for piling up more and more debt. No harm, no foul!

Therefore, Krugman believes, Spain should be as fortunate as the United States: “The good news about America is that we aren’t in that kind of trap: we still have our own currency, with all the flexibility that implies.”

America can create debt and inflate its currency all it wants to and no one else can do anything about it!

Yet, there is a conspiracy afoot. Now, Krugman has joined Oliver Stone! The “bad guys” are trying to stifle government spending and constrain the Federal Reserve System. These “bad guys” are trying to “voluntarily put (America) in the Spanish prison.”

Does Krugman advocate the demise of the euro? Krugman doesn’t really see this happening because of the disruption it would create. Therefore, Spain must remain in a prison of its own creation.

Germany has contemplated this move. But, Germany really doesn’t want the Euro-zone to fall apart. (See “Crises Shake German Trust in Euro-Zone”: http://www.nytimes.com/2010/11/27/world/europe/27germany.html?scp=10&sq=michael%20slackman&st=cse.)

Maybe the continuing efforts to provide rescues to member nations may lead to a more unified Euro-zone that realizes and accepts greater coordination of national economic policies. The road to such a solution, however, has many, many bumps and potholes along the way. Countries that have established overly-generous social policies may not be able to reconcile their demands with that of the more controlled nations, like Germany, that support greater fiscal and monetary discipline.

The conclusion to this story is far from over.

More on Europe's 'Trilemma'

The name of John Maynard Keynes became prominent once again with financial collapse beginning in 2008 and the “Great Recession” that followed. I would like to introduce his thinking once again to maybe put the idea of the “Trilemma” into a historical perspective.

Yesterday, I wrote of the idea of the “Trilemma” and how it applied to the current situation in Europe (see “Europe’s ‘Trilemma’, http://seekingalpha.com/article/204066-europe-s-trilemma). Today I would like to hold up an earlier example that I believe highlights the difficulties faced by the European Union in attempting to resolve the problems it now faces. The earlier example is that of the United States going off the gold standard in August 1971.

The basic economic framework the world worked within in the 1950s and 1960s was created at the Bretton Woods conference in July 1944. Essentially, the Bretton Woods system was a fully negotiated monetary order aimed at governing monetary relations between member nations. The conference included 730 delegates from all “allied” nations which numbered 44 at the time. Out of this conference grew the International Monetary Fund (IMF) and the body that became the World Bank. These latter organizations became operational in 1945.

Primary among the obligations flowing out of the Bretton Woods system was the obligation for each country to adopt an economic policy that would maintain a fixed exchange rate (within a range of plus or minus one percent) in terms of gold. The IMF would be used to bridge temporary imbalances in a country’s balance of payments.

Historically John Maynard Keynes came to dominate the discussions at Bretton Woods and the resulting agreement that was signed by the participants reflected many of his ideas, some of which he had been promoting for twenty years or so. For more on the role Keynes played in international financial discussions during the 1919 to 1945 period see the book by Donald Markwell titled “John Maynard Keynes and International Relations” (http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell).

Keynes was very forceful in promoting two policies he felt were crucial for the peace of the post-World War II period: the first was fixed exchange rates; and the second was independence for nations to follow their own economic policies. What he did not want was international capital mobility. That is, capital flowing freely between countries.

The driving force behind these policies was the worker unrest that dominated Western Europe in the post-World War I period which, of course, included the Great Depression. Of great concern was the possibility that Western civilization, the culture that Keynes was prominent in, was under siege. The problem was the Russian Revolution and the fear of potential Bolshevik revolution throughout Europe in the 1920s and 1930s.

It was crucial to Keynes that governments kept workers “fully employed” and not allow their (nominal) wages to decline. To do this, governments had to adopt economic policies that promoted “full employment” and that were necessarily independent of other nations so that they could respond to their internal labor markets.

The way to achieve the autonomy of the economic policy of governments was to fix the exchange rate of the currency.

But, there was a third part of the plan. The international movement of capital needed to be discouraged. Of course, at the time, gold was still an important aspect in the international movement of capital. Coming out of the experiences of the 1920s and 1930s there was grave concern that capital should remain inert, at best. A very lucid exposition of the existence of this attitude can be found in Liaquat Ahamed’s award winning book, “The Lords of Finance: The Bankers Who Broke the World” (http://seekingalpha.com/article/121616-financial-collapse-a-lesson-from-the-20s).

So, in line with the conclusions of the “Trilemma” argument, the post-World War II world implemented just two of the three policy goals. The Bretton Woods agreement created a world in which there were fixed exchange rates and autonomous national economic policies, but discouraged free international capital mobility.

The result: relative stability in the system during the 1950s when governments were generally conservative in terms of their monetary and fiscal affairs. However, in the 1960s, nations began to implement “Keynesian” type fiscal policies (note the “Keynesian” tax cut enacted by the Kennedy/Johnson administration) connected with a monetary policy stance that encouraged inflation (note the inflation/employment trade off in the popular economic model labeled the Phillips Curve). By 1968 or so, we Americans at least, were all “Keynesians” according to President Richard Nixon.

What occurred in the 1960s was the re-ignition of inflation and inflationary expectations as the Johnson administration pursued a fiscal policy that included both “guns and butter.” As inflation and inflationary expectations grew, financial innovation advanced as commercial banks became more international in scope and began raising funds throughout the world through the management of their liabilities. Note, for one, the development of the Eurodollar deposit.

International capital market mobility became a reality!

As a consequence, the Bretton Woods system could not hold. According to the “Trilemma” diagnosis, the world was trying to live with all three of the policy goals connected to the “Trilemma” and one of them had to go.

President Nixon believed that full employment was very important to him in terms of his re-election bid and so the autonomy of his administration’s economic policy could not be aborted. Furthermore, globalization was in its infancy and business and finance were pushing as hard as possible to keep international capital markets expanding. Hence, the fixed exchange rate had to go!

On August 15, 1971 President Nixon announced to the United States (and to the world) that America was going off the gold standard and the value of the dollar would be floated. The world was now different than it was before.

The basic reason I wanted to bring this episode to your attention was to provide some historical backing to the dilemma now facing the European Union. The “Trilemma” problem is relevant to what they are trying to achieve. Ignoring or assuming that Europe can overcome the conclusion reached in the “Trilemma” analysis is foolhardy. Therefore, we shall all be waiting to see how the European Union can resolve their dilemma. Enacting a bailout package is only a stopgap to dealing with the real issues the leaders of the EU face. The problem concerns the absence of real leadership in Europe!

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 http://www.ft.com/cms/s/0/be41b758-58a7-11df-a0c9-00144feab49a.html.) It seems as if people, and governments, living well beyond their means ultimately have to “pay the piper.”

Martin Wolf in his ft.com/wolfexchange of May 4 raises the question, “Must All Capital Inflows Always End In Crisis?” (http://blogs.ft.com/martin-wolf-exchange/). 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 http://www.ft.com/cms/s/0/7a717746-5b60-11df-85a3-00144feab49a.html) 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.