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Sunday, May 22, 2011

Is Italy, Not Spain, the Real Elephant in the Euro Room?

Looking through the latest round of EU GDP data, one thing is becoming increasingly obvious: when it comes to future monetary policy decisions at the ECB, and to exactly how many more interest rate hikes we are going to see, then the performance of the Italian economy is going to be critical. The growth pattern now is clear enough: Germany and France move forward at a lively pace, while the so called "peripheral" economies (Portugal, Ireland, Greece, and Spain) either remain in or continually flirt with recession. They are constrained by the combined burden of their lack of international competitiveness, their over-indebtedness and the contractionary impact of their austerity programmes. In this sense, given its size, Italy is in a key position to tip the balance between core and periphery one way or the other. And the fact that, growth in the Italian economy seems once more to be grinding to a halt is not good news in this sense, with the quarterly gowth rate falling back from a quarterly 0.6% in Q2 2010, 0.5% in Q3, 0.1% in Q4 and 0.1% again in Q1 2011. Slow Growth Champion? I suppose it shouldn't really have surprised anyone to find that Italy’s GDP growth rate continued to slip back in the first three months of this year - both in absolute terms and with respect to core Europe - since Italy's average growth rate during the first decade was only about 0.6% per annum. It shouldn't have surprised, but I'm sure it did, since the financial markets have only been thinking of how comparatively low the Italian deficit has been since the start of the crisis, rather than worrying their heads off about how a country with such a low growth rate and such a high pending elderly dependency ratio is ever going to pay down the already accumulated debt. Italy's debt to GDP ratio is currently just short of 120%, while the population median age is 45, so lets just say Italy is Japan without the current account surplus. Now were the quarterly GDP growth rate not to accelerate beyond the 0.1% expansion achieved in the first three months of this year, then even the current IMF forecast for modest 1% GDP growth in 2011 would start looking very optimistic. And if the country now slips back into recession (certainly not excluded) then the under-performance would be much greater. Some Do Not Also Rise The Italian result contrasts sharply with the strong performance in the main components of core Europe, emphasising yet again that despite the fact that it is managing to stay clear of bond market wrath at the moment, Italy essentially forms part of the low-growth high-public-sector debt economies on Europe's periphery. Both German and French real GDP growth in Q1 2011 came in much stronger than expected, with the former posting an impressive 1.5% quarterly increase (6% annualised), significantly stronger than the 0.9% expected by the markets, while French GDP increased by 1.0%, in this case with a strong contribution coming from domestic demand which was reflected in a strong increase in imports, imports which in theory should have benefitted Italy. France and Germany are in fact Italy’s main trading partners, accounting between them for about a quarter of Italy’s total exports. So although we do not have a breakdown of Italian Q1 GDP yet, the above developments point to a stagnating domestic demand only partially compensated by stronger net exports. The most recent results mean that German GDP has now passed its pre-crisis peak, while Italian GDP is still stuck at the level it reached at the end of 2004. The chart below (which comes from a recent report by PNB Paribas economist Ken Wattret ) shows the path of constant price GDP in the four largest eurozone countries (plus the UK) relative to where they were in Q1 2008. France is in a similar position to Germany, since fourth quarter 2010 GDP was around 1.6% lower than its pre-crisis peak, and it just rose by 1%. The picture in the other countries, however, is very different. In Italy, Spain and the UK, GDP is currently 5.2%, 4.3% and 4.1%, respectively, below the peak levels reached in Q1 2008. So what accounts for the differences? In the German case the strength of the rebound is in-part a by-product the exceptional depth of the recession there. Between March 2007 and March 2008, German GDP collapsed by a cumulative 6.6%. This compares with peak-to-trough GDP declines of around 3.5% and 2%, respectively, during the recessions of the early 1990s and during the first years of the present century. The Italian Economy Resembles The German One, Consumption Is Weak And Growth Depends On Exports: Unfortunately The Italian Economy Is Not Competitive Enough For This To Work Germany’s strong export dependency, and consequent high sensitivity to fluctuations in global trade, is the key reason why the country goes from strong growth to deep recession and back again (in fact quarterly GDP growth in Q1 2008 was 1.4%, just before the economy fell into recession). This dependency is reflected in the unusually high share of GDP which is accounted for by exports (over 50%), and may well be associated with the unusually high median population age of 45. As can be seen in the chart, the cumulative contractions in GDP in the other large European economies were typically significantly smaller than in Germany, even in a country like the UK which was extremely vulnerable to problems in the financial sector. A similar picture can be found in the US, where problems in housing and the banks formed a central and archetypical feature of the global crisis, even though GDP declined by only a cumulative 4% from peak to trough, two-thirds of the German drop. On the other hand, the Italian case offers an evident exception to the idea that the harder they fall the steeper they rise. The cumulative decline in Italian GDP from its Q1 2008 peak to the Q2 2009 trough was nearly 7% - making the output loss bigger even than that experienced in Germany. But the rebound has been much less impressive than the German one, with GDP still nearly 5% below the pre-crisis high, and basically still on the level of Q4 2003. In large part, this situation is a result of the weak performance of Italian exports. In Germany, exports are now back above their pre-crisis peak, while in Italy exports are still more than 14% under their Q1 2008 high point (See chart). Productivity Is The Key Average quarterly growth in German GDP since the economy bottomed in Q1 2009 has been nearly 1%, while in Italy, it has averaged under 0.3%. The geographical composition of German and Italian exports is one factor which influences the relative export performance between the two countries. The share of German exports which go to faster growing developing markets like China, has accelerated sharply since outbreak of the crisis, while Italy is still largely dependent on developed - and heavily indebted - economies. In addition Italy has a major competitiveness problem. Incredibly, and according to Eurostat data, in the first decade of this century the Italian hourly productivity index only climbed by 0.75%, while the German one climbed by 13.3%. That is to say, German productivity was up an average of 1.3% a year over the decade, while Italian productivity barely moved, rising only 0.07% a year. As a result, rising wages meant that Italian unit labour costs surged sharply. So, during the first decade of the Euro the Italians paid themselves more for producing virtually what they were producing at the start of the century. Naturally this is not sustainable. Labour Inputs Shoot Up, But Output Doesn't The situation is even more incredible if you take into account the fact that during these years the labour force grew steadily, and the country received several million new migrant workers. Between 2002 and 2010 the number of non-Italian citizens officially residing in Italy was up by 3 million (or 200%). During this time the labour force grew by about a million: while employment was up by around 1.5 million. In fact, since Italy left recession the number of those employed has hardly risen, while the percentage of those who are formally unemployed has remained near its crisis highpoint, which has been good for productivity, but not for consumer consumption, the ideal combination would be to see output and employment growing at a healthy pace, with output growing faster than employment. At the present time employment is hardly growing, and the rate of increase in output is slowing notably. That is to say we do not have "lift off". Naturally, this lack of competitiveness is to be seen in Italy's deteriorating external position, and the drag on growth which this causes is seen clearly in this current account deficit and GDP growth comparison. Exports have been growing rapidly since the middle of last year, but imports have been growing even more rapidly, and hence the goods trade deficit has widened considerably. Growing Your Way Out Of Debt? Aside from the impact on Italian living standards and welfare services, the big issue which arises from Italy's low and declining long term growth outlook is what this is likely to do for Italian plans to reduce the burden of its outstanding government debt. Is, for example, lower than expected growth likely to jeopardise Italy’s achievement of its deficit target for 2011? Well, if there was no increase in spending to compensate for the economic slowdown (and remember, Prime Minister Berlusconi's party just did very badly in regional and local elections) then the knock-on effect on the deficit would probably be small and probably not a large enough change to seriously call into question the Italian government's commitment to its fiscal policy targets given that the 4.6% deficit achieved in 2010 was 40bps below target and that the Government is aiming for a 2.7% deficit by 2012. But Italy's problem has not been its high deficit level during the crisis, it is the high debt level the Italian government has accumulated over the years, and the continuing under-performance in growth terms means the government may well struggle to turn the situation round, and that some sort of restructuring (soft or hard) at some point may well be needed. Let's take a look at why. According to OECD data, while Italy ran cyclically adjusted primary deficits (that is deficits before including interest payments) every year between 1970 and 1991, the country has run cyclically adjusted primary surplus every year since 1992 - even during the depths of the recent crisis. Thus Italy’s cyclically adjusted primary balance (as a % of GDP) has been in better shape than the balance of many of the largest developed economies. Notwithstanding this, the weight of debt as a % of GDP has continued to rise. So, while Eurostat recently confirmed that the Italian 2010 public deficit was 4.6% of GDP, and 40 basis points below the Government target,the debt to GDP ratio was revised up to 119% (in this case higher than the Government’s target number). What makes the difference is the impact of history and the weight of the accumulated debt, since interest needs to be paid on the debt. Ambitious Targets Which Will Be Nearly Impossible To Achieve Now Italy has set itself the objective of reducing the overall deficit below 3% of GDP by 2012. Indeed, the government’s 2011 Economics and Finance Document (EFD) sets itself extremely ambitious targets for fiscal policy. The objective is to achieve a broadly balanced budget by 2014 through the achievement of a deficit/GDP ratio of 3.9% in 2012, 2.7% in 2013, 1.5% in 2013 and a 0.2% in 2014 and (as the document says) “so on systematically increasing the primary surplus to continue on the path to reduce the public debt”. The aim is to maintain the fiscal balance within a range which is compatible with reducing the debt. But just how realistic is this objective? Well, to make a comparison, back in March, ECOFIN proposed quite far-reaching changes to the current Stability and Growth Pact (SGP). In particular the Finance Ministers proposals included the incorporation of a principle of extra fiscal effort for heavily indebted countries – a principle which has become widely known as the "debt-brake" condition. According to the new proposal excess debt, i.e. public debt above 60% of GDP, should be reduced by 1/20th per annum. This new debt-brake condition has important implications for heavily indebted countries who have so far escaped the full force of market attention, such as Belgium and Italy, since these two have to deal with debt to GDP ratios hovering around 100% and 120% respectively. What is surprising about the fiscal path proposed by the Italian government in its EFD is that it appears even tougher than that implied by the new EU debt-brake condition. Of course, assuming Italy meets its fiscal deficit objectives - which naturally imply no counter-cyclical stabiliser deficits during recessions (is this really realistic??) - the key variable to watch for the debt/GDP ratio is nominal GDP. Now Italy managed to achieve nominal GDP growth of around 4% a year in the decade before the crisis, and a rough and ready calculation suggests that with nominal GDP growth of around 4% debt to GDP would be down under 100% following the Econfin criteria, and under 95% following the Italian government's own EFT. Catch Me (Out) If You Can But is a 4% growth in nominal GDP realistic for the rest of this decade? It is important to remember that the composition of the earlier 4% average annual growth, since only around 1% of it came from real GDP growth, while 3% came from inflation. And, of course, during this time, as we have seen, Italy lost considerable competitiveness with Germany. So what may help with one thing (debt to GDP) may be positively harmful to another (international competitiveness, the current account defecit). As Goldman Sachs economist Kevin Daly put it in a recent report:
"For countries attempting to address these twin imbalances within a currency union, there is a ‘Catch 22’ situation: competitiveness can only be regained via real exchange rate adjustment (i.e., by running lower inflation than the Euro-zone average). However, in order to boost public sector finances, economies need stronger nominal GDP growth and, thus, relatively low inflation (or deflation) has the effect of exacerbating the public-sector deficit problem. In other words, it is difficult to address one imbalance without exacerbating the other, and vice versa".
If we simply take this years outlook as an example. Italy, as we have seen, is unlikely to achieve more than 1% real GDP growth (and this a year of strong global expansion), but the country might just get nominal GDP growth of 4%, since inflation is currently running near to 3%. At the same time Germany may have GDP growth nearer 4%, and inflation around 1% lower than Italy. These kind of inflation differentials just don't make sense, when you consider that it is Germany that is booming, and Italy that is near to falling back into recession. Such differences are symptoms of deep economic rigidities in Italy. So what if Italy were to have 1% inflation, and 3% real GDP growth? Well, just how plausible is this? Germany, as we have seen, has only been able to get 1.3% annual growth in productivity over the last decade, and it is hard to see Italy doing better, no matter how deep the structural reforms introduced. Indeed, Italy's long term trend growth has been slipping steadily over the last half century, at the rate of about 1% a decade, according to the Italian economist Francesco Daveri:
"Italy’s per-capita GDP growth was 5.4% in the 1950s, 5.1% in the 1960s, 3.1% in the 1970s, 2.2% in the 1980s and 1.4% in the 1990s. A rough-and-ready extrapolation of this decade-long continued slowdown would lead to expect no more than 0.5% in the 2000s."
Since he wrote this in 2006, and growth over the decade was something like an average of 0.6% I would say that his expectation wasn't a bad guess. What puzzles me at all the people who now "guess" that Italy will be able to put in enough a much higher growth rate over the next decade. All Together Now: "I Believe In Structural Reforms" The IMF are expecting real growth of about 1.3% between 2012 and 2015, and the EU forecasts are not substantially different. As average growth rates this seem very optimistic to me, especially given the recent performance. All efforts seem to be directed towards impelling structural reforms, and this in itself is worrying, since what we seem to have is something more akin to blind faith than to sound empirical economic analysis. The most recent IMF Article IV Report concludes that: “only a bold and comprehensive structural reform program will unleash Italy’s growth potential”. But what is the likelihood of such a bold and comprehensive programme being introduced, and anyway, how much do we really know about Italy's real growth potential at this late day in its demographic history? While echoing the "structural reforms" mantra, the OECD is rather more cautious:
Italy’s economy has passed the deep recession triggered by the global crisis and seems set for a gradual recovery. The strength of this recovery is uncertain: it would be wise to plan for no more than the rather sluggish growth seen in the decade prior to the crisis.
The problem is, like many on Europe's periphery, after a decade of Euro membership the Italian economy is seriously distorted, and badly in need of devaluation, but of course, as elsewhere there is no currency left to devalue, hence some sort of debt restructuring to reduce the burden of interest payments may be the only alternative while we await the jury's verdict as to whether all these structural reforms work or not. Many, of course, will say that Italy is a lot richer than it seems, since so much economic activity takes places in the informal sector. But this is entirely beside the point, since the informal sector by definition does not pay taxes, and I will believe a promise to reduce the importance of the informal sector when I see the results. In the meantime Italy is, at best, a country which is much richer than it seems where government finances are in danger of spinning off into an unsustainable debt spiral. As Standard & Poor's put it in the statement accompanying their decision last week to put Italian Sovereign Debt on rating watch negative: "In our view Italy's current growth prospects are weak, and the political commitment for productivity-enhancing reforms appears to be faltering. Potential political gridlock could contribute to fiscal slippage. As a result, we believe Italy's prospects for reducing its general government debt have diminished."

Sunday, May 15, 2011

Greece: Last Exit To Nowhere?

"Some economists, myself included, look at Europe’s woes and have the feeling that we’ve seen this movie before, a decade ago on another continent — specifically, in Argentina" - Paul Krugman: Can Europe Be Saved

"Think of it this way: the Greek government cannot announce a policy of leaving the euro — and I’m sure it has no intention of doing that. But at this point it’s all too easy to imagine a default on debt, triggering a crisis of confidence, which forces the government to impose a banking holiday — and at that point the logic of hanging on to the common currency come hell or high water becomes a lot less compelling."
Paul Krugman - How Reversible Is The Euro?

Krugman is certainly right. Looking over towards Athens right now, you can't help having that horrible feeling of deja vu. Adding to the uncomfortable feeling of travelling backwards rather than forwards in time (oh, I know, I know, when history repeats itself it only piles one tragedy onto another) is the uncomfortable presence of Charles Calomiris, a US economist of Greek origins. I can still remember reading, back then in the autumn of 2001, an article by the then Argentine Economy Minister Domingo Cavallo published in the Spanish newspaper El Pais which proudly proclaimed that everything was going well, and that the country's reforms were being generally well received with the regretable exception of "a small number of neurotic US economists who continue to insist that we will default and break the peg". He was, of course, referring to Calomiris, and at the time we were only a matter of weeks away from the dramatic moment when Adolfo Rodríguez Saá (the man who was President for a mere 8 days) would enter both history and the Argentine parliamentary chamber to utter the now immortal phrase "vamos a coger el torro por los cuernos" (we are going to take the bull by the horns). A phrase which was obviously belonged to the class of so called Austinian performatives, since at one and the same time as uttering it he effectively ended the peg. Well today Calomiris is again with us, and he is still hard at work going through the numbers, only this time round he is using his special insights to scrutinise his family homeland, for which he is prophesying not only eventual default, but also the generation of sufficient contagion to bring the whole Euro project itself to an untimely end. In an article in Foreign Affairs entitled "The End Of The Euro", he tells us:

Europe is living in denial. Even after the economic crisis exposed the eurozone's troubled future, its leaders are struggling to sustain the status quo. At this point, several European countries will likely be forced to abandon the euro within the next year or two....The only way out of this conundrum is for countries with insurmountable debt burdens to default on their euro-denominated debts and exit the eurozone so that they can finance their continuing fiscal deficits by printing their own currency. Here's a hint for Europe's politicians: If the math says one thing and the law says something different, it will be the law that ends up changing
Really, I don't think of Calomiris as a prophet (or even as a Cassandra), I don't even think of him as an especially insightful economist when it comes to the macro problems of the real economy, but I do think he has one exceptionally strong merit: he can do the math, and as he says, if it gets down to a battle between legal details and arithmetic, arithmetic will always win.

Easy Said & Easy Done, Down the Argentina Path We Go!

As it happens, the issue of Argentina as a reference case for Greece has surfaced again this week, in the form of an Op-ed in the New York Times by the co-director of the Center for Economic and Policy Research Mark Weisbrot.

Weisbrots's argument is not new, but it is different, not only because he thinks Greece would be better off leaving the euro (many economists share that opinion), but because of the apparent eulogy he makes of the Argentine case.

"For more than three and a half years Argentina had suffered through one of the deepest recessions of the 20th century......Then Argentina defaulted on its foreign debt and cut loose from the dollar. Most economists and the business press predicted that years of disaster would ensue. But the economy shrank for just one more quarter after the devaluation and default; it then grew 63 percent over the next six years. More than 11 million people, in a nation of 39 million, were pulled out of poverty"

Now these are strong claims. But let's leave aside the issue of whether or 11 million people were pulled out of poverty or not, and dig a bit deeper into what actually happened in Argentina, and let's do this by comparing it with another country, one which arguably has similar social and economic development characteristics, Chile (see chart above). At the turn of the century Chile had a population of more or less 15 million, as compared with the 39 million Argentinians mentioned by Weisbrot. Now in 1998, just before Argentina entered its depression, Chilean GDP was some 79 billion dollars, while Argentina's was 299 billion dollars. Now let's fast forward to 2010, Argentina's GDP at the end of last year was 370 billion dollars, and Chile's 203 billion. That is to say, between 1998 and 2010 Argentina's GDP (as measured in dollars, we'll come back to this) increased by 24%, while Chile's increased by 156%. As they say in Spanish "no hay color" (there is simply no comparison). Especially when you take into account when that Chile has only 38% of Argentina's population, while it has 55% of Argentina's GDP. So over the 12 years between 1998 and 2010 Chile (which maintained a floating currency throughout) evidently did a lot better than Argentina (despite Argentina's abandonment of the float). And here's another relevant piece of information: between 1998 and 2010 the Argentinian price level rose by 143%, while in Chile the price level rose over the same period by 48%.

So why use USD as the measure of comparison? I do this since it gives the most convenient yardstick evaluation (euros would do equally well) of the relative external values of the two economies. This is important, since Argentina apparently high growth levels have been also associated with high inflation levels, which have been constantly compensated for by devaluing the peso. In fact Bank of America Merrill Lynch currency strategist - and former IMF economist - Thanos Vamvakidis makes an essentially similar point (although with different conclusions) in a research note covered recently by FT Alphaville's Tracy Alloway:

"In our view, ...(the results of our study).... point to the conclusion that exchange rate devaluations do not lead to permanent competitiveness improvements in rigid economies, such as in the Eurozone periphery. In this context, tail risk scenarios about EUR exit are misplaced. Structural reforms are the best bet to improve the periphery’s growth prospects, within or outside monetary union".

Does this whole debate sound familiar to anyone? Anyone remember when Italians were paying themselves in million lira notes? In fact, it was precisely to break the Southern European countries from the high inflation, high interest rates, periodic devaluation dynamic that the Euro was thought to be such a good idea in the first place. It hasn't worked as planned, but that doesn't mean that the most traditional and the most simplistic solutions are necessarily going to be the best ones.

On the other hand, does this mean we should then go on to dismiss the coming out of the euro option out of hand for Greece? Evidently not. Let's look at another comparison, this time Argentina and Turkey.

Now in 1998 Turkey had a dollar GDP of $269 billion, and by 2010 this had become $742 billion. That is it had nearly tripled. Yet Turkey's dollar GDP dropped sharply in 2001 following a substantial devaluation of the Lira. Conclusion, competitive devaluations are sometimes useful, so what makes the difference?

Well Paul Krugman got near to it, when he said in his article on Weisenbrot's proposal:

"Greece, as a relatively poor country with a history of shaky governance, has a lot to gain from being a citizen in good standing of the European project — concrete things like aid from cohesion funds, hard-to-quantity but probably important things like the stabilizing effect, economically and politically, of being part of a grand democratic alliance".

We can sum the essence of all this up in a couple of phrases "institutional quality" and "structural reforms". Or put another way, Turkey devalued as part of an IMF programme (it was actually recommended, in the days before the heavy hand of the EU took management control at the IMF), while Argentina broke the peg and devalued in order to get out of one. Turkey was not only able to benefit from the reform pressure instigated by the IMF (the stick), but also by the promise of EU membership under certain conditions (the carrot). Indeed, curiously, EU cultural reservations about Turkish membership have probably lead to far stricter reform hurdles than were either applied to the current members in the South or the East, and Turkey is undoubtedly the great beneficiary of this strictness.

Which brings us to the main point: should Greece leave or not leave the Euro? Well, let's go back to something Krugman said in another blog post (How Reversible Is The Euro):

"Think of it this way: the Greek government cannot announce a policy of leaving the euro — and I’m sure it has no intention of doing that. But at this point it’s all too easy to imagine a default on debt, triggering a crisis of confidence, which forces the government to impose a banking holiday — and at that point the logic of hanging on to the common currency come hell or high water becomes a lot less compelling."

or as he argues in his latest post:

"That said, Weisbrot is right in saying that the program for Greece is not working; it’s not even close to working. At the very least there must be a debt restructuring that actually reduces the debt burden rather than simply stretching it out. And the longer this situation remains unresolved, the less hope I have that Greece will be able to stay in the euro, even if it wants to".

The present situation is unworkable, and unsustainable, not only because the accumulated debts are unpayable by Greece alone, but also because the tiny size of the manufacturing industry Greece has ended up with and the general lack of international competitiveness of the Greek economy make an export-lead growth process with the present state of relative prices virtually impossible. There are solutions to both these problems consistent with remaining within the Eurone and without default - issuing Eurobonds to accept part of the Greek debt and enforcing a substantial internal devaluation to restore external competitiveness, for example - but since the adoption of these two strategies is virtually unthinkable given the current mindsets in Brussels, Frankfurt, Berlin and Madrid then we are more or less guaranteed to find ourselves facing some kind of Greek default, and given that the programme as it stands isn't working (this is where the situation so resembles pre-default Argentina as the extent of the fiscal correction means the economic contraction feeds on itself given that exports cannot expand fast enough to counteract the decline in government spending and domestic consumption), it would be strongly advisable to accompany this default with some sort of devaluation.

Put another way, if the most valid argument against going back to the Drachma always was that this would imply default, now that default is coming, why not allow Greece to devalue? As Krugman says, the issue isn't whether Greece would openly decide to exit the euro, the issue is what happens if the markets force this solution on Greek and European leaders against their will? Given the programme isn't working, the likelihood of this kind of event occurring in the next 2 or 3 years is far from being negligible, so why not be proactive rather than always relegating ourselves to being reactive? What matters is whether Greece becomes Turkey (oh, what a historical irony) or Argentina. If the powers that be can agree on an ordered restructuring of Greek debt, and a controlled exit from the Eurozone, then Greece has some possibilities of turning the situation round. If exit is forced on Greece in order to escape the clutches of both the EU and the IMF then the move will be, as I suggest in my title, simply the last exit to nowhere. And especially in a historic context of ageing populations and rapidly rising elderly dependency ratios, ratios which will only rise further if thousands of young people exit Greece in the search for work elsewhere, as young Argentinians did in 2002/3. That's another difference most people who make this comparison don't mention: when Argentina devalued the country still had a fertility rate which was slightly above replacement level. Greece has just had more than 30 years with a total fertility rate in the region of 1.3. So while Argentina could look forward to years of demographic dividend and rapid "catch up" growth, if things go wrong Greece can only look forward to an ever older population and ongoing social and economic decline

The tragi-comic events surrounding the fate of IMF Director General Dominique Strauss Kahn may well mean that we are about to see significant changes in that organisation. It is to be hoped that, if this is the case, such changes will also involve a rethink of the IMF's role in Europe's crisis, and in particular of the objectives and means of implementation of the Greek programme, with the Fund moving towards a less-eurocentric and more balanced position, one which would be in the collective interest of the community of citizens of the wide variety of countries the institution represents.

The Great Greek And Spanish GDP Mystery - One Hypothesis

Many an economic eyebrow must have been raised last Friday when Europe's first quarter GDP data was released, and people discovered that the Greek economy had suddenly surged forward, rising by 0.8% over the level it had attained in the last three months of 2010 (or at a 3.2% annual rate, or faster than the US). Since almost everyone with knowledge of the situation is forecasting a further contraction in the economy this year, the result may have been thought to be a surprising one.

Well, there is no need to call in Sherlock homes just yet, or even the strong-arm boys from Eurostat, since I think I may have worked out what happened to Greek GDP in Q1, or at least I have a good working hypothesis. In the process we will also examine why it was that, against all prognoses, and against a colossal amount of anecdotal evidence that the Spanish economy is falling back towards recession, Spanish GDP actually accelerated.

But first, a brief intro to Econ 101 macro. It is important to grasp the fact that GDP isn't the be all and end all of economic analysis, and certainly doesn't give us a complete measure of economic activity. Indeed there are many economic processes which may be of interest to economists - levels of indebtedness, for example, which are simply not captured by the measure, since GDP is what it is: a measure of domestic value added, according to the following formula:

GDP = Consumer Demand + Investment Demand + Government Spending + Net Trade (change in exports minus change in imports) + Net Change in Inventories

Now, in general we know that the first three items on the list are falling in Greece. even if there does seem to have been some slight improvement in retail sales during the quarter, after a very steep fall in the autumn.

But what about the net trade component? Well, before going further it is important to consider is how this calculation works. Basically net trade can improve either by the rate of export growth accelerating, or by the rate of import growth decelerating. Now in Greece we know that exports have improved, but Greek exports are proportionally so small, and form such a limited part of total economic activity, how can they possibly pull the economy upwards in this way (causing a 0.8% q-o-q increase in GDP)? Well, looking at the chart for imports it can be seen that just as exports have been accelerating, imports have been decelerating, so the combined impact might be quite large (please note we don't yet have the March data).

This impression that it was as much a drop in imports as a rise in exports that was behind the sharp quarterly rise in GDP is further reinforced if we look at the year on year performance of the two variables. In recent months Greek imports are sharply down y-o-y (despite the surge in energy prices) while exports are up.

So GDP rose, but what about does this tell us about living standards? Well, this is just the point. Since the fall in imports reflects a fall in demand, it implies a fall in living standards,and this is the strange thing about what GDP measures and what it doesn't measure. GDP can rise sharply, even when unemployment is rising, and people are getting poorer. This is largely because one of the things GDP doesn't measure is the evolution of what some call the "financial balances" (for more explanation of this idea see the pioneering work of the Canadian economist Rob Parenteau (here in somewhat polemical form, and here as a more technical explanation).

In countries running an ongoing trade and current account deficit, the rise in living standards which comes from an increasing excess of imports over exports figures in national accounts as an output negative (apart from the transport and retail outlet activity which are a spin-off), and the counter party to all that "living beyond our means" feel-good added credit-driven purchasing power really only shows up as a negative item on the financial side of the accounts, as money borrowed from the exterior, money which is used to finance the deficit. It is a negative item, because all that potential capacity to spend is being diverted away from national activity to external activity. So while you pay for the products consumed (through debt) others get the long term benefit of your spending. Which is why it is such a bad idea to run sizeable current account deficits over any great length of time, since they are financed by credit, and credit is only a way of transferring demand from the future to the present, which means you will feel richer now, and poorer in the future, and this is exactly what is happening to Greece. It is also why the only way to put the situation straight is to export more, and run a trade and current account surplus, since then the value of your net external debt falls. So the correction is necessary and inevitable, although the curious thin is that while it is taking place, and while exports are rising and imports and living standards falling GDP rises, even though people feel much worse off.

Obviously, having an economy appearing to accelerate like this is a bit counter intuitive. Evidently it is not the same as having a devaluation-induced import-reduction with demand remaining equal, and more productive activity taking place inside the country as relative prices result in steady import substitution, but then demand deflation policies have these peculiarities attached. Maybe we could think of the type of correction Greece is engaged in as less future demand being brought forward to today, under the hope that the subsequent path of the economy will eventually be on a higher level than it otherwise would have been. Pay now, live later.

In the Greek case, since private sector borrowing is at a total standstill, and public sector deficit borrowing is being steadily reduced, the current account deficit is being forced to close, with the consequence that since exports can't rise much (due to competitiveness issues, and their low base) imports will need to fall while unemployment will probably continue to rise.

If this analysis of what has been going on in Greece is correct, then it can also help us understand the latest set of Spanish GDP numbers a bit better. According to the latest data, in the first quarter of this year Spain's GDP rose by 0.3% over Q4 2010 and by 0.8% over the year earlier quarter. This surprised many analysts since the Bank of Spain has previously estimated growth to be around 0.2%, and a number of 0.1% was often anticipated.

In theory the Q1 performance marks an acceleration over the 0.2% quarterly rise registered in the last quarter of 2010. Such an acceleration seems odd, since all the recent data, industrial output, retail sales, unemployment has been negative, and doubly so since the government is in the process of a very sharp (3.2%) fiscal adjustment process.

Yet, if we come to look at the relative import/export performance, we will see a milder version of the same phenomenon. It seems exports rose and imports fell in the first quarter, creating a very special kind of "win-win" situation.

This is a much milder version of the Greek story, but possibly similar processes are at work in both cases, as Spain's previously large current account deficit is also being steadily forced to close.

On the other hand, in Spain's case other factors might be at work, like overspending before this month's regional and local elections. In any event, I am describing all the above as a hypothesis because we still don't have either the March trade data or the detailed GDP data. When we have access to both of these we will have a better idea of just how valid this hypothesis of mine actually is. At the end of the day, one swallow doesn't make a summer, and one month's GDP surprise is simply a drop in the ocean in relation to the major challenges which face these economies in the quarters and years ahead.

Monday, May 9, 2011

Is There Really Such A Thing As A Eurozone Credit Cycle?

America, we know, has a currency union that works, and we know why it works: because it coincides with a nation — a nation with a big central government, a common language and a shared culture. Europe has none of these things, which from the beginning made the prospects of a single currency dubious.
Paul Krugman - Can Europe Be Saved?
All theory depends on assumptions which are not quite true. That is what makes it theory. The art of successful theorizing is to make the inevitable simplifying assumptions in such a way that the final results are not very sensitive.' A "crucial" assumption is one on which the conclusions do depend sensitively, and it is important that crucial assumptions be reasonably realistic. When the results of a theory seem to flow specifically from a special crucial assumption, then if the assumption is dubious, the results are suspect.
Robert Solow, A Contribution To the Theory of Economic Growth, 1956

One of the key premises underpinning the establishment of the Euro as a common currency to be shared by a number of individual national states rather than one single nation was the central idea that the several economies of the participating countries would eventually converge to one common typology. That is to say, even if the individual nations would not be dissolved into one single superstate, then the idea was that the difficulty this could obviously create would be overcome by the generation of a number of different, but to all-important-economic-effects identical economies, each one a replica (in minature or "a lo grande") of the other. Absent this, it is hard to see how people could have convinced themselves that having a single currency and a single monetary policy could possibly work in the longer term.

Convergence Towards a Common "Steady State"?

This critical idea of convergence was based on a simple (and possibly rather simplistic) application of the kind of neo-classical economics widely taught in the modern university. Every economy, it is postulated, is capable of generating some sort of relatively constant "steady state" growth rate , and given the application of sound common monetary policy and an appropriate mix of relevant structural reforms these relatively constant growth rates should not diverge too much one from the other, since if they did, and continued to do so on a sustained basis, then a fiscal mechanism would need to be created to serve as a stabiliser able to redress the consequences of such steadily diverging rates of growth with the associated large differences in living standards. Political consensus could never realistically be maintained behind a process which was manifestly generating inequality between participating countries.

Naturally, if there was no eventual convergence then any fiscal mechanism which was created would need to be something more than an ad hoc fund for handling the impact of a one-off asymmetric shock (like the bursting of a property bubble), since it would need to be permanent and systematic and operate in a way which is broadly similar to the internal redistribution mechanisms which operate between north and south in countries like Spain and Italy, or between rich and poor states in the USA. Naturally, in the course of the current crisis, no one with any degree of institutional authority even in the most desperate of moments has been prepared to publicly contemplate the possibility that the creation of such a territorial equalisation mechanism might eventually be need, even though, as will be argued here, successfully saving the Eurozone will almost inevitably mean putting just such a fiscal compensator in place. Just think about it: the Greeks never had a fiscal deficit problem at all, since what was lacking was adequate compensation for their growth imbalances! You can just see the anxious (or enraged) look on all those German faces. Yet just this is the conclusion that I think can be drawn about the creation of a common currency area among a group of countries where convergence is not operative, since the consequence of not doing so, as is now becoming clear enough, is that the countries with lower underlying growth profiles become steadily weighed down by the burden of their indebtedness to the higher growth economies - that is to say debt obligations are created where fiscal transfers are lacking.

Now, as we all have come to know only too well, this kind of fiscal mechanism was neither contemplated by the founding fathers of the Euro, nor has anything even remotely resembling it been envisioned as part of the collective response to the present crisis. Indeed the need for its creation remains one of the most highly controversial topics in the current debate (rivalling in the emotional charge it engenders only the suggestion that some sort of internal devaluation might be needed for the zone's struggling peripheral economies). Advocacy of this move has been restricted to commentators outside the mainstream, most notably among them Wolfgang Munchau (see here, and here), and for his pains he has acquired the honorary title of "Enemy of Spain" from the Spanish newspaper El Mundo, who presumably found his suggestion that Spain might need to be a beneficiary of such a mechanism an insult to their national honour.

Diverging Not Converging Economies?

Meanwhile back in the world of the real economy, nothing could be more evident from all the signs we are seeing during the present recovery than that the Euro Area economies are not converging - indeed they are visibly diverging in all manner of different ways. Some economies are now called "peripheral", and others are called "core". Yet neither the core, nor the peripheral economies resemble the other members of their sets in a way which standard theory might lead you to expect that they should.

France is a domestic consumption driven economy, running a goods trade deficit, where manufacturing industry seems to be losing competitiveness, while Germany has weak domestic consumption, is completely export driven, runs a large external surplus, and German manufacturing industry seems to get more (rather than less) competitive by the day.

Among the peripheral economies Greece would seem to distinguish itself for its extreme fiscal profligacy, while Italy and Portugal have just passed through a decade of slow growth, which contrasts with the case of Spain and Ireland where fiscal deficits and government debt were not a large issue during the first decade of the Euro's existence, but where a growing mountain of private sector debt (fuelled by negative interest rates and a growing housing bubble evidently was) evidently was.

The consequences of needing to accommodate policy to this diversity of economic "types" have, however, still to be recognised, yet the lessons of why convergence hasn't occurred do need to be assimilated, otherwise effectively staying in denial will only raise the chances of an eventual disorderly disintegration of the zone itself. Interestingly, Poul Thomsen, IMF Mission Chief for Portugal recently emphasised in the context of the bailout there that as far as the IMF is concerned, "Every country is different and there is no one-size-fits-all for the programs we support". How long will it be before this message reaches Frankfurt?

As an anecdotal aside, I cannot help having the feeling that the practitioners of academic neo-classical economics spend far too much of their time building models based on premises which remain far from self-evident in order to tell the world how it ought to be, leaving the pathways through which empirical facts-on-the-ground could work their way back to influence or modify the initial assumptions rather obscure, to say the least.

To give one example, on a recent visit to the monetary policy department of one of Europe's smaller central banks I found myself engaged in a rather frustrating debate about the relative merits of competitive devaluation and structural reform as ways of getting heavily-indebted export-dependent economies back to economic growth and job-creation in sufficient volume to be able to start paying down the debt. Unfortunately the discussion became a rather unrewarding "dialogue of the deaf" of the kind to which I have by now become so accustomed. In fact the whole think so evidently became so tiresome that one of the ever courteous central bank particpants took me aside on my way out to reassure me that "there was of course nothing personal in our exchange". Well, of course not! But that being said, the debate did seem to me to be rather asymmetric and one-sided, because while I am absolutely convinced you need structural reform alongside any (hypothetical) competitive devaluation (otherwise all the old ills simply return), the other side of the argument obviously does not accept the need for competitive devaluations to accompany structural reform. Au contraire, the one is seen as the complete and much more desirable alternative to the other.

During our discussions, in my frustration at the fact we were obviously getting absolutely nowhere, I asked the central bank representatives what it would take to convince them they were wrong. Surely, I asked, if the economies in question did not return to a reasonable and sustainable growth rate within the next 3 to 5 years, then they would need to ask themselves whether or not they had been doing something wrong. I for my part clearly recognise that if those economies I consider to be in need of competitive devaluations to underpin structural reforms do achieve significant and sustainable economic growth over the next five years without them then I have been missing something, somewhere (in fact I consider such recognitions of reality to be in my own best interest, to be taken on board on a "sooner the better" basis). Yet,“no”, came the answer, loud and clear, “that would simply mean that the structural reforms had not been deep enough or sufficiently energetically implemented”.

I am now put in mind of a recent (and rather infamous) press conference given by the Real Madrid football club coach José Mourinho. When asked by one of the journalists what responsibility he felt his players and he had in the recent series of defeats by their rival Barcelona FC, "zero" was the answer he gave to the astonished journalist. Well, there you go, learning by doing in action!

Am I the only one to find something strange (and even frustrating) about this kind of answer? What is the connection between the fundamental assumptions of the kind of economics that is being applied in this crisis on Europe's periphery (which in many ways means prioritizing micro and ignoring the core theorems of applied macro) and reality? And how do we test these assumptions? Surely anyone with any kind of scientific frame of mind should look for facts that can confirm (or better, following in the footsteps of Sir Karl Popper refute) the hypotheses they advance. Which brings us back to the lack of symmetry in the argument we are having at the moment. I personally do consider the lessons learnt from our attempts to handle the crisis to form a vital part of the knowledge acquisition process. As I say, I for my part am clear that if these economies do return to reasonable and sustainable growth within a 3 to 5 year time horizon, then there will be something wrong with the way I have been going about things. On the other hand, since several hundred million Europeans are currently being subjected to a massive social and economic experiment, it would be a pity if economic theory were to prove itself unable to learn anything substantial from the eventual outcomes.

In the meantime I find myself gasping for air, trying to pin down threads in the argument that can be examined and tested, which is why I think the convergence issue is important, since either convergence is taking place or it isn't. Put another way, is convergence taking place across a meaningful, in the here and now, time horizon, or is it simply one of those things which is only destined to happen in the longest of long runs by which time, as Keynes so tactfully put it, we will all be well and truly dead? Evidently the future of the Euro depends on the kind of answer you give to this question, and the conclusions you draw from that answer.

Business Cycles and "Business Cycles"

Now one of the areas in which mainstream economic theory surfaces in search of some real world air is in the context of what many analysts call the “credit cycle”. This concept is interesting, since it allows for the introduction of some data, and enables us to take a look and see if the real world is as theory (and all those models they work with) imagines it should be.

In fact, the idea of a credit cycle is a natural offshoot of the idea of a business cycle, insofar as central banks pass though an interest rate cycle which maps to some extent movements in the business cycle (that is to say as the economy slows rates come down, and as it accelerates they go up), while demand for credit in the private sector of the economy tracks movements in both of the aforementioned cycles. That is to say, private demand for credit declines during recessions (despite the fact that interest rates fall, and public sector demand for credit rises to offset this drop and cushion real economy impacts), while the subsequent recovery in the demand for private sector credit can be seen as one of the key indicators influencing central bank decision taking when it comes to interest rate policy, since an over-rapid expansion in credit can produce excess demand which can lead to inflation, and in a “normal” world central banks tend to want to fend off any unwarranted surge in inflation or in inflation expectations.

The problem with all this is that business cycles are not such straightforward beasts as they are often assumed to be, nor is it really clear how useful conventional business cycle theory really is during a structural (as opposed to cyclical) crisis like the one we are presently living through. Evidently in every economic expansion (or contraction) there is a structural and a cyclical component, and normally the former is less important than the latter in explaining short term movements in output, but during the present crisis this situation has been reversed in both the developed and the developing economies. Take the following charts illustrating recent growth patterns in the Spanish and Chinese economies, can anyone really spot the cyclical components, since I sure as hell can’t.

Spain didn't have a single quarter of contraction following the ending of the 1992/93 contraction until the great global economic crisis broke out, and China hasn't had one during this century at least. Obviously in each case there are reasons for these phenomena (catch up growth, inappropriate expansionary monetary policy lifting you through the roof), but the only point I want to make is that they are clear examples of where structural elements far outweighed cyclical ones, and I would argue that this situation is much more common than is often admitted.

So, we need to be very careful, and in the context of the current global recovery we need to be be at great pains in trying to distinguish between cyclical and structural components in growth, whether this is in the context of growth in GDP or in private sector credit.

A Eurozone Credit Cycle?

Now one of the points of core dogma which is institutionally enshrined at the heart of the ECB is that aggregate Eurozone data has some sort of useful, or valid, or interesting interpretation. So strongly is this belief held that the central bank representatives seldom examine interpretations of the data that drill down and try to identify what is happening (and more importantly why it is happening) at the individual country level. This is hardly surprising since as suggested above, the very existence and survival of the Euro is seen as hanging on the idea that (given the appropriate country level structural reforms) all the individual economies will converge, and any recognition that tailor-made monetary policies are needed for individual countries would be tantamount to accepting that the founding assumptions of the monetary union had sprung a leak.

However, as we will see, credit conditions do in fact vary widely across member countries, and this uneven availability-of and demand-for credit across the Eurozone has become just one more headache to add to the far from small number policy-makers at the ECB currently have, since the growing economic recovery in some countries is being facilitated by the relatively easy availability of credit, while in others problems resulting from a debt overhang and a lack of competitiveness are only reinforced by the difficulties their banking systems face when trying to provide new credit to viable enterprises and solvent households.

In any event, starting with the aggregate data released by the ECB such as it is, we find that Eurozone-wide bank lending - which has (truth be told) remained far from strong since the official ending of the recession - lost some of its limited momentum in March, suggesting any real recovery in aggregate Eurozone domestic demand is still a long way off. Private-sector lending increased during the month by 2.5% over March 2010, after rising by 2.6% year on year in February. In fact, the recovery from the economic and financial crisis has been characterised across the Eurozone by weak bank lending, particularly to businesses, and although the annual growth rate of loans to non-financial corporations rose in March, it continued to expand at the relatively modest rate of 0.8% following a 0.6% rise in February. Loans to households have been doing slightly better, and grew at a 3.4% rate compared with the 3.0% registered during the previous month. The annual growth rate of lending for house purchases grew to 4.4% in March from 3.8% in February.

(The legend and titles in the above chart are in Catalan, since they have been taken from a report by Catalunya Caixa, but if you bear in mind that "Societats No Financeres" are private sector corporates, "Llars: Consum" is household consumption and "Llars: Habitatge" is home mortgages then you shouldn't have too much difficulty, especially if you remember that the economic net worth of this data asymptotically approaches zero, in the sense that the more time you put into trying to understand it the less you will really learn about how the Eurozone actually works).

At the same time broad money, or M3, rose by an annual 2.3% (M3 comprises currency in circulation, overnight, short-term deposits and debt securities of up to two years, repurchase agreements, and money market fund shares), and the three-month moving average of the annual rate of change of M3 was +2.0%. Thus monetary growth still remains well below the ECB's reference value of +4.5% for the three-month average, a monetary growth rate it considers to be broadly in line with an inflation rate of just under 2% over the medium term, implying there is little risk that broad money growth will push up inflation in the eurozone, although it is unlikely that this particular detail will cut much ice with policymakers at the ECB in relation to their interest rate decisions, since it is not monetary fuelled demand-side pull that worries them, but rather commodity induced supply-side push, and in particular the impact this could have on inflation expectations.

Credit Tightening Or Credit Loosening? Spain & Germany Compared

The latest ECB quarterly bank lending survey suggested only a moderate tightening of credit standards for both enterprises and households in the current quarter. But as I am saying, this appreciation of the aggregate sitution conceals significant differences at the individual country level. In Italy, France, Finland and Germany (for example) credit seems to be widely available, while in Spain, Portugal and Greece credit conditions remain very tight. The Bundesbank noted only last week that in Germany there had been a "marked easing of credit standards in lending to both enterprises and households" in the first quarter of this year and that surveyed banks expect little change in credit standards in the current quarter. This view was reinforced by the Ifo Institute who reported that the percentage of German firms which have difficulty accessing credit fell by 1.1 percentage points in April to a record low of 22.6%.

Meanwhile in Spain, the central bank state in their latest quarterly report on the economy that notwithstanding the reduced tension in capital market attitudes towards the country, "accessibility by the resident private sector to funding became somewhat tighter".

The peculiar thing here though, is that if you look at the comparative inter-annual rates of change the two countries don't seem to be that different.

What is apparent is that in each case (Germany or Spain) and regardless of whether or not we are talking about total private sector lending, corporate lending or mortgage lending, the rate of increase in borrowing is extremely low, with the only significant difference between the two countries being that in the German case such extremely low rates of credit growth date back to the turn of the century, while in the Spanish case they area recent phenomenon following the bursting of the housing bubble. (I have dealt with this comparison between Spain and German at greater length in this post here).

The big difference between these two countries is, of course, the level of international competitiveness of their economies, since Germany is well able to live with such low levels of domestic credit growth due to its strong export capacity, which enables the country to generate significant GDP growth (currently over 3% annually). Spain's economy, on the other hand, has been unable to expand export capacity fast enough to compensate for the sharp loss in domestic consumption, and hence what little growth there is has been supported by a substantial government fiscal deficit and even this has still left the economy continually flirting with recession.

Further, in the German case credit conditions are comparatively loose even though there is no great demand for additional credit, while in the Spanish one credit conditions are tight (for a variety of reasons) so potential home-buyers and companies have difficulty getting as much credit as they would like to have, and this despite the fact that prevalent interest rates in both countries are broadly similar, and result from one common monetary policy.

And Then There Is Portugal & Greece

In fact Spain is not unique in this sense, even if the country does offer a somewhat dramatic example of a larger problem. Credit conditions in Portugal are also now tightening, and demand for loans is falling.

And we find a similar picture in Greece.

What is most remarkable about these charts for Spain, Portugal and Greece is how they so resemble each other in the sharp decline in credit to the private sector. Nor should any up-tick be expected since all these countries are already heavily in debt, and the only serious way for them to attain sustainable growth is to de-leverage via export-induced saving. That being said, this transition is likely to prove, as we all know, pretty painful. Even during the German transition from 1999 to 2005 things weren't entirely easy, yet these three countries now face a far more difficult and far more demanding challenge, given the scale of their external debt and the current market conditions.

Who Needs More QE And Doesn't?

To help them move through that challenging process what they arguably need, in the same way as the UK and the US do, is some form of quantitative easing. Unfortunately excessive reliance on aggregate data leads ECB policy-makers to miss this relatively self-evident fact. So these countries are being asked to make a structural transition of almost monumental proportions without carrying out a competitive devaluation, with accompanying monetary and fiscal tightening. It is hard to see a successful outcome, and indeed I imagine we won't see one.

But the monetary union's problems don't end here, since there are another group of countries where monetary easing from the ECB does appear to have been having an impact, and where credit growth has, to some extent taken off. The first of these would be Italy.

Now there is little to alarm us here, since Italy's private sector is not especially indebted, but it is interesting to see how the pattern varies, and how credit conditions in Italy are very different from those elsewhere in Southern Europe. On the other hand, if we move across the continent to Finland, once more we find little sign of difficult credit conditions:

Indeed, the low interest rate policy of the ECB during the crisis really does seem to have worked in the Finnish case, in that housing demand and private consumption never really collapsed (see this earlier post on the property boom in Finland). Finally, in this brief survey, there is France, where even though corporate borrowing remains restrained, demand for consumer and housing credit seems to be really kicking back to life.

Evidently France is becoming a very special case, since France's private sector is not heavily indebted, although looking at its comparatively young population profile it could easily become so. If there is one country where a property bubble could be produced, that country is France - for both demographic and low-indebtedness reasons (just look at the line of take-off for household mortgages in the above chart). So evidently, at least in the French case ECB tightening makes perfect sense, as it does when we look at the inflation expectations chart.

So Just How Many Sizes Do We Need To Fit All?

The purpose of this brief survey of credit conditions in a number of individual Eurozone countries has been to draw attention to one rather neglected area of policy difficulty. It is common knowledge that having a "one size fits all monetary policy" can prove problematic, in that the application of negative interest rates to an economy that is essentially booming can lead to significant structural distortions, and even produce asset bubbles of one class or another.

But the issue of credit conditions and credit availability is normally given far less attention, even though it is an equally important one. It is clear that it is hard to identify one common "credit cycle" among the zone's diverse economies, and indeed the need for credit is always going to be very different in an economy which runs a large and continuing external surplus when compared with an economy (like France's) where domestic consumption remains strong and the country continues to run an external deficit.

It is clear that some of the difficulties which were likely to be faced by countries attempting to handle the rigidities associated with participating in a common currency were well anticipated in advance, even if few of those involved in setting it up were able to listen at the time of its creation. Other problems which were not so clearly foreseen have emerged with time. The difficulty presented by surrendering powers from your own central bank with respect to monetising government debt is only now becoming clear, as is the problem created by acquiescence in the kinds of structural distortions which permit the accumulation of high levels of external debt, debt which fickle markets may suddenly decide they are no longer willing to support. The fact that cheaper interest rates might lead to larger fiscal deficits and growing government debt was foreseen, but the danger presented by ever larger private indebtedness funded by external borrowing surely was not.

However, the problems entailed by the absence of any meaningful common credit pattern and the consequent difficulty of maintaining the core idea of ongoing convergence raises perhaps one of the most serious obstacles to Euro credibility and continuity, since, as I try to argue at the start of this study, even the issuing of Eurobonds and the creation of a common fiscal treasury can only represent a stopgap measure in such a situation given that what this then produces is a constant and ongoing transfer of resources from one set of countries to another. This outcome is neither sustainable nor is it desirable, since voters in the funding countries will eventually grow tired of it (even under the rather dubious hypothesis that they were willing to entertain it in the first place) while those who are funded would find themselves in the unpleasant situation of having their long term dependency institutionally re-inforced, even as they find themselves watching a steady trickle of their educated youth moving towards the funding countries in search of better remunerated work.

Basically it is not clear at this point whether this growing mountain of associated system-management problems really is capable of being digested and resolved, but one thing is surely very evident, and that is that not talking about them won't make them go away. It really is high time the ECB stopped boxing itself into a corner by examining monetary policy impacts only at the aggregated data level, and started to analyse and identify policy implementation impacts at the individual country level. Simply throwing the issue back to the various national governments by saying "this is your problem, what you need are more structural reforms" is no response at all. This will be especially true if the proposed structural reforms prove not be sufficient to handle the scale of the problem, since this will only produce an even greater loss of confidence in the Euro than that which has been sustained to date, precisely the outcome that ECB governing council members must be anxious to avoid. Or will we be told that the structural reforms implemented simply were not deep enough. What has been argued here is that the idea of a common Eurozone-wide credit cycle associated with ongoing convergence between member state economies could be regarded as a "crucial simplifying assumption" in the sense used by Robert Solow in the quote at the start of this study, an assumption which underpins the whole theoretical apparatus on which the common currency is based. The question is, after ten years of operation, does this assumption still remain plausible and reasonably realistic?