Tuesday, December 25, 2012

A solution to Europe’s curse: United States of Europe?

A few days ago, EU chief José Manuel Barroso hinted that the ultimate solution to Eurozone’s ongoing crisis called for greater fiscal integration. Though the task apparently seems very challenging given the strong political biases in the region, it is important –in itself- that the leadership has started to discuss such sensitive issues which remain critical to the survival of Eurozone. Though European Central Bank (ECB) didn’t hesitate to bring in its bazookas (LTROs, SMP and now OMT) to reduce the fears of downside but deep down everybody knows that ECB is just kicking the can down the road. Because theoretically while ECB can buy all the troubled sovereign debt through its liquidity injections programs, those debts either have to reverse –causing liquidity constraints- or have to be effectively written off by haircuts –resulting in direct injection of hot money-  both requiring a further action and ultimately a vicious spiral like a ponzi game.
While Eurozone has offered great political and economic benefits for its members, the eurozone has always been a heterogeneous mixture with different political as well as economic structures and policies. For example,
1-      Eurozone continue to suffer from differences in economic competitiveness. At one extreme there are countries with very high economic efficiency like Germany, France and Netherlands etc and on the other hand there are economically uncompetitive economies like Greece, Portugal, Spain and so forth.  Even if Eurozone would operate closed, these differences would ultimately result in assets laden competitive countries and debt laden uncompetitive economies unless the union operated in perfect harmony (Balanced trade and budget accounts). However, this would only be possible given all the economies converged to similar competitiveness that would only be possible
a.       If Competitive economies would shed some of their competitiveness, which has not happened.
b.      Or if the uncompetitive economies would grow rapidly in competitiveness to catch up with competitive economies, which hasn’t happened either since its too unrealistic to suppose that Greece would become Germany in a decade or so.
So in either case, sooner or later, a collapse would be imminent due to structural imbalances which need to be addressed when idea of creating such union was being worked out.
2-      The eurozone economic and political dynamics can be considered as a game with peripherals holding the moral-hazard card. If Greece had piled up debt from both within and outside the Eurozone due to its uncompetitiveness, the easiest way would be to default on the debt since it naturally didn’t have the capacity to generate enough resources to  pay them back. However, if Greece defaulted on her debt, the choice of second player –say Ireland- would also be to default on her debts since she faced a similar problem. But this chain reaction would also mean the destruction of assets held by competitive economies because their asset holding would effectively be the debt issued by peripherals (A classical piece on the issue was written by Martin Wolf named “The grasshoppers and the ants – a modern fable” see notes for reference). This would also mean that if a competitive country - for example Germany - is perceived as economically strong, it is because it derived its growth and asset holdings from economically uncompetitive economies and thus could not escape the damage of chain reaction, if started. So the best interest of such countries would be to stop peripherals from defaulting by bailing them out (what has been happening so far).
3-      Thirdly Eurozone has been in a situation where one Monetary Policy has to face 16 different Fiscal policies by individual members. This not only makes Monetary Policymaking challenging for ECB but also distorts the Monetary-Fiscal coordination. Furthermore, banking regulation of monetary union has also been a challenge where around 6000 banks operate under the supervision of different national central banks with varying degrees of supervision and regulations.
However, would such proposal be a workable idea?  Answer can be yes.  For example, we can look at the economic model of US where different states operate with greater autonomy under one federal administration. For example, a state can levy taxes on her residents, can raise debt from market with municipal debt. Likewise a similar model can be adopted for Eurozone with greater political acceptability. This may include
1-      A tax contribution or tax for proposed supranational fiscal body (just like federal taxes in US)
2-      Autonomy to raise domestic taxes as well as debt as per needs of member countries.
This would be more acceptable to general residents since
1-      All residents will pay similar tax
2-      A tax contribution would be more acceptable to common German -given a Greek is also making a similar contribution- instead of footing the German funded bailout of Greece.
The economic benefits of such a superanational body would be manifold for economic stability of the region since
1-      The Collected taxation at superantional body may be used in restoring the economic competitiveness across the region. This can either be done by supernational-regional government partnership projects or directing the funding to its most efficient use. This would effectively create a development wedge which would be helpful for peripheral countries in need for infrastructure investments.
2-      Since the financial position of Superantional body would be much improved vis-à-vis member countries (due to revenue generation ability), the supernational body would be able to raise funding much more economically as compared to member countries. Thus this would also help member countries bring down the costs of their development expenditures since the high cost of debt raising would mean more cost on development activities of government as well.
  Though arguing about the feasibility- both politically and economically- of idea and appropriate structure would be farfetched at the moment. But there is, nevertheless, a growing awareness and political will amongst the policymakers that a collective effort would be required to tackle the issue on permanent basis. The only thing of concern is that whatever to be done should not be “too late to be done”. 
(This work in an intellectual property of Author, I have no issues with the material being used given accompanied by a proper acknowledgment of source)   
1-Barroso calls for EU ‘federation’ 
2-The grasshoppers and the ants – a modern fable

Sunday, December 9, 2012

Can Maradona Really help Policymakers?

Coined by Sir Mervyn King, the maradonian theory of interest rates holds that a central bank may let expectations of economic agents work to its advantage instead of acting. An avid fan of soccer himself, Sir Mervyn actually derived his theory from one of the most astonishing goal runs made by Diago Maradona where he single handedly beat five English midfielders to score one of the most celebrated goals in the history of soccer. He argued that after receiving the ball near centerline, Maradona -famous for his turns and dribbling moves- interestingly made a straight run towards the English goal. The English midfielders, who were expecting him to make usual fast turns, were taken by a complete surprise.
Likewise he argued that a central bank, after fueling expectations about interest rates, doesn’t necessarily needs to act since economic agents start making behavioral adjustments under expectations. To what extent he can be agreed with, is debatable. I will try to put forth both arguments for and against this in the later section.
A fact that has certainly worked to the advantage of Central banks has been that inflation hasn’t picked up. While Ben, Dragi and King may attribute this to central bank’s credibility, softening commodity and oil prices, household deleveraging and sluggish global growth did play their role in keeping the aggregate demand subdued especially in developed economies. Secondly and importantly, the inflation expectations didn’t pick up despite Central Banks launched rounds after rounds of their analogs Quantitative Easing program –interestingly, BoJ is now being pressed for an open ended QE by political policymakers-. Despite all odds, Central Banks did succeed in keeping the monetary policies accommodative yet at no risk of inflation –the only exception is BoE where inflation remained over inflation target for an intended period subsequently softening-  
However, one should ask himself if Maradona scored such a spectacular goal again? Or putting in literal words can a central bank can just ‘cheat’ an extended period of time by not acting? Answer is quite obvious. A simple example used in Macroeconomics is the impact of central bank’s credibility over labor supply. It says that economic agents engaged in labor initially increase their labor supply given central bank outsmarts them by allowing a higher inflation. Result is an increased labor supply and increased output at higher prices, leading to an expansion. However, as the central bank keeps outsmarting them,  the ultimate result is the demands for wage indexation or a decreased supply or labor hours since the labor’s price for labor falls relative to leisure, resulting in people preferring not to work.

To further elaborate why Maradona can’t always make a blistering run consider the market as English players and maradona as central bank. In scenario A markets are so used to central bank’s credibility that they virtually neglect the possibility that central bank would cheat them.
This given central bank a chance to ‘cheat’ them, resulting in higher economic activity at higher inflation which agents consider exogenous rather than a direct result of central bank’s actions. However, given central bank repeats the strategy and defeats the expectations of economic agents, economic agents start to price in the possibility of “cheating” and start positioning them for inflation (Scenario II).

The more central bank doesn’t act, the weaker the credibility grows and less effective central bank becomes for an economy since if the cheating behavior becomes obvious, the agents start seeking inflation protection (Scenario III). 
This is quite obvious from the subsequent rounds of QE by central banks which has fueled more inflation expectations than initial ones because markets came to realization that “Bazooka” with the central bank no longer works.
So can maradona help policymakers? Yes it surely can. However, can it always help policymakers? The answer depends upon till how long it can pull out the same stunts while keeping others dumb. In Next post I will try to post some of the empirical evidences for this phenomenon. 
(This work in an intellectual property of Author, I have no issues with the material being used given accompanied by a proper acknowledgment of source)