Wednesday, February 26, 2014

A simple plan to fix the Euro (Part II)

In part I of this post I discuss the fundamental problems with the euro.  Without capacity for debt monetization nor a mechanism for an orderly sovereign default, the euro relies on member-state bail-outs as a way to preserve the integrity of the currency.  Such prospect allows for credit arbitrage and leads to imbalances as evidenced by huge capital flows directed at the periphery during the boom years only to be followed by massive capital exit as the financial crisis struck.  The fact of the matter is that you cannot have credit-based currency without a central bank prepared to monetize the obligations of a common fiscal authority thus fulfilling the promise of default-free debt embedded in modern money.  Since the ECB does not have the legal capacity to monetize member-state debts, such authority does not exist.  Other issues with the euro include inability to deal with asymmetric shocks and lack of fiscal stabilizers.  Last but not least, the ECB, just like any other central bank, is constrained by the zero lower bound prompting fears of continued stagnation and high unemployment.

Throughout the crisis, the ECB has stood ready to provide liquidity, but financial stability was truly restored only after the promise of OMT, which called for unlimited sovereign-debt purchases by the ECB.  However, the legality of OMT has been challenged and the program's future is uncertain.  As things stand today, neither the ECB nor the other EU rescue-mechanisms have a plan to deal with the solvency of national sovereigns.  The other prescribed remedies include structural reform, austerity and internal devaluation.  However, in the face of the Great Recession, these measures initiated further downward pressures which resulted in higher debt burdens and confined the periphery to depression-like conditions.  As documented in this research paper (Downward Nominal Rigidity and the Case for Higher Inflation in the Eurozone) published in the Journal of Economic Perspectives, wage rigidities do not allow for internal devaluation but rather lead to unemployment.  There could be many causes for such rigidities, but one likely explanation is that anti-deflation policies by the ECB could also be preventing a decline in wages.  This is a scary prospect due to the self-reinforcing nature of such causality.  If allowed to persist, high unemployment and continued economic distress could threaten the viability of the union itself.

Academics and commentators have called for unconventional measures in response to the crisis.  Granting the ECB with a clear authority to monetize sovereign-debts is the logical solution.  As I explain in part I that would imply loss transfers between member-states in the form of higher inflation.  It is not at all clear that the European Union has advanced to the point where such arrangement would be acceptable.  If member-states are not prepared to pay the price of bad sovereign debts in the form of higher inflation, it is even less likely that they will accept actual write-offs.  That makes any talk of fiscal union, debt mutualization or even outright restructuring very difficult.  Others have called on the ECB to target higher inflation.  That's easier said than done in the face of the zero lower bound.  The experience of three rounds of QE by the Fed, which produced minimal to no inflation in the US, is instructive.  Negative interest rates have also been proposed.  I've addressed this idea in a previous post. I am afraid negative interest rates will only act to bring more disruption and stress on the financial system.

Here, I will discuss a solution based on the hybrid approach to government intervention.  The idea is to equip the ECB with fiscal policy tools in the form of VAT and Investment Credits.  Such tools can enable the ECB to overcome the limitations of the zero lower bound as well as customize policy to the specific needs of each member country.  Such authority could be a substitute for EU fiscal union, and it can act as a stabilizer in times of crisis.  More importantly, the tax credits can be funded with new Euro-zone debt, which will not involve transfers between member-states.  The emergence of Euro-zone debt will sever the link between the euro and the credit of member-states, which will go a long way toward transforming the euro into a true, credit-based-currency.

First, let's see how the credit could work in practice. Member-states set the maximum VAT within their national borders.  Let's say average VAT collections in Spain run at 12%.  Spain would raise the VAT to a slightly higher level - let's say 15%.  At the same time, the ECB will set the credit to 3% leaving net VAT unchanged at 12%.  The ECB will also guarantee 12% VAT proceeds to the Spanish government whereby the ECB will be responsible for funding any shortfall but would be in a position to claim any excess collections in exchange for such guarantee.

Now, suppose economic conditions in Spain deteriorate calling for looser monetary policy.  At the same time Germany is operating at full capacity calling for tighter policy.  The ECB could choose to respond to economic conditions in Germany by raising interest rates while also increasing the VAT Credit in Spain in order to mitigate the impact of higher rates.  Let's say the ECB increases the credit in Spain from 3% to 10% which brings net VAT down to 5% from the original 12%.  The ECB could then issue Eurobonds to fund the 7% shortfall to the Spanish treasury.  The ECB could also supplement this policy with investment credits to spur higher capital formation in Spain. 

Such tax credits act to increase euro reserves in Spain which replicates conditions consistent with lower rates.  There is one important distinction.  Consumption and investment credits expand the money supply through monetary flows in the real economy, while interest rates affect money balances sitting in bank accounts or stuffed in mattresses. This distinction becomes very important at the zero lower bound as I will discuss shortly.  The credits can also work in reverse.  Should the Spanish economy begin to overheat, the ECB could lower the credit down to zero, which acts to increase VAT to 15%.  Higher VAT drains excess money supply from Spain and goes to pay off the Euro-bonds issued during the downturn.

This example clearly demonstrates how combining fiscal and monetary tools can enable the ECB to respond to asymmetric shocks.  Currently, the ECB is constrained to one-fits-all monetary policy.  The original intent was that movements in labor and capital between member-states would absorb asymmetric shocks in the same manner such flows smooth-out regional differences in the US.  However, unlike the United States, Europe continues to be defined by national, regulatory, and language borders to name a few.  This has had a particular effect on the movement of labor as evidenced by persistently high-unemployment in the periphery. 
VAT and Investment credits could also be powerful tools that can do away with the limitations of the lower zero bound.  As I discuss at length in my post on negative interest rates, the core problem at the lower zero bound is that people can arbitrate their negative expectations of the future by holding cash at 0%.  Regardless of how much money central banks print, people can turn around and stuff the newly-minted balances in mattresses or bank accounts with no effect on the real economy.  Many labels have been used to describe this conditions - liquidity trap, pushing on a string, infinite liquidity preference.  As I noted above, VAT Credits expand the money supply through real monetary flows with an immediate impact on the economy.  Using the above example, the ECB could increase the credit to let's say 20% and turn the VAT into a VAC (value-added-credit) in effect paying people to spend and invest.  On a more wonkish level, the zero lower bound is caused by higher marginal utility associated with future spending.  VAT Credits give the ECB infinite capacity to increase the utility of current spending.  Equipped with such tools, a central bank will never again have to fear the limitations imposed on monetary policy by the zero lower bound.

The hybrid approach to government intervention, which calls for equipping central banks with fiscal tools in the form of consumption and investment credits, could offer a powerful boost to the ECB in the fight against the Euro-crisis.  For starters, the ECB could engineer a massive infusion of money into the real economy by funding a large VAT Credit across the entire Eurozone.  Such action will act as a union-wide fiscal stabilizer, which will instantly do away with deflationary pressures and the limitations of the lower zero bound.  In addition, the ECB could fund business investment credits in the periphery to boost capital formation and productivity.  The ECB could operate the fiscal credits as a self-funded program through its claim on excess tax collections.  This largely mitigates the likelihood of transfers between member-states, which has been the biggest barrier to further European integration.  The ECB will also reap a political benefit - it will be seen as helping Main Street as opposed to just the banks and big money interests.

However, the biggest impact will be felt in the long-term.  Clearly, such new tools will give the ECB greater capacity to respond to asymmetric shock.  More importantly, by funding the upfront credits with Eurobonds, the ECB will be in a position to issue assets free of default risk which are not linked to the credit of individual member-states.  This creates a substitute for a union-wide fiscal authority and a central bank prepared to monetize its debt.  As I referred to in the beginning and discuss at length in part I, this is a fundamental requirement for any credit-based currency.  As a result, the euro will become more resilient and would be in much better position to withstand a sovereign default by a member-state.  It is precisely the lack of such mechanism that has fueled the credit arbitrage and the mountain of sovereign debt which casts a cloud over Europe's future prospects for growth and greater prosperity for its people.

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