Friday, June 22, 2012

How Portugal Found Itself in Crisis

Despite Being a Well-Managed Economy
NY Times Article on Crisis in Portugal
The story of Portugal is one of how a small, soundly run economy can be battered by unstable market forces in its immediate environment. Prior to the crisis, Portugal had a well-managed economy which had low debt levels, roughly in line with the Maastricht criteria, as well as economic growth rates ranging from 3-5% per annum. As soon as the crisis emerged however, Portugal became a victim of increased borrowing costs due primarily to panic on the European markets, as well as high levels of exposure to financial sector external shocks. 

According to the New York Times, Portugal has reduced its budget deficit by more than one-third since this time last year. Furthermore, the IMF reports that contraction in output due to austerity measures has been milder than expected. Nevertheless, the IMF reports that the 2012 outlook for Europe has deteriorated substantially, affecting primarily the PIIGS economies. Essentially, Portugal's situation has been quite seriously undermined by continually deteriorating market sentiment, which is largely being driven by Eurozone stress (for which, Portugal is not responsible).

To illustrate matters further, the European national debt graph below, originally published by the NY Times last quarter, outlines that Portugal began 2009 with debt levels equal to those of Germany and have faced an increase in borrowing costs only since the Greek situation -and resulting mismanagement of the crisis- unfolded.

In other words, the IMF reports that while Portugal's fundamentals are fine in and of themselves, as is Portugal's management of the stormy economic climate thus far, Portuguese assets are being sold-off based on contagion fears stemming from the EU's (and Germany's) lethargic reaction to the crisis.

What Should Be Done?
In short, Portugal should be offered financial stabilization along the lines extended to Central and Eastern Europe under the auspices of the Vienna Initiative. In 2009, as the crisis swept through Eastern Europe, a coordinated crisis response was swiftly agreed and implemented primarily by the EIB, EBRD, The CEE region central banks, and the Austrian government. The Vienna initiative was a win-win response so effective in restoring confidence and avoiding severe economic contraction and austerity in Central and Eastern Europe that by 2010, the ECFIN Country Focus Report for Poland was titled “The Polish Banking System: hit by the crisis or merely a cool breeze?”
About the Author: 
Max Berre is a financial-regulatory economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands. 

Monday, June 18, 2012

ECB Study: Lack of Crisis Response Causing Contagion in Europe

Empirical Study on European Sovereign Spillover Risk

An empirical ECB study published in February 2012 analyzing the effects of the sovereign debt crisis found that spillover from the economic situation in Greece is affecting risk premiums across the PIIGS countries, as well as in the Eurozone at large, to a smaller degree. In other words, the European Union’s inaction with respect the European sovereign debt crisis is making the situation worse. This is happening due to investor fears of contagion. The fear is that the longer European leaders remain inactive in attempts to contain the situation in Greece, the more afraid investors become.

This was determined empirically by testing European bond yield spreads for sensitivity to general market conditions, publication of the budget-balance-to-GDP ratio, sovereign credit ratings changes, and Greek, Irish, and Portuguese sovereign credit ratings changes.The ECB study points out that a lot of the movement in the market happens automatically, as large institutional investors fulfill their fiduciary obligations to dump their riskier investments as they rebalance the risk profile of their portfolios.

The study concludes that because of economic losses caused by the simple contagion fears, the Eurozone’s highest priority should be to reduce contagion risk in Europe. It’s just a shame that Angela Merkel doesn’t see things that way.

Since the intensification of the crisis in September 2008, all euro area long term government bond yields relative to the German Bund have been characterized by highly persistent processes with upward trends for countries with weaker fiscal fundamentals. Looking at the daily period 1 September 2008 – 4 August 2011, we found that three factors can explain the recorded developments in sovereign spreads: (i) an aggregate regional risk factor, (ii) the country-specific credit risk and (iii) the spillover effect from Greece. Specifically, higher risk-aversion has increased the demand for the Bund and this is behind the pricing of all euro area spreads, including those for Austria, Finland and the Netherlands. Country-specific credit ratings have played a key role in the developments of the spreads for Greece, Ireland, Portugal and Spain. Finally, the rating downgrade in Greece has contributed to developments in spreads of countries with weaker fiscal fundamentals: Ireland, Portugal, Italy, Spain, Belgium and France.

The European Central Bank (ECB) is the institution of the European Union (EU) that administers the monetary policy of the 17 EU Eurozone member states. It was established by the treaty of Amsterdam in 1998 as the Eurozone's central bank. 

Saturday, June 9, 2012

The Economist Scolds Merkel's Obstructionism

Half-Baked Rescue Plans, Overwhelming Focus on Austerity
In mid-June of 2012, the Economist ran a piece scolding Angela Merkel for Germany’s obstructionism in the face of organized efforts to address the rapidly forming European sovereign debt crisis.  In the view of The Economist, Germany’s actions have done a great deal to turn a crisis in Greece – around 3% of the Eurozone’s economy- into a crisis of the 17-member Eurozone at large. “The overwhelming focus on austerity; the succession of half-baked rescue plans; the refusal to lay out a clear path for the fiscal and banking integration that is needed for the single currency to survive". The Economist points the finger directly at Merkel’s government over these policy failures “Since Germany has largely determined this response, most of the blame belongs in Berlin.”

The Consensus in the Rest of Europe – and World
According to the economist, the feeling in the rest of Europe, as well as in the US and China, a number of policy measures could be put in place to respond to the crisis. They proposed measures would help save southern economies as well as northern banks.

“Outside Germany, a consensus has developed on what Mrs. Merkel must do to preserve the single currency. It includes shifting from austerity to a far greater focus on economic growth; complementing the single currency with a banking union (with euro-wide deposit insurance, bank oversight and joint means for the recapitalisation or resolution of failing banks); and embracing a limited form of debt mutualisation to create a joint safe asset and allow peripheral economies the room gradually to reduce their debt burdens. This is the refrain from Washington, Beijing, London and indeed most of the capitals of the euro zone. Why hasn’t the continent’s canniest politician sprung into action?”

For their part, southern Europe’s banks have thus far proved to be considerably more resilient in the face of European volatility than their northern counterparts. So far, Spain has only seen one bank collapse… four years into the crisis at that. Compare this result with UK, Ireland, Holland or Belgium.

Why the Arrogance Then?
“She believes, first, that her demands for austerity and her refusal to bail out her peers are the only ways to bring reform in Europe; and, second, that if disaster really strikes, Germany could act quickly to save the day. The first gamble can certainly claim some successes, notably the removal of Silvio Berlusconi in Italy and the passage, across southern Europe, of reforms that would recently have seemed unthinkable.”

In other words, the Economist accuses that the action of Merkel’s government are designed to override the sovereignty of both the European Union’s 26 other member nations (and their democratically-elected governments) and the European Union itself. Berlusconi notwithstanding, the removal of foreign heads of state and the forcing of policy changes in foreign countries is a direct affront to the idea that the affairs of a country should be decided by that country’s voters: Democratic Sovereignty.

What Should be Done?
First, the proposed measures should be enacted. These are; the formation of a banking union, and the partial mutualization of debt. Second, the democratic sovereignty and national interest of the other 26 member nations should be defended as aggressively as is necessary. Germany’s austerity-demand-based obstructionism can, for example, be overcome by a series of bilateral agreements which simply exclude German participation.  
Max Berre is a financial regulatory economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.

Friday, June 1, 2012

Stamp Scrip: Episodes in Economic History

On July 5th 1932, in the middle of the Great Depression, the Austrian town of Wörgl made economic history by introducing a remarkable complimentary currency. Wörgl was in trouble, and was prepared to try anything. Of its population of 4,500, a total of 1,500 people were without a job, and 200 families were destitute. The mayor, Michael Unterguggenberger, had a long list of projects he wanted to accomplish, but there was hardly any money with which to carry them out. These included repaving the roads, streetlighting, extending water distribution across the whole town, and planting trees along the streets.

Rather than spending the 40,000 Austrian schillings in the town’s coffers to start these projects off, the mayor deposited them in a local savings bank as a guarantee to back the issue of a type of complimentary currency known as 'stamp scrip'. This requires a monthly stamp to be stuck on all the circulating notes for them to remain valid, and in Wörgl, the stamp amounted 1% of the each note’s value. The money raised was used to run a soup kitchen that fed 220 families.

Because nobody wanted to pay what was effectively a hoarding fee, everyone receiving the notes would spend them as fast as possible. The 40,000 schilling deposit allowed anyone to exchange scrip for 98 per cent of its value in schillings. This offer was rarely taken up though.

Only the railway and post office refused to accept the local money. Ultimately, people paid their taxes early using scrip as well, resulting in a huge increase in town revenues. Over the 13-month period the project ran, the council not only carried out all the intended works projects, but also built new houses, a reservoir, a ski jump, and a bridge. The people also used scrip to replant forests, in anticipation of the future cash-flow they would receive from the trees. 

In other words, Stamp Scrip improved local-level C, I, and G, three of the four components of GDP.

The key to its success was the fast circulation of scrip within the local economy, 14 times higher than the schilling. This in turn increased trade, creating extra employment. At the time of the project, Wörgl was the only Austrian town to achieve full employment. Formally, it calls to mind the Quantity Theory of Money, whereby:
MV = PY and 
dM+dV = π+dY

Six neighboring villages copied the system successfully. The French Prime Minister, Eduoard Dalladier, made a special visit to see the 'miracle of Wörgl'. In January 1933, the project was replicated in the neighboring city of Kirchbuhl, and in June 1933, Unterguggenburger addressed a meeting with representatives from 170 different towns and villages. Two hundred Austrian townships were interested in adopting the idea.

At this point, the central bank panicked, and decided to assert its monopoly rights by banning complimentary currencies. Wörgl's citizens sued and lost in the Austrian Supreme Court. It then became a criminal offense to issue 'emergency currency'. The town promptly went back to 30% unemployment. In 1934, social unrest exploded across Austria, which was followed by annexation four years later. 

The 1920s had already seen a scrip currency called the 'wara' in the German town of Schwanenkirchen. This saved the town's economy and kept a coal mine operating. The wara started circulating more widely and became part of the 'Freiwirtschaft' (Free Economy) movement, based on the ideas of Silvio Gesell. Central to Gesell's ideas was the use of a hoarding fee of the kind used in Wörgl (technically known as 'demurrage'). In 1936, the soundness of the idea was affirmed by Keynes in the General Theory of Employment, Interest and Money.

The most groundbreaking feature of demurrage is that it is intrinsically anti-inflationary. Whereas conventional currencies are progressively devalued by interest, anti-inflationary money steadily increases in value. As each monthly stamp is added, the value of the note effectively increases by the stamp amount. This is technically equivalent to a negative interest rate.

The present short-term focus of investments and lack of long-term vision are exacerbated by interest-driven currency devaluation. This reduces the financial appeal of longer-timescale projects. The use of a demurrage currency gives a rate of return simply lending out money. When money is repaid (remember these are non-interest currencies), it will have increased in value owing to the money saved by having avoided paying the monthly demurrage fees. This has the potential to enable investment in highly beneficial but economically marginal activities such as earth repair.

Recently, the Federal Reserve Bank of Cleveland has launched an economic commentary brief explaining how a stamp scrip plan would work in the US. In 1933 during the great depressesion, a US plan for the issue of Stamp Scrip was drawn up by Irving Fischer.
This article is a re-posting of  of a 2002 blog article originally posted by Laboratory Readings. It has undergone minor modification to the text.