Thursday, 31 March 2016

A plan to turn the Euro from zero to hero

Guest post by Ari Andricopoulos

It is difficult to read the history of inter-war Europe and the US without feeling a deep sense of foreboding about the future of the Eurozone. What is the Eurozone if not a new gold standard, lacking even the flexibility to readjust the peg? For the war reparations demanded at Versailles, or the war debts owed by France and the UK to the US, we see the huge debts owed by the South of Europe to the North, particularly Germany.

The growth model of the Eurozone now appears to be based largely on running a current account surplus. Competitive devaluation is required to make exports relatively cheap. While this may have been a very successful policy for Germany during a period of high economic growth in the rest of the world, it cannot work in the beggar-thy-neighbour demand-starved world economy of today.

As I've explained elsewhere, reasonably large government deficits are very important for sustainable economic growth. However, in the Eurozone this is prohibited both by the Stability and Growth Pact (SGP) and by the fear of losing market confidence in the national debt. At the same time credit growth for productive investment is constrained by weak banks and Basel regulation. And the Eurozone as a whole is already running a large current account surplus; the rest of the world will not allow much more export-led growth. Helicopter money would be a solution, but politically this is a long way away. Summing up, if economic growth cannot be funded by government deficits, private sector debt, export growth or helicopter money it is very difficult to see where nominal GDP growth can come from.

In a way, this can be seen as a Prisoner’s Dilemma. Every country knows (or should know) that if all states provided fiscal stimulus, the Eurozone would benefit from more economic growth. However, for any individual state, a unilateral fiscal boost would increase their own government debt whilst giving a fair amount of the GDP growth to other states (because some of the stimulus would go to increasing imports from the other nations). And if all others provide stimulus, then it is in an individual state’s interest to take the benefit of the other states’ stimulus, and become more competitive versus the rest.

The huge imbalances created by the fixed exchange rate system, described in this great piece by Michael Pettis, are still there. The enormous current account surplus built up by Germany makes it extremely difficult for the less competitive countries to run a current account surplus. The only way for this to happen, without German inflation, is by internal devaluation; a long and painful process to lower wages, which may succeed in achieving a current account surplus, but only at the expense of shrinking the economy. The debt owed to the creditor nations therefore gets larger in real terms. In the end, the debts owed by the South to  the North are unpayable without the Northern countries running a current account deficit and using the savings built up during the amassing of the surplus to buy goods from the South. But the Northern surpluses are only getting bigger.

On top of this, all countries in the Eurozone are committing the "original sin" of borrowing in a foreign currency. This can only be a time bomb, waiting to devastate Europe. 

The effect of all of this becomes clear when comparing GDP growth in the Eurozone to that of the USA. In the period up to 2008, before the problems of the Eurozone structure became apparent, the growth was pretty comparable. This is to be expected with two similarly developed large blocs. The trend growth is driven by innovation and there is enough money flowing through the system to support it. After 2008, however, is a different story.  The growing gap between the two economies is largely due, in my opinion, to the existence of the Euro.

My prediction, as things stand at the moment, is that the ECB will never be able to have positive interest rates again. Growth will only deteriorate from here and eventually the currency union will have to break up. I do hope that I am wrong on this and that a political solution can be found.

Having said all of this, I believe that there is a solution that, given the political will (admittedly this is a big caveat) could make the Euro a workable currency. It consists of three parts, and the idea came from a Twitter discussion with Frances Coppola a few months ago, following this post by Simon Wren-Lewis on using inflation as a metric for determining how large the government deficit/surplus should be.

A three-point plan

1) The ECB should make an implicit guarantee of all Eurozone government debt, just as the Bank of England, the BoJ or the Federal Reserve do. 
They should state that all interest payments by all states will be approximately the same, ie. no member state has credit risk. This interest rate is thus a reflection of nominal growth rates across the Eurozone, and not of the individual default risk of any member state.
This is important because otherwise countries with default risk must borrow at higher rates, thus worsening their already (by definition) bad situation. This avoids the potential death spiral that hit Greece when the market lost confidence.
It also removes the risk to the banking system caused by holding national debt with default risk. Currently a teetering bank and teetering government could pull each other over the edge of the cliff.

2) The stability and growth pact should be scrapped and replaced with a new one that is fit for purpose. In a more appropriate stability and growth pact, the fiscal mandate of all member states is purely to target inflation. It does not matter if a government has a budget surplus of 5% or a budget deficit of 5%; all that matters is that it hits the inflation target.
Punishments, in the form of large fines, should be given to any government that strays too far from its cumulative target, on either side of the target, as it is a crucial part of maintaining growth and balance in the economy. Any state running too high a deficit will get higher growth rates, but they will add to the inflation of the Eurozone and thus devalue the currency for everyone else. Any state running too low a deficit will get a competitive advantage that takes demand from the other states and gives them a current account surplus at the expense of the others.

3) Although the average inflation across the Eurozone can remain at 2%, this inflation target should be different for different members. A country running a large relative current account surplus with a large accumulation of net foreign assets needs to run a higher inflation rate, say 3%. This would be set each year in advance by an independent formula. A country with large debts should run a lower inflation rate, say 1%.
The targets would be cumulative. So if a country needed to run 3% a year for 3 years and in the first two they only hit a 2% inflation target, then the target in the third year would be just over 5%. Likewise if they were getting 4% inflation for the first two years the target would be just over 1% in the third year.
This would mean that over the years, the (long under-rewarded) workers in the creditor countries would get wage rises and have more and more buying power, enabling them to buy more goods from the debtor countries. The increase of buying power means the previously accumulated savings by people in the creditor countries now flow back the other way. This makes it possible for debtor countries to be able to repay the creditor countries. Balance is restored.

In the past, the South consumed more than they produced, using money borrowed from the North to fund their consumption. In this new regime, the South would be effectively be working their debt off for the North.

This is far better than the current situation where the South is not working and the North is not getting paid.

This does not preclude the running of a current account surplus. If this is to be the desired policy, then (probably through currency manipulation) it could still be achieved. The difference would be that the surplus would be balanced across the whole Eurozone, and achieved at the expense of the rest of the world rather than other Eurozone members.


This three-point plan would address all of the main structural problems of the Eurozone.

It addresses the imbalances between nations by using inflation to force nations to equalise their competitiveness. This balance is important because it allows money to flow both ways, meaning that debts are less likely to arise and, if they do, can be repaid without creating hardship. These imbalances are the cause of the previous Eurozone crises and are responsible for Greece’s current predicament. Point 3 of the plan prevents them from building up.

It solves the Prisoner’s Dilemma problem above because it forces coordination of fiscal stimulus – it does not allow one country to take advantage of the others to boost its own competitiveness.  It means that Eurozone nations would no longer be undercutting each other for competitiveness.

It removes default risk, allowing governments to run large enough deficits to allow nominal GDP growth. It removes fear of borrowing so that governments can invest in projects that will improve future growth. It means that governments would no longer need to pay credit spreads to bond-holders; a cost no sovereign currency government normally has to pay. And it removes the sword of Damocles from above the head of every debtor nation. No longer would economic survival be a case of "there but for the grace of the bond markets go I".

It does so without allowing any country a free pass.  One nation may have larger debt than another, but not enough to cause the inflation so feared by Germany in particular. And because of the differential inflation rule, higher debt countries will naturally be able to pay off that increased debt.
And there are no fiscal transfers between countries. These, for obvious reasons, are very unpopular between nations and can cause a lot of resentment. Every time a country defaults in the current system, transfers are made and rifts between nations are built up. This is very damaging to European unity and can be avoided.

But the biggest benefit of all is that it would mean higher economic growth for every nation in the Eurozone.

It is my wish that we can find the political will for this type of solution. Surely this is the true meaning and spirit of European cooperation; working together to have a better outcome for all.


Ari Andricopoulos is a principal at Dacharan Advisory AG, an investment manager. He has a Ph.D in Financial Mathematics from Manchester University and has published in various academic finance journals. His personal blog is Notes On The Next Bust. Follow him on Twitter @ari1601.

Image from Carlos Latoff via, with thanks. 

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  1. Realistically how effectively do you think individual states within the Eurozone can hit inflation targets? Is there ever going to be enough fiscal freedom? I think the evidence suggests that even monetary sovereigns are poor at hitting inflation targets. Personally I would include employment rates in there as a target too. Getting rid of the current stability and growth pact is obviously a good idea but I can see a lot of political resistance - pretty much the same as fiscal transfers. There just seems to be entrenched thinking against such a move.

    1. I think that fiscal policy is actually a much more straightforward way to hit an inflation target rather than relying on the more indirect effects from monetary policy. Fiscal policy allows direct injections of money to boost demand - monetary policy is less targeted. This is especially true at the lower bound where the monetary policy used is of the barely tested variety.

      I agree with you about the political will needing to be there and this part would be very difficult to achieve. Partly this is because there is not widespread agreement that there is even a problem to solve.

    2. Aw here there's an easy way to sort it all out----scrap the EU in the morning and we can all look after our own affairs and take responsibility for our own successes and failures and hopefully avoid being pushed over a cliff by incompetent Eurocrats.

  2. It is easy inducing a fiscal stimulus if inflation is low but less easy to constrain (I.e austerity) when inflation rises over target. It is at this point that monetary tightening (rate increases) becomes a better tool for managing inflation. In fact this highlights that the two need to work in tandem. It is because we have this irresponsible fiscal constraint that we need to go full throttle with money. Both levers then become useless.

    1. Inflation over target would be a nice problem for the Eurozone to have!
      Increasing taxes over spending (the direct opposite of fiscal stimulus) is in fact a very effective way of reducing inflation. But again movement of the EU/Eurozone towards tax harmonisation limits the potential of this.

  3. If you want the ECB to implicitly guarantee of all debt, why not simply ask every member of the EZ to hold a referendum that would read...

    Do you want to become a territory within the federal United States of Europe, with the federal government to be based in Brussels or Berlin.

  4. This seems to be a "constrained" form of fiscal union (no transfers). Rather similar to what might eventually have been proposed should Scotland have voted to leave the UK but wished to retain Bank of England as its central bank. Politically impossible I suspect, but not unreasonable.

    But would ECB be a "proper" central bank, a lender of last resort to the € zone commercial banks? That would also be necessary, I think. At the very least it would require a € zone deposit insurance scheme. This is also politically very difficult and reopens the transfer issue.

  5. Disagree with this article on a fundemental level.
    He wants the south to resume "work" to pay off the north.
    This working for nothing will just add to costs (inflation)and therefore reduce the standard of living even further.

    The function of work should be to produce goods for consumption ( not to add to Capitalistic friction in the name of work)

    The author wants to become another US or Uk inexplicably forgetting these are also failed societies.

    Refer to Oliver Heydorns recent piece - "the social credit path to sustainable consumption."

    It has become very clear that "working" or near full employment in the UK has had devastating effects on the real standard of living given the wasted effort required to access the mainly european industrial surplus.

  6. "The south working the debt off to the north"
    This is the "successful" Irish model of export lead growth...
    A economic model that requires sociological collapse.
    A continual neverending and chronic deficit of local consumption
    The ICB recorded another 3.7% drop of Loans to households in February.(consumer credit is the only current domestic albeit grossly inefficient and destructive means to distribute purchasing power)
    Currently it's absence is creating a massive house purchasing crisis rather then a physical house shortage as is commonly purposely falsely stated.

    The crisis is one of distribution of purchasing power.
    The current system requires additional production to distribute additional purchasing power.
    But this additional production creates costs which can never be recovered.
    We see in Ireland the fascist national roads authority beginning to restart production and destruction of the countryside so that people can save 5minutes of their lives while almost all local shops and pubs have closed.

    How on earth can such a economic dystopia be someones vision for the future?

    As Oliver Heydorn states you must be prepared to freely give more so as to prevent the chronic waste witnessed in our breaking societies.

  7. If government deficits no longer matter, why should a country be worried about a fine when it doesn't hit the inflation target?

    1. Hmm, good point. And there are other issues, like running large non-inflationary deficits by, for example, giving big tax cuts to the rich or otherwise giving out monetary favours.

      These sorts of problems would need to addressed some way, but in the end this idea does need the governments to act responsibly or it too will fail.

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  10. Dork, you are off topic AGAIN. Last two comments deleted for this reason. This post is not about the UK.

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  11. Varoufakis and the 40 Thieves knocking at our backdoor. That's the idea of the potato soup communists all across EUrope. It's their freedom to do so but then we will have to quit. The French did not want Austria to join the E.U. Well then, they were right.

    That's more or less a similar idea Mr. Heiner Flassbeck has been promoting for years now. As far as I have understood he simply suggested that in a first step Germany has to raise the incomes and people should buy (which is the hard part) and the countries should focus on their unit/labor costs - that's inevitable. If they want more those countries should focus on becoming more productive. That's more or less enough to make the EURO work again.

    The Germans will not weaken their economy and their people will not buy more, because those who need the money will not get it anyway. No way.

  12. What do you think the answers are for Scotland Frances ?

    Was it a mistake to take extra powers since they don't have their own currency ?

    1. The UK is a full fiscal union with fiscal transfers, unlike the Eurozone. Obviously the further we go with devolution, the more the union is weakened. That's why the Smith Commission stopped short of recommending full transfer of tax and spending powers to Scotland.

    2. Thanks,

      But when the Scots tax more and the spending keeps on getting cut is that not a reciepe for disaster.

      Would it not have been better to leave the taxes alone and let people spend or save ? Or try policies that would make people spend instead ?

      I'm not sure how the new set up will work. How will the extra taxes be turned into Scottish goverment spending in this new set up? Because as we know in the current set up they are destroyed in the reserve drain.


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  14. National level inflation targets do not make sense, when any product or service that can be traded long distance is not priced nationally and out of control of national governments. Maybe a nominal wage inflation target could make some sense, though targeting any inflation number when you don't control the money supply is a bit fishy.

    An open guarantee of member state debt is not gonna happen, it's too much of an open chequebook. Ari do you give your credit card number, CVV and PIN to all your friends and just expect them to behave? There's no alternative to an Eurozone treasury and matching institutions.

  15. Regarding the inflation, I always say that inflation of domestic goods and services is the only important measure as any inflation/deflation imported from abroad is not a measure of domestic demand. One should raise interest rates only if domestic demand is too high. Imported inflation, if anything, has a tightening effect, which should not be added to by further monetary tightening.

    So yes, I agree, domestic inflation or wage inflation are both more sensible measures than raw inflation numbers.

    The point about the 'open chequebook' is that every other major economy has the same open chequebook and still act responsibly. I don't believe that an economy can work effectively without full central bank support. I write about this a lot in the paper on my blog.

    I would also suggest that many countries run suboptimal policy (eg the UK) by thinking that the chequebook is arbitrarily closed when it isn't.

    I'm not saying there aren't huge obstacles to any plan like this working. There would need to be a lot more rules put in place. There would probably, for example, need to be some synchronisation of tax policy. And certain commonly agreed standards for government spending.

    What I am saying is that I believe that something like the suggestion above is the minimum requirement for a currency union of this nature. And without it the optimal option, by far, is an amicable, organised break up of the Eurozone. And soon, because it causes more and more damage every year it runs.

    1. No, no major economy allows others to print their currency. Through your ECB guarantee on member state bonds, you allow any member state to print euros (because the guarantee makes bonds = banknotes) which is both too riksy and has zero chance of becoming politically acceptable. If you need to add more and more rules at some point it should be obvious your solution is much harder to implement than a federal treasury. This proposal is the worst of both worlds: it combines the disadvantages of federalism with the disadvantages of disbanding the euro (which is indeed also an option).

      I don't think central banks, or more generally money, have as much impact as monetary geeks thing they have... (though I fully understand that people like to think their area of expertise is all important.) Try to play through the following thought experiment: what would happen if governments simply withdrew from the business of money issuance? Would the world end or would people simply use some asset index or other as a unit of account? Any liquid paper is currency at the functional level. To avoid distractions, assume paper cash has gone Swedish (been replaced by electronic payments) worldwide for the purpose of the thought experiment.

  16. It's always interesting to read new proposals to make the Euro a "viable currency". The problem is however the same at least since the International Clearing Union was first proposed: no matter how sound the coordination rules would be, there is no way they can be enforced. Points 2 and 3 are therefore based on wishful thinking. They would replace the current (stupid) rules with admittedly better rules but they would be equally inapplicable. Deficits countries will be forced to adjust, while surplus countries will not be under the same pressure. And power politics will always make sure that sanctions are never imposed.
    So the only real solution would be point 1 which would essentially make intra-EZ trade imbalances irrelevant. Countries could keep financing their trade deficits while maintaining employment through fiscal deficits. This would make the EZ into a quasi federation. Of course if such a proposal were to be realistically made, it would drive Germany and other countries away from the project and lead to the collapse of the Euro. Trying to "save" the Euro by making it something else from a fixed e/r arrangement is a self-defeating strategy.
    Only countries with flexible exchange rates and autonomous fiscal and monetary policies can avoid - to a large extent - the need for coordination. This is after all the lesson of the Gold Standard demise of the 1930s, as Eichengreen has explained.

  17. What is really needed is an implicit guarantee of the ECB of my debts. Then at least i would be happy.