Those who think there is a realistic alternative to the euro are living in cloud cuckoo land

DISCLAIMER: This blog post is not, and should not be construed as, a recommendation or solicitation to buy or sell currencies, financial instruments or securities of any kind.

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

(J. M. Keynes, The General Theory of Employment, Interest and Money, 1936)

I read this morning in Swiss daily Le Temps that markets are focusing exclusively on the crucial matter of knowing whether Signor Berlusconi, the Italian Prime Minister, is going or not to resign. As I write this, the yield on Italian ten-year bonds is not very far from 7 per cent. That’s right: if those bond yields were, at some point in the next ten years, to drop to, say 3.5 per cent (German government bonds currently carry under two per cent, so it’s not that absurd an assumption, and Italy’s were trading at not far above that level at the start of this year), anyone who pushed them today would stand to make a massive capital gain on their investment. If they merely stood still, the annual yield would still be unprecedentedly high, in real terms.

The particular turn of events taken at this juncture by the ongoing Eurozone ‘crisis’ is perhaps a good reflection of what—really rather understandably—repels conventional critics on the Left about ‘markets’: their patent irrationality, indeed at times their stupidity; how can the fate of a middle-aged, failed Italian gentleman with died hair be the only factor underpinning the wider issue of what happens to the world economy?

Is Italy’s situation really that dire?

Italy's budget deficit
Source: Paolo Manasse — Figures based on Eurostat and Signor Manasse’s calculations.

Is Italy’s situation really that bad? The above figures, based on Eurostat numbers, show how, according to Signor Paolo Manasse, the commenter who provided them:

[…] ‘fifteen years ago, the elimination of currency risk allowed Italy to bring down the average cost of debt from 10 to below 4 percent today, while the interest bill fell from 12% to 4 percent of GDP, allowing a significant improvement of the budget and a strong reduction of the debt ratio, at least until 2004. Note, however that the adjustment effort, represented by the primary balance relative to GDP, gradually weakened over the years. In 2005-6, coinciding with the third Berlusconi government (3), the debt/GDP ratio started to climb back. In 2008-2011, thanks to the crisis and the fourth Berlusconi term, the debt ratio reached its 1996 level, and the primary balance fell in negative territory (and marginally rebounded): 15 years of progress were squandered’.

Yet is the panic really justified by fundamentals? Italy’s budget deficit, as a percentage of GDP and as estimated by The Economist, is lower than that of France: 3.7 per cent against 5.8 per cent: it only threatens to rise because interest rates are skyrocketing, not the reverse, a classic case of chicken-and-egg gone slightly mad. Public-sector debt, moreover, is not all the story. The indebtedness of Italian families and Italian non-financial corporations, according to The Economist, is the lowest in Europe (42% of GDP, compared with 103 per cent in the UK, 84 per cent in Spain, 63 per cent in Germany and 51 per cent in France) and this makes the Italian aggregate debt lower than that of Great Britain, Spain and France, and similar to that of Germany. There is thus little overall rationality in the huge spreads currently demanded of Italy—Italy is not insolvent.

The Greek case can be treated in isolation, as its awful fundamentals justify

Greece’s situation is considerably more dire. But that is precisely why it ought to be treated in isolation by the authorities of the Eurozone—and based on fundamentals alone, not on market sentiment. Although I don’t wish to embark on comprehensive analysis, I’d like to make few chosen comments about the prospect of Greece leaving the Eurozone: one trivial, simple lesson can be learnt—and it seems it still hasn’t been by many people: there is nothing wrong with voluntarily choosing to give up control of monetary policy, by entrusting it to a well-run, credible supranational entity. But if you choose to do this, it is the height of folly to mismanage the only macroeconomic policy instrument that remains available to you, namely fiscal policy.

The Greek government and people who, unlike the Italians, have been living ever since the 1990s on the untold assumption that they could indefinitely rely on the credit of the rest of the zone, because at a mere 3 per cent of it, this was something their partners could afford to do and be willing to do in perpetuity, have had their bluff called [i]. They appear to be discovering this with sudden rage—and the same can be said for many sections of society and, indeed, government—which refused to see the Greek Ponzi game collapse coming—in other parts of the Eurozone. But the difficulty had been foreseen when the foundations of monetary union were established twenty years ago. It isn’t the system that needs mending—but rather its implementation.

The euro wasn’t designed on a whim: but its basic premise, which implied resurrecting a Continent-wide gold standard, cannot alone sustain the economies of the zone in an era when massive quantitative easing is the rule everywhere else

The euro wasn’t designed on a whim, nor was it a technocratic monstrosity conceived without any understanding of, or interest in, the practical workings of European economy. The opposite, in fact, was unquestionably the case. Monetary Union was based on decades of previous work, including the Werner Report that had preceded earlier attempts at setting up a single currency in the 1970s, the ill-fated snake in the tunnel.

According to the Werner Report, ‘monetary union came to imply the irreversible convertibility of currencies; the elimination of fluctuations in exchange rates; the irrevocable fixing of parity rates; the complete liberation of capital movements and the centralization of fiscal policies’ (Werner Committee, 1970).

From the experience gained in the course of all those earlier, failed attempts at monetary union in the 1960s, the groundwork for the single currency was laid. In the Delors report, and subsequently in the Stability and Growth Pact, adopted in 1997, a framework was proposed and adopted aimed at ensuring that fiscal discipline would be maintained and enforced in what was to become the euro zone. The difficulty is not that the framework was inadequate: it is that the rules were not kept—and that France and Germany, the zone’s largest members, gave a bad example almost from the start by not sticking to them. It’s little wonder that everyone else followed suit.

That is not the say that the institutional framework of the Eurozone does not need to evolve. Paul De Grauwe recently made a convincing case for this: the zone cannot continue to function according a sort of resurrected gold-standard, with the European Central Bank (ECB) taking only inflation into account and refusing to act as lender of last resort when the Federal Reserve, the Bank of England and the National Bank of Japan all do so on a massive scale. The basic premise underpinning the European central Bank’s foundation, namely that it should not in any circumstances bail out participating member states, was born out of a rather curious, quasi-mystical marriage of convenience between the ancient German phobia of inflation and the reluctance of all member states, in the 1990s, to surrender control of fiscal policy as well as monetary policy. The ECB was also created at a time when monetary orthodoxy and central bank independence were the dominant economic praxis.

Neither of these premises holds quite as true today: despite massive, worldwide quantitative easing, inflation has not come back in anything like a threatening form in any major OECD economy. This does not mean it will not rear its ugly head eventually, or even that that would be altogether a bad thing. But the point is that at present that fear is less likely than ever to deter the participating countries of the Eurozone from aligning their mutualized monetary policy more closely on what has recently become the norm elsewhere. Equally, the disastrous failure to control state budget deficits, which has now been shown to be a huge mistake, means that the core countries will have no choice but to make their fiscal policies converge also, and in a more sustainable manner.

Governments should stick to improving economic fundamentals rather than living in fear of the markets: the same markets which are currently unhappy that the ECB cannot flood the economy with unlimited supplies of liquidity could just as easily complain if the rules governing the ECB were suddenly revised to allow it to carry out quantitative easing

It certainly wasn’t a good idea for Greece to join the Eurozone in the first place. Yet the fact that the treaties don’t provide for withdrawal from the common currency is irrelevant: Greece accounts for just 3 per cent of the Eurozone’s GDP, so technically restoration of a national currency would not be infeasible, though of course the resulting adjustment in living standards, with the cushy prop provided by the rest of the zone gone, will be painful for the Greeks. yet paradoxically, for that same reason, while Greece's departure from the euro would be justified on fundamentals, and would send healthy signal that would prod the financial markets away from their current state of exuberant bearishness over Italy, the reality is that even if Greece does not leave, the euro will survive, because there is simply no better alternative to it—no other major reserve currency has substantially better (or worse) fundamentals: the same markets which are currently unhappy that the ECB cannot flood the economy with unlimited supplies of liquidity could tomorrow complain, with equal aplomb, if the rules governing the ECB were suddenly revised to allow it to carry out quantitative easing.

The essential lesson, for the Eurozone, of the past ten years, is that governments should strive to provide the legal, macroeconomic and structural environment to allow economic agents to produce wealth—not focus their attention, as the French government seems in particular to have done for a while now, simply on market sentiment. Any analysis that focuses on the European treaties as the root cause of Southern Europe’s problem is simply wrong. The reason why Greece, Spain and France are all experiencing serious difficulties in achieving their growth targets is rather because there are to many structural obstacles to wealth creation.

The reality is that markets are irrational—and that is why they provide opportunity for any investor who merely acts more rationally than the average. Keynes demonstrated this about as scientifically as can ever be hoped [ii]).

Indeed, as I write this, the euro remains strong against both the dollar and sterling. This reflects the fact that markets have little to choose from by way of alternative investments: they can hardly allot all their assets under management to Swiss franc short-term deposits or gold, which offer nil or negative income. Meanwhile, the massive quantitative easing embarked on in the US and the UK, while they may or may not pay off in the longer terms by inducing the much-desired economic recovery, don’t make for more attractive investment vehicles in the short term. Thus while I wouldn’t hold much hope for the Greeks, I don’t for a moment think that Italy, let alone the euro, is doomed. Those who think otherwise are living in cloud-cuckoo land.

  1. Figures show clearly that for years Greece was importing massively from Germany and France and financing for those imports was provided by German and French banks, often on basis of fiddled statistics. In reality, poor fundamentals made this situation totally unsustainable. The reluctance of the French and German governments to countenance the inevitable Greek default is thus explained by the fact that it would shift the problem from being a Greek economic problem to a German and French financial one.
  2. ‘According to Keynes, animal spirits are a particular sort of confidence, “naive optimism”. He meant this in the sense that, for entrepreneurs in particular, “the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death”. Where these animal spirits come from is something of a mystery. Certainly, attempts by politicians and others to talk up confidence by making optimistic noises about economic prospects have rarely done much good.’ (The Economist, Economics A to Z.