Archive for the ‘EU’ Category
The title says it all: my next blog post will likely be up in August 2009, thanks to a four month sabbatical. Hopefully by the time I return from Southeast Asia / New Zealand / Fiji, the various Fed & Treasury efforts will be having a lasting – positive – effect on the economy. Regardless of if things will look better or worse, I am going to be back with charts and commentary on Wall Street and DC in the summer. In the meantime, feel free to continue to leave comments on my previous posts (they’ve been a huge source of value-add so far, thanks to all who contributed!); I look forward to picking up where we left off later this year.
As I’ve been asking colleagues and friends what topics they’d like me to address here, I got a number of interesting nominations: from a closer look at the Iceland debacle over economic damage control to the question of what needs to happen for things to finally get better. I plan on spending time on all of the above in the very near term, but the one topic that currently occupies me is closely related to the previous posts – at least in substance, if not geographically.
I believe that inflationary tendencies are a significant concern for the US over the medium term. The same holds true for Europe, but the stakes are different. Not only does Europe have to worry about its economic future, but the economic union also has its common currency to look after. Starting last fall, talk of the EU’s Economic and Monetary Union (EMU) potentially falling victim to the financial crisis began to surface as European spread levels came to indicate that the currency union should not be taken for granted. In addition to widening spread levels, prediction markets are trading futures on the likelihood of at least on Eurozone member leaving the currency union by the end of 2010, and the prices indicate a likelihood of more than 20% of such an event occurring, with prior highs of more than 30%.
To take a step back from prediction markets or bond market realities (i.e. spread levels) and understand the macro mechanism behind what we’re seeing, I once again revert to textbook simplicity – what are the advantages and disadvantages of a currency union?
Primary advantages of a currency union per Harvard economists Robert J. Barro and Alberto Alesino:
(1) diminished transaction costs for goods & financial services (scalable with the number of member countries)
(2) peripheral members “import” the inflation rate of the anchor country (or anchor countries, in this case Germany and France which account for 45% of the Eurozone’s population and 52% or $4.4 trillion of the Eurozone’s $8.4 trillion combined GDP in 2006)
Primary disadvantages of a currency union:
(1) loss of flexibility in monetary policy, especially for peripheral members
(2) loss of seigniorage revenue unless elaborate currency union treaties are in place
(3) import of inflation rate for peripheral nations does not necessarily translate to price stability
What makes the Euro vulnerable to the current crisis is that it is an EMU product only by name – while the fifteen nations of the Eurozone are bound by a common currency and interest rates are set by the the European Central Bank, the union is a monetary union only and not an economic union. The impact of and responses to the global financial crisis vary from country to country, and quite drastically – yet all Eurozone members are subject to the ECB’s interest rate policy. As inflation expectations and the strength of individual countries’ banking systems diverge, we may come to a point where the advantages of sovereign monetary policy may outweigh the disadvantage of increased transaction costs.
William Buiter recently articulated a different view in the Financial Times, as picked up by Yves Smith at Naked Capitalism on January 15. Buiter suggests that “a eurozone country defaulting and leaving the euro is close to an unthinkable event.” What do you think?