May 26, 2011

Exiting the Euro Crisis

Are the currency’s days numbered?

What do economics and history have to tell us about the ways euro zone countries are likely to resolve their problems of fiscal unsustainability and banking system insolvency? In answering that question, I am among the most pessimistic observers of the likely future of the euro and its membership. In my view, the euro zone’s likely failure to avoid at least some departures, if not total collapse, reflects its poor initial institutional design. Countries were joined together that were unlikely to be able to survive as a common currency zone, and there were no credible institutions in place to enforce long-term fiscal discipline or to coordinate the resolution of exigencies.

Euro Zone crisis
Illustration by Barbara Kelley

Why doesn’t everyone share my view? I think their relative optimism can be traced to differences in worldview. My worldview is that of a non-European economist and historian. Here is why that worldview leads to pessimism.

Arithmetic Trumps Legalism

As an economist, I place more stock in arithmetic than in the legalities of what countries supposedly are or are not permitted to do; legislation or politicians’ pronouncements about the impossibility of a departure from the euro zone counts for little if the math ultimately requires it. I will argue that in the case of at least one country—Greece—the fiscal arithmetic strongly favors not only a sovereign debt restructuring but also a departure from the euro zone, and there may be others for whom this same outcome will soon become a necessity as well.

Real Exchange Rate Theory and Political Economy

Since before the establishment of the euro, American economists have had a distinctly more pessimistic view of the euro experiment than have their European colleagues.

Two years ago, distinguished European economists Lars Jonung and Eoin Drea published a detailed and quite humorous review of the differences in opinion about the euro between American and European economists. Its title characterized what it (then) regarded as the excessive pessimism of the Americans: "The Euro: It Can’t Happen, It’s a Bad Idea, It Won’t Last. U.S. Economists on the EMU, 1989-2002." In fact, my own 1999 paper predicting the eventual collapse of the euro was included in that review. The implicit theory behind the Jonung and Drea paper was that American economists (perhaps out of jealousy or nationalism) did not want to believe that the euro would work. In light of recent events, an alternative theory may have greater weight: Europeans were in denial.

As early as 1999, in an essay for the Cato Institute titled "The Impending Collapse of the European Monetary Union," I predicted that roughly a decade after its creation, either some members of the euro zone would be forced to leave, or the currency would depreciate dramatically as a means of keeping those countries in the euro zone. In particular, I predicted that southern European countries would become fiscally unsustainable, and that losses of European banks would create significant bank insolvencies, which would put further fiscal pressure on governments through the costs of bank bailouts.

The consequences of the euro’s launch were predictable for the simple reason that the euro zone was not an "optimal currency area." Its demise was a likely result of the deadly combination of fundamental economic inconsistencies among its members and the predictably myopic political palliatives that would be applied by individual members to ease the pain caused by those fundamental inconsistencies.

All signs point to Greece exiting the euro zone. Portugal could face a similar fate.

Southern Europe (especially Greece, Portugal, and Southern Italy) has low long-term productivity growth, particularly in tradable goods. This relative productivity growth gap was likely to persist as the result of a combination of pre-existing trade patterns, human capital differences, rigid labor laws in the south, and low labor mobility in Europe. As we learned from the experience of the East Asian fixed exchange rate collapses of 1997, and from the Harrod-Balassa-Samuelson theory of real exchange rate determination (as embodied in many macroeconomic models, including the rational expectations models of real exchange rates pioneered by Rudiger Dornbusch in the 1970s), if two countries with persistent productivity growth differences in their tradable goods sectors adopt a common currency, eventually the slow-productivity growth country will experience recessionary pressure. In time, that country will either have to suffer continuing price deflation or devalue its currency.

Of course, in the short run, countries do not have to accept the dismal choice between slow growth and currency devaluation. Instead, they can apply fiscal stimulus, or facilitate (through easy bank credit) the growth of the non-tradables sector (also known as housing). In fact, that temptation to compensate for low productivity growth with fiscal stimulus and easy credit will be greater if the establishment of the currency union itself lowers the interest rates on sovereign debt or bank debt that the low-tradables-productivity-growth countries face. That was an important contributor to the fiscal binge of Greece, which ran fiscal deficits in excess of 5% of GDP in its boom years of 2004-2006. It should not be a surprise that Greece, Portugal, Italy, Spain and Ireland all underwent (albeit in different degrees) significant fiscal spending and bank lending booms, and that some of them saw remarkable rates of appreciation in their housing markets. This is precisely what one would expect from the long-run implications of real exchange rate theory and the short-run implications of political economy theory.

"Why, Sometimes I’ve Believed as Many as Six Impossible Things Before Breakfast."

As a historian, I know that "impossible" things—from a legalistic perspective—happen regularly in financial and monetary history. For example, consider the U.S. departure from the gold standard at the beginning of 1862, which began a seventeen-year span known as the period of suspension under the "greenback" standard. Prior to the creation of legal tender notes by the federal government and the suspension of gold convertibility in 1862, the U.S. government had never issued legal tender notes, nor was there any credible basis for the view that the government had the Constitutional authority to do so.

The government had issued some treasury bills during the War of 1812, for a brief time, and had made them receivable for payments of taxes, but it promptly withdrew those notes after the war ended, and never declared them a legal tender for private debts. That experience comported well with the consensus that had emerged from the founders’ constitutional debates over the monetary powers of the U.S. government during the Constitutional Convention. Under the Constitution, the federal government was not given the right to declare anything but gold and silver a legal tender, but neither was it strictly forbidden from establishing other legal tender currency (in contrast, the individual states were forbidden). Delegates avoided the strict prohibition on the argument that it might be expedient as a temporary war measure to permit the federal government to issue paper legal tender, but there was also a consensus against allowing a permanent role for government-supplied legal tender.

Very few people would have argued, say, in 1860, that the federal government was likely to assert the right to create legal tender paper money as a permanent component of the money supply, or to substitute it for gold and silver as the definition of the dollar. But then the Civil War happened. Within a few months of the outbreak of the War—which was initially regarded as an event likely to cost the North little, and to last for only a few months—it became clear that the war would, in fact, cost much more, and take much longer, than anyone had guessed.

In the fall of 1861, the initial debt offerings by the government had not gone well, and the government enlisted the banks of New York, Boston, and Philadelphia to subscribe to the debt as a syndicate. Within a few weeks of stuffing the banks full of new government debt, however, the Secretary of the Treasury, Salmon Chase, released a report estimating substantial increases in war expenditures, and proposing not to increase taxes to help finance the war. The result was a collapse of the value of government debt, which prompted a suspension of convertibility of deposits in the banking system (whose assets had suffered major losses from the depreciation of government debt).

"Why, Sometimes I’ve Believed as Many as Six Impossible Things Before Breakfast."

The legal tender law of 1862, which established a new inconvertible paper legal tender currency, was effectively a bank bailout. By creating a new, depreciated numeraire (the greenback), and by allowing dollar claims (including deposits) to be denominated in this depreciated version of the dollar, rather than in gold or silver, the government offset the negative shock to bank assets from government bond depreciation with a similar negative shock to the value of deposits. Later, in the 1870s, the legal basis for legal tender notes was challenged, but since it had been employed during wartime as an expedient to ensure the survival of the government and the banks, and since it would have been very difficult to unwind the sequence of payments that had been made on a depreciated currency basis over several years, its constitutionality was upheld. To ensure that it was upheld, President Ulysses S. Grant added two justices to the Supreme Court (another outcome that many would have dismissed as far-fetched in 1860). The force majeure of fiscal necessity can be a source of great legal innovation.

Nor was this U.S. experience exceptional. In 1933, the U.S. government prohibited the enforcement of gold clauses in private debt contracts. It did so to assist debtors who were suffering the double blow of a weak economy and a depreciated dollar (which increased the burden of paying gold-denominated debt). In a five-to-four Supreme Court decision, that action was upheld in 1935. That Supreme Court decision was widely regarded as permitting the government to orchestrate illegal takings from creditors and was decried as such in an apocalyptic minority dissent.

As recently as 2002, the Argentine Republic put aside its constitutionally mandated adherence to a dollar-linked currency board. It left the dollar standard and redenominated dollar-denominated and dollar-indexed contracts into the newly depreciated peso. The precipitating event that led the Argentine government to recognize the need to resolve its longstanding fiscal crisis—which had been going on for over two years—was the run on Argentine banks that occurred in December 2001, which precipitated a suspension of the convertibility of deposits.

The Divergent Realities of the Euro Zone

I will not repeat here in detail my prior analyses published elsewhere of the currently unsustainable paths of Greece, Portugal, Ireland, Italy, and (depending on its bank bailout policies) Spain. I would, however, emphasize that these countries are not all facing the same problems. Their strategies for dealing with their problems should differ, as should the EU strategies for agreeing to loss-sharing arrangements to address those problems.

There are three distinct problems related to euro zone membership that confront this group of countries: (1) over-indebtedness, (2) high deficits in combination with over-indebtedness, and (3) non-competitiveness. These problems are distinct and pose different challenges for policy. The relative weight to attach to each problem also differs across the euro zone countries that are currently under the greatest pressure. First, debt sustainability refers to an excessive amount of debt relative to GDP, which must be addressed through some form of default and restructuring.

High deficits add another dimension to that problem. A country that defaults on its debt will find it difficult to fund its continuing deficits through new issues of sovereign debt into the market. Thus, a high-deficit country that is also in need of restructuring either must leave the euro zone to print money to finance its continuing deficits, or obtain public-sector support for deficit borrowing "in arrears" in the wake of its default (presumably with the hope of quickly ending its deficits, so that public sector support does not result in a second debt default).

Also, countries with over-valued exchange rates (which resulted from their slow productivity growth in tradable goods and their rigid labor markets) face the difficult choice between a protracted period of recession as their wages and prices decline to restore competitiveness, or departing from the euro zone, depreciating their currency, re-denominating their wages, prices, and bank deposits in the newly depreciated currency, and immediately beginning their recovery. Under either of those scenarios, long-term reforms of labor markets and other policies to address competitiveness are desirable. But those long-term reforms will not resolve the short-term problem; in the short term, over-valuation implies a clear trade-off between continuing recession and devaluation.

Countries that leave the euro zone could and should re-join it in a matter of a few years, after undertaking significant reforms to their fiscal affairs.

In my view, all three of the fundamental problems listed above are severe for Greece. It is a matter of simple arithmetic that Greece’s debt is not sustainable. Greece’s deficits are also large, and it would be challenging for it to succeed in credibly promising to shrink those deficits to obtain sufficient short-term financing in arrears to avoid leaving the euro zone as it restructures its debts.

Even if financing in arrears were possible, the economic costs of remaining in the euro zone would be large because continuing over-valuation would deepen Greece’s recession. It is hard to see how—absent a massive transfer (not a loan) to Greece of roughly two hundred billion euros—Greece can avoid both debt default and exiting the euro zone. Portugal’s situation is not as dire, but a similar logic applies to its case. A restructuring and an exit from the euro would seem to make sense as a means of resolving all three of its problems.

Countries that leave the euro zone could and should re-join it in a matter of a few years, after undertaking significant reforms to their fiscal affairs, labor markets, and pension systems. It makes no sense to prohibit them from re-joining, and that prospect could be a useful source of encouragement for reforms.

Ireland and Spain are in a somewhat different position than Greece and Portugal. If they can avoid domestic government assumption of their local banks’ debts held abroad (e.g., by German, UK, Belgian, and Danish banks), then they are not clearly in unsustainable fiscal positions (although Ireland’s absorption of bank debt already has placed it at substantial risk in that regard). And if Spain and Ireland can avoid the debt sustainability trap that would result from absorbing their banks’ debt problems, then there is the possibility of improving their economic competitiveness and performance. But if they absorb their failed banks’ debts, they will make their sovereign debt problems much worse, and probably unsustainable. Although the right policy choice is clear, Ireland and Spain have come under enormous pressure from European counterparts (and from domestic political friends of insolvent cajas in the case of Spain) to absorb those debts. They must find the political will to say no.

Italy’s situation is also unique. Its debt sustainability problem could be solved with quick, significant, but not crippling, cuts in fiscal expenditures, combined with significant reforms in tax collection and corruption. But Italy is deeply broken politically. There is little prospect that timely and necessary policy changes will be implemented.

What Should Happen vs. What Will Happen

The best path forward for the euro zone would be to encourage the policy adjustments for Greece, Portugal, Ireland, Spain, and Italy discussed above, and to agree to loss-sharing arrangements to absorb, in an orderly way, the losses that would result to German, UK, French, Belgian, Danish, and other countries’ banks from sovereign defaults and failed Irish and Spanish banks’ and cajas’ defaults.

If history is a guide, however, this is not the way the euro crisis will be resolved. Governments likely will try to postpone taking unpopular measures, and thus will not resolve the problems at hand. The most likely outcome will be a chaotic sequence of ad hoc and poorly coordinated emergency measures, taken in response to bank runs that will begin in Greece or somewhere else as depositors become increasingly wary of continuing euro convertibility of their deposits. The time to act is now, as the possibility of undertaking an orderly and sensible resolution of the crisis is slipping away.


Charles Calomiris is the Henry Kaufman Professor of Financial Institutions at the Columbia University Graduate School of Business and a professor at Columbia’s School of International and Public Affairs. He is a member of the Shadow Financial Regulatory Committee, was a senior fellow at the Council on Foreign Relations, and is a research associate of the National Bureau of Economic Research.


Letters to the editor

What Can the History of the Fed Teach Us About Today's Euro Zone?

Professor Calomiris, in his thought provoking article entitled "Exiting the Euro Crisis," provides a valuable service in highlighting the role of economic history as a tool for analysing the current travails in the euro zone. In referencing a time period stretching from 1812 to 2002 he traces events which support the view that "impossible" things happen often in financial history.

The paper that Lars Jonung and I wrote entitled "The Euro: It Can’t Happen, It’s a Bad Idea, It Won’t Last. U.S. Economists on the EMU and the Euro 1989-2002"—and which Calomiris cites—identified that U.S. economists viewed the Euro zone as a non-optimal currency area. This was a primary reason for their broadly negative assessment of the Euro project.

However, much more surprising from a European perspective, was that the development of Euro zone monetary structures did not give rise to a wider historical debate among U.S. economic historians. For example, there has been little focus on the potential lessons for the European Central Bank (ECB) and the Euro zone from the evolution of the Federal Reserve System in the United States. Yet, some striking parallels merit consideration.

The Federal Reserve Act of 1913 represented a compromise between diverse banking interests and between Federal and state control. By the mid 1930s the institutional framework of the Fed had changed markedly in response to the perceived institutional flaws of the system laid bare by the Great Depression. Only with the 1935 Banking Act did the Board of Governors get full power to implement monetary policy. Research has shown that the U.S. system of federal fiscal transfers was established during the 1930s approximately 70 years after the creation of a uniform national bank note system.

From a long term perspective, the reforms of the 1930s can be seen as the United States finally reaching a fully-fledged monetary union as defined by Hugh Rockoff—a period of nearly 150 years after political unification in 1789.

The question arises: was the United States an optimum currency area (OCA) in 1913 or did it require the turmoil of the late 1920s/early 1930s to provide the political and banking will for greater reforms to take place?

The implications for considering the ECB and the Euro zone are clear. Rather than focusing on the strict criteria of an OCA and comparing the Euro zone with the present characteristics of the Fed system—is there not a more historically accurate comparison as that between the present Euro zone structure and the Fed of the 1920s? In terms of real integration—goods, capital and labour—Michael D. Bordo has highlighted that the Euro zone resembles the U.S. of at least a century ago.

The Euro and the ECB are just over 10 years old. The Euro zone is not an OCA. The current crisis has been exacerbated by the uncoordinated response of European institutions and member states. The ECB is flexing its political independence and irking many through its strict adherence to its single policy objective of “price stability”. Yet, the Euro remains an economic project backboned by political will. If that strength continues then economic reform will follow, albeit in a disjointed fashion.

The Fed of the 1920s was fundamentally altered a decade later. The Euro zone will undergo a similar level of change over the next decade if the Euro is to prosper. If not, U.S. economists can truly say “I told you so….”

--Eoin Drea

Department of History

University College Cork, Ireland.


Letters to the editor may be sent to definingideas@stanford.edu. Editors reserve the right to reject or publish (and edit) letters.