Capital Flows in Greece

Data from the Greek central bank indicates that capital flight has reached and all time high. Over the last six months through March, about 62 billion euros ($67 billion) were taken out of Greece, approximately 25% of GDP.


Why?  Depositors and investors are moving their euros out of Greece to safer places such as Germany, depriving the Greek economy of the private investment.  Negotiations over loans from Germany and other official creditors are bringing Greece ever closer to sovereign default and possibly its exit from the Euro zone.

For the full article:

Chapters 7 and 8 of The Euro Crisis

Chapter 7
The situation in southern Europe is mostly seen through the lens of Greece. The author claims that had Ireland asked for financial assistance first, then Greece would not be the center of the Euro crisis, but in fact it would be Ireland. Politically speaking, Ireland is a less attractive scapegoat because it involves a situation similar to that of the U.S.   Debt to GDP ratio was 54% of GDP in 1998 and came down to 25% in 2007.
Greece on the other hand missed the 1999 entry into Euro and joined Euro in 2001. Covered up debt and budgetary deficit was never below 4.5% (Ceiling was 3%) Public Debt was 129% of GDP (60% benchmark). Greeks used more pension money, had a lower retirement age, and did not spend EU grants well.

Euro Crisis revealed two flaws in the Euro Area framework.

First is assumption that threats to stability would come from Public Sector. Private sector is also major source of instability.

The second mistake was assuming that monitoring deficits year after year was enough to prevent a public finance disaster.  Financial crises often appear very suddenly and there needs to be a plan in place for when things go wrong.

The author goes on to say that blaming Greece for the crisis is an oversimplification of the problem: “Since the state is the insurer of last resort, its finances are vulnerable to all sorts of economic and financial shocks. Acknowledging this potential fragility and designing an adequate surveillance framework is more difficult than stigmatizing a small Mediterranean country for its (very real) turpitudes”

Chapter 8
Inflation rates across the Euro area  were very different, but the ability to spend was the same (interest rates). A Price differential occurred in non-tradable goods across the currency union, thus leading to differing rates of inflation. With the nominal interest rate being fixed for each country,  real interest rates began to differ as a result of the differences inflation.  This means that the ease with which households could borrow money depended on the inflation rate of the country they lived  in. When Spain adopted the euro in 1999, interest rates dropped as a result of accelerated convergence. This resulted in lots of credit and massive real-estate investment. The net effect was Spain’s external deficit widened from 4% to 10%. Divergence in Euro Area become a problem around 2005 and 2006. Even worse, the Central Bank of Spain could not do much to fix this because interest rates are set by ECB.

In short, European institutions did not hold up their end of bargain to monitor inflation rates and ensure that they were similar across the Euro Area.  Policy makers failed to act because they believed external deficits were not  big deal in a currency union.

Notes on Chapters 5 and 6 of The Euro Crisis and Its Aftermath

Chapter 5

In short, those who promoted common currency hoped it would eventually lead to common political institutions.   Euro-area members, however, kept their respective seats at IMF, G7, and other international organizations. So the members of the Euro did not completely unify themselves politically.  Economic policies do not have to be identical to be part of a currency union but counties do have to put more thought into unintended consequences of their economic policies.

European countries should have put more thought into whether or not joining the Euro was a good idea economically. The United Kingdom ran stress tests to determine whether or not it should join monetary union. Clearly the decision was political and the tests where just a way of checking a box, but more countries should have adopted an approach similar to that of the UK.

Chapter 6
France ran it larges current account surplus in its history when entering the Euro in 1999, while Germany ran a large deficit. Twelve years down the road and Germany was running a surplus while France was running a deficit. Why?

It took time for Germany to get back on its feet after reunification. East and West Germany formed a monetary, economic and social union. West Germany was economically competitive and East Germany was not. People in the East wanted to buy goods in the West. Infrastructure and capital stock had to be replaced. Germany chose to reinvent itself by removing parts of its economy which it knew it did not have a comparative advantage. It focused on thinks like technology that required a highly skilled labor force. People began exporting parts and importing partial goods as firms began to embrace globalization. This eventually resulted in destabilizing factors.

Germany  saved during the first decade of the Euro which caused problems. As a result of saving, demand in countries in the north decreased will demand in south kept increasing. Before long, countries in the north were financing countries in the south.

The other destabilizing factor was the interest rate policy. The monetary policy had to be set for the euro area as a whole, not individual countries. This means that a country like Germany who deserved a low interest rates was causing other countries like Greece to get the same low rate. In other words, the monetary policy was too expansionary for the countries in the south.

Indifference and Political Gridlock Could Result in Grexit

The other day in class, part of our discussion on Greece involved discussing whether or not Greek politicians were indifferent to their debt issues.  This Bloomberg article asserts that Greece will likely leave the Euro in part because its politicians simply do not care about their overwhelming debt.  The evidence for this  comes from a lecture given by Yanis Varoufakis in 2013 where he recommends Greece defaulting like Argentina did:

“My proposal was that Greece should simply announce that it is defaulting, just like Argentina did, within the euro in January 2010, and stick the finger to Germany and say `well, you can now solve this problem by yourself’.

What is more insightful is his attitude toward the consequences of Greece defaulting:

“The most effective radical policy would be for a Greek government to rise up or a Greek prime minister or minister of finance, to rise up in EcoFin in the euro group, wherever, and say “folks, we’re defaulting. We shall not be repaying next May the 6 billion that supposedly we owe the European Central Bank. My God you know, to have a destroyed economy that is borrowing from the ESM to pay to the European Central Bank is not just idiotic, but it’s the epitome of misanthropy. Say no to that. Put them in front of their contradictions. Make them face the contradictions of the euro zone themselves. Because the moment that the Greek prime minister declares default within the euro zone, all hell will break loose and either they will have to introduce shock absorbers, or the euro will die anyway, and then we can go to the drachma.”

However, it is not fair to place all the blame on Greece and the author does mention that leaders in the Euro area should put less pressure on Greece to pull itself together. The article suggests that this is unlikely when talking about German Finance Minister Wolfgang Schaeuble and his thoughts on Greek debt.

Ultimately, the Euro may be unsustainable because politicians in both parties simply refuse to work out a deal.

Irrational Investing

Interesting article about people in the Euro Zone not taking advantage of access to higher interest rates.

Debt to GDP Ratios Since the Financial Crisis

I found this short article and it kinda reminded me of what we said about Greece being the tip of the iceberg with regards to the Euro zone. However, this article only briefly mentions Greece and looks at debt since the Financial Crisis. It was interesting to see how global debt to GDP has increased since the Financial Crisis. Even more intriguing was how much China’s debt to GDP ratio has gone up in comparison with both the U.S. and Germany.

Why the Euro?

The second chapter of The Euro Crisis gives the reader some insight to both the political and economic reasons behind unifying the continent of Europe underneath one currency.  A Canadian Economist named Robert Mundell  first came up with the idea, known as an optimal currency area, in 1950. There are three factors to consider when determining whether or not two countries should share common currency:

1. Degree of integration – If two countries frequently trade and invest with each other, then a common currency reduces risks and conversion costs.

2. Degree of asymmetry – When two countries produce similar goods and services, they are likely to require similar economic policies.  If this is true, then they should consider using a common currency. However, if these two countries are asymmetric with regards to these factors, then they should avoid using a common currency.

3.  Mechanisms that correct for divergence – Countries can diverge in a variety of ways such as migration, capital flows, and internal price flexibility. If there are strong polices in place to counteract divergence, then countries should consider sharing a single currency.

There were differing opinions about whether or not the euro met this criteria.
People like Jeffrey Frankel of Harvard and Andrew Rose of the University of California, Berkely said unifying European countries underneath one currency would diminish asymmetries and strengthen correction mechanisms.  In other words, European countries did not meet the criteria for forming an optimum currency area, but the very act of doing so would make them eligible over time.  Others like MIT economist Paul Krugman disagreed saying companies in the same sector would moves so as to gather geographically in an area and strengthen asymmetry between countries(the book uses Silicon Valley and Wall Street as examples).

Policymakers chose to disregard advice against forming the euro for a number of economic reasons:

1.  Europeans do not like fluctuating exchange rates (A topic the book was not considerably helpful on except to say that monetary policy played a role in the disputes European countries has with each other).  The cause for a common currency was reinforced by the idea of an internal market for goods and services along with protection against competitive devaluations.

2. The second reason was the trilemma: Countries cannot have stable exchange rates , free capital movement, and independent monetary policy all at the same time.  Europeans generally wanted stable exchange rates and free capital movement, so they chose to give up independent monetary policy.In pursuing free capital movement and stable exchange rates, Europeans where left with fixing an exchange rate or developing a common currency.   Countries tried pegging their currencies to the German mark as it was seen as being the  superior currency (though the author does not clearly state why). However, the monetary policy set by the Bundesbank catered to Germany’s needs and not Europe’s.  Additionally, German monetary dominance was not likely to last forever, so the next logical step was to form a monetary union.

But there were also political reason for forming the euro.
French president Francois Mitterand wanted to ensure Germany did not dominant the continent in the post-Cold War era and thought that unifying Europe as whole would accomplish this.  Other European leaders also felt compelled to unify Europe in some way.  German Chancellor Helmut Kohl agreed to the euro project in the interest of showing that  unifying East Germany and West Germany would benefit Europe as a whole.

WSJ Documentary on Debt Crisis

I watched a short documentary on Greece and the European Debt Crisis by the Wall Street Journal.  There were two major points that stood out to me as it pertains to the research question:

1. Countries belonging to the Eurozone must be fiscally responsible

This does not mean that member countries never borrow or spend on credit. It means that they are both willing and able to pay back money that they borrow.

2. Some central authority, like the ECB, must ensure the members of the Euro area maintain fiscal responsibility if they refuse to do so on their own.

It is doubtful that the Euro will be sustainable in the long run if member countries will continually require bailouts or default on their debt.