Monday, 18 July 2011

Plan A for austerity; Plan D for default and devaluation

Slí Eile: Events are moving fast on the European monetary plains. Suddenly, various 'unthinkables' are being mentioned as real possibilities rather than impossibilities. Whatever the coming days and weeks hold a number of inconvenient truths are emerging:

European political leadership is at an all time low since the foundation of the European Coal and Steel community in the 1950s.

National interests are dominating over any sense of collective European 'esprit de coeur' and to the fore in various national interests are national financial interests.

The institutions of the European Monetary Union are not up to task - we have in some respects a house built on sand (and when the gales blew etc)

In the long-term (and possibly in the coming months) you can have a 'transfer union' and growing federalism or you have an EU without a single currency but you can't have both.

Like marriage single currencies are very attractive and lead to all sorts of mutual gains, lowering of transaction costs and increased market certainty when the partners are 'in it together'. But when communication breaks down so does trust and the current arrangements represent a pact 'til dissolution do us part'. Moreover, when the partners squabble endlessly over what is mine in terms of assets, debts and sharing of these then trouble is on the horizon. Responses at the European level have, to date, focussed on fiscal austerity with the addition of some clumsy attempts to rescue a number of peripheral countries in the Eurozone while all the time denying that there is a larger elephant in the European Euro parlour.

At the end of the day all of this comes down to who gets paid off and who has first claim to the assets of an insolvent corporation. Without wishing to over-simplify the current politico-economic crisis - financial institutions and funds in France, Germany, the UK and the US want to get paid back, the ECB wants to save the Euro and are ready to sacrifice absolutely anything for it, German and French politicians are watching their electoral backs. The IMF is playing good guy but you really would not want to be dependent on the IMF if you can help it. Read up on the last two decades of reform and adjustment in various nations in receipt of its magnificence. As for the domestic political response in the periphery let charity restrain this commentator.

'Plan A' meaning austerity (as Wolfgang Münchau terms it)is not working as it is compounding the problem by embedding debt through automatic fiscal stabilisers. Plan B is a muddle through involving some type of debt relief together with some fiscal transfer and contributions by bondholders. Plan C is Plan B plus a wider EFSF umbrella to save the big ones like Spain and Italy and Plan D is - you have guessed already - default and devaluation to continue with Münchau's terminology.

One way to prepare for the future is to deny it. Another is to assume the worst and prepare for it (secretly or openly). One wonders if policy makers and senior officials in Merrion Street are currently discussing 'what if' scenarios at a more leisurely and studied pace than what happened in September 2008. A good night's sleep would help.

And still more options include hoping for the best and proactively going for it while being prepared for the worst. The Euro is not dead yet. Even it if does not survive in the shape that we know it (in other words some countries exit in a more or less orderly fashion) it may be worth giving it another try. There is a lot to be gained and lost both ways. The protagonists for default and devaluation here in Ireland (the latter meaning the creation of An Punt Nua) need to spell out what that might mean for savings, deposits, capital controls, direct foreign investment, interest rates, mortgages and ultimately - jobs and living standards. They may argue that we are going down the swanny anyway and it is best to exit or threaten to exit before events impose themselves on us. Now they have a point bearing in mind the denial of reality in September 2008 and again in the latter half of 2010. However, the risks involved in wholesale and large-scale sovereign default allied to currency break-up are huge, unknown and without precedent. Ireland, Greece, Portugal, Spain and Italy are not Russia, Mexico or Argentina.

Right now citizens and progressive movements in Europe need to act together and reason out a number of solutions. One modest - very modest - way forward is for a European wide push that henceforth bondholders for insolvent banks should not be paid a cent. It will not - of itself - kick start economic growth and job creation but it points in the right direction and would help countries who desperately need some fiscal elbow room to crowd in investment where economic activity is being crucified by a thousand cuts. The idea of letting these categories of bondholders take the hit is hardly a revolutionary proposal as economist Colm McCarthy argues in the Sunday Independent here that:

Minister Noonan should now be seeking European support for an end to payments to holders of bonds, guaranteed or unguaranteed, in the Irish banks. Every cent paid to them is at the expense of the holders of Ireland’s sovereign debt, who have been treated in quite cavalier fashion at the behest of the European Central Bank and apparently in response to threats from this unique organisation.

Surely progressive economists and commentators can be a tad more radical and courageous than an existing pillar of economic orthodoxy?

Can we hope that at last the cent is beginning to drop on politicians, economists and progressives?


Madeline McKeever said...

I would be interested to know what you and your colleagues imagine would happen in the event of Plan D. I can only see as far as the ATM machines giving up.

disgruntled observer said...

As someone who has quite clearly come down on the side of leaving the euro, I’ve thought about this position a lot. I’ll be straight up and say as a lay man, I’m not even close to being an expert on knowing the immediate consequences of such a decision. I would assume capital controls, which as Gary O’Callaghan on the Irish Economy blog has pointed out would leave us with about a year, due to cash balances already built up, to get some semblance of control over the situation. His stance is that we have within our domestic banking system a surplus of domestic assets over liabilities.

Okay, maybe my view is overly simplistic, but here goes nonetheless. (Please correct me if I am wrong).

The euro is essentially a straight jacket. It’s an asymmetric system with a deflationary bias, built around a trade-surplus creditor core. As it provides no means of endogenous credit creation it necessarily implies running a trade surplus. However, short of every country running a trade surplus, it therefore entails both de-industrialization and persistently high unemployment in large sections of the currency zone. Now this may seem like something that could be corrected, however, it would imply either a restructuring of core-creditor, trade surplus countries towards domestic demand growth, which (note the demographics of these countries) they are wont to do, or it would require an outright treaty change to allow the ECB to fund deficits.

Absent deficit spending by governments, credit creation proves the purview of the shadow banking system. In fact, this is a necessary correlation of trade surpluses in creditor countries. The money must go somewhere. It did. It chased yield and ended up in the Irish and Spanish property markets amongst other places. The rise in our real economy interest rates and the fall of Bund yields are to a large extent a function of the breakdown of this system. There is a reversal of this flow of funds from the core to the periphery, which is driving down the cost of credit in the core. With all other things being equal, and in theory at least, this would facilitate the rebalancing in the core, (which may well prove the case in the medium term), however, the most likely effect given the current bias towards wage restraint to control “inflation-expectations” of all things, just implies an asset price bubble in the core, or some sort of carry trade.

to be cont...

disgruntled observer said...


The problem with this is that whilst the core rebalances, the periphery remains on the rack. The economic consequences are enormous, as we are now experiencing. Our trade surplus may be very real, but note the carnage in the domestic market. We are faced with continuous declining credit, which implies continuing and declining deposits. I take Steve Keens view very seriously, that it is credit that creates deposits, in contrast to the mainstream neo-classical view that it is the other way around.

Now if we peripheral nations were to default on the banking debt/national debt, I would say fair enough, we could remain in the euro and given an appropriate economic structure run a fairly healthy economy, however, I don’t see this happening. First, the politics, but second, given the eurozone economic structure, this would become a recurring theme. Default would become a built in feature. It was one of the criticisms of the ESM. But also, we essentially need cheap credit and higher taxes: on wealth, high incomes, excessive profits, etc, in order to get us out of this. But the Maastricht treaty runs contrary to the former, and without it we cannot do the latter.

I’ll be perfectly honest with you I am not an economist. I may be wrong with what I’ve written above, but if there’s any truth in what I’ve described, it’s because its there to be seen. However, I don’t have any models for what might happen should we re-introduce our own currency. A large portion of it would depend on the politics of the event, but also what would accompany it. However, I will say, that economies are essentially stochastic systems with dynamic loops feeding one on the other. Ours are utterly destructive at present, and in the absence of serious economic reform (not meant as a euphemism for austerity), Europe wide, I cannot see how the euro is fit for purpose. My call is really for to bite the bullet whilst we still have teeth.

One last thing: In a comment on a previous thread I spoke angrily of the politics of the EU. I stand over those comments. Democracy is the imperative. Everything else is secondary. And far too many of our European and even native politicians are not democrats. That needs to be understood.

Slí Eile said...

@Madeline - your question is exactly mine. Those calling for default and devaluation now need to be upfront and clear on what the risks are. Nobody knows for sure exactly what would happen. Various scenarios are possible depending on the movement of political events. A breakdown in cash flow and closure of banks for a a number of hours or days is certainly possible. Iceland managed their Plan D but it involved much pain for most people - especially the poor and vulnerable. A more severe economic slump is possible here in the wake of D. Inflation on imported goods would rapidly erode living standards. Many more would be pushed into negative equity. My point was that Plan A is leading unavoidably to Plan D. I don't think that A or D are the right way to go. We must try some combination of B and C. However, politically that may not be possible and we may be faced with D whether we like it or not. So, we have to be ready for all eventualities. One thing is certain - continuing on with the present course is not tenable. Sooner or later something will give. What we need now is strong courageous leadership - at European level and Irish. If some of the fire and courage in today's Taoiseach's speech on the Cloyne Report and the Vatican's response were translated to the economic sphere at European level - well we would moving forward.
@disgruntled observer Economists don't have a monopoly on political economy. I think that morally your argument is impeccable. Intellectually you may be right. Politically - that is the problem.

Madeline McKeever said...

Thanks Sli Eile, It seems to me the powers that be are hell bent on A, leading to D sooner or later. I think that many the negative consequences of D could be mitigated by some planning for its possibility. Certainly living standards would be eroded but we are still a lot better off than Somalia. I do hope Enda Kenny can maintian his courage in the face of a breakdown in society that could follow default.

Slí Eile said...

@Madeline Martin Wolf argued with some good reason in the FT (5 July):
'At some point, the present value of the cost of debt must be drastically lowered. This does not have to happen today. But it has to happen soon enough to give people hope. In its absence, failure is not just likely. It is close to a certainty.'