Category Archives: Euro

When not to put your money in the bank.

Negative interest ratesIt seems that in Europe negative interest rates are common place. Below are the current rates of some central banks:

European Central Bank -0.3%
Swiss National Bank -0.75%;
Danish Central bank -0.75%
Swedish Central Bank -1.1%

Why are they in negative territory?
For all these countries it is the the exchange rate against the Euro that is important. Negative interest rates weaken a country’s currency and make imports more expensive and exports cheaper. Furthermore central banks could be trying to prevent a slide into deflation, or a spiral of falling prices that could derail the recovery.

In theory, interest rates below zero should reduce borrowing costs for companies and households, driving demand for loans. In practice, there’s a risk that the policy might do more harm than good. If banks make more customers pay to hold their money, cash may go under the mattress instead. Janet Yellen, the U.S. Federal Reserve chair, said at her confirmation hearing in November 2013 that even a deposit rate that’s positive but close to zero could disrupt the money markets that help fund financial institutions. Two years later, she said that a change in economic circumstances could put negative rates “on the table” in the U.S., and Bank of England Governor Mark Carney said he could now cut the benchmark rate below the current 0.5 percent if necessary. Deutsche Bank economists note that negative rates haven’t sparked the bank runs or cash hoarding some had feared, in part because banks haven’t passed them on to their customers. But there’s still a worry that when banks absorb the cost themselves, it squeezes the profit margin between their lending and deposit rates, and might make them even less willing to lend. Ever-lower rates also fuel concern that countries are engaged in a currency war of competitive devaluations. Source: Bloomberg

Greece – the problems started with the euro-entry exam in 2000

When Greece went through euro-zone entry exam in 2000 it is said that it cheated on its deficit figures. Greece was able to enter the currency bloc after claiming its deficit was less than 1% of GDP, well within the bloc’s 3% threshold. EU reports have since revealed Greece’s budget hasn’t been within the 3% limit a single year since its accession. Below is a video from RealNews which explains the background to the present crisis. Worth a look

What would happen if there was a Grexit?

The Greeks vote on Sunday whether to accept a June 25 offer from the International Monetary Fund, European Union and the European Central Bank (collectively known as “the Troika”) to provide Greece with desperately needed bailout money. In exchange, the Troika demanded that Greece implement a list of tax increases, spending cuts, and economic reforms. If there is a no vote then there could be the following scenario.

Negatives
* Overnight the Greek authorities would have to circulate a new currency (most likely the Drachma)
* The Drachma would depreciate against the Euro – according to some analysts this would increase Greek debt from the current level of 175% to 230% of GDP.
* Interest rates would increase causing businesses to go bankrupt – some have indicated that this would be around 50% of businesses
* The risk of a run on the banks would mean that the monetary authorities would have to introduce controls on money flows – especially abroad.
* Social unrest would no doubt escalate in the short-term and many Greeks will leave the country (if they can afford it).
* The Greek government would find it difficult to raise funds from overseas as investors become more prudent and see Greek bonds as an even bigger risk than before.
* A devaluation will would do nothing to change Greece’s structural problems.
* The euro will lose credibility in the long run and its weaker members will be exposed to bank runs which will ultimately extinguish any chance of a recovery.

Positives
* A weaker currency would make Greek exports a lot cheaper and may resurrect the textile industry that collapsed a few years ago.
* However the biggest benefit would be the tourism industry where holidays would become very cheap relative to similar destinations in Europe.
* The Greek government could keep printing money to finance the promises made Alexis Tsipras’ government – maybe an inflationary threat.
* Interest rates would no longer be determined by the ECB and a more expansionary monetary policy could be implemented by Greek authorities to tackle the downturn.

We’ve been here before as Jeff Sachs mentioned in his piece from Project Syndicate.

Almost a century ago, at World War I’s end, John Maynard Keynes offered a warning that holds great relevance today. Then, as now, creditor countries (mainly the US) were demanding that deeply indebted countries make good on their debts. Keynes knew that a tragedy was in the making.

“Will the discontented peoples of Europe be willing for a generation to come so to order their lives that an appreciable part of their daily produce may be available to meet a foreign payment?” he asked in The Economic Consequences of the Peace. “In short, I do not believe that any of these tributes will continue to be paid, at the best, for more than a few years.”

The Greek government is right to have drawn the line. It has a responsibility to its citizens. The real choice, after all, lies not with Greece, but with Europe.

Below is a chart from Bloomberg Business explaining the outcomes.
Greek referendum

Greek Crisis – A game of chicken

Chicken gameThe negotiations between Greece and the Eurozone financial chiefs represent a typical game of ‘Chicken’. Chicken readily translates into an abstract game. Strictly speaking game theory’s chicken dilemma occurs at the last possible moment of a game of highway chicken. Each driver has calculated his reaction time and his car’s turning radius, which is assumed to be the same in both cars. There comes a time when each driver must decide to either swerve or keep going straight towards the other car. This decision is irrevocable and must be made in ignorance of the other driver’s decision. There is no time for one driver’s last-minute decision to influence the other driver’s decision. In its simulations, life or death simplicity, chicken is one of the purest examples of John von Neumann’s concept of a game. The way players rank outcomes in highway chicken is obvious. The worst scenario is for both players not to swerve – they crash and both are killed. The best thing that can happen is for you to keep driving straight letting the other driver swerving. The cooperative outcome is not so bad as both drivers are still alive although no one can call the other chicken.

As in the game of Chicken, both Greece and the Eurozone have the option to make concessions (Swerve) or hold firm in negotiations (Drive Straight). As with most negotiations, the best outcome for a party is to stand their ground while the other party makes the concessions. However, as both parties want this outcome, this raises the possibility of both sides holding firm and no settlement being reached. In the Greek-Eurozone crisis, this would mean a Greek default and the associated consequences that would ensue for the rest of the Eurozone.

Fortunately there is a third outcome that can prevail in Chicken – both parties can swerve their car at the same time. If both sides are willing to make concessions, then the second best outcome in this game can be attained for everyone. This co-operative outcome could be reached if the Eurozone extended further concessions to Greece, while Greece made binding promises to implement meaningful reforms to get their economy back on track.

However this is unlikely as each player achieves their best outcome by doing the opposite of their opponent. For example, if Greece believes the Eurozone will make concessions, it will achieve the best outcome by standing firm; if it believes the Eurozone will stand firm in negotiations, it’s best option is to make concessions to avoid the dire consequences of a full-blown default.

Chicken - Greece Germany

From the beginning of June until the end of December Greece needs to find another EUR28bn in total. After that point repayments drop off – one reason why Greece’s creditors are keen to ensure new reforms are enacted ASAP.
The inference however is clear: Greece won’t make it that far without a new deal. Greece is waiting on further funding from the IMF and the ECB (EUR 7.2bn) in order to meet some of these payments, but with both sides digging in, it isn’t a given that Greece will receive the funds. See graph below.

Greece repayments

Sources: NAB Australian Markets Weekly, Christoph Schumacher Massey University, Open Economy – Open minded Economics, Prisoner’s Dilemma – William Poundstone

Greece's problem is insolvency not liquidity shortfall.

This is an interesting video clip from the RT Network featuring Max Keiser. Everyone knows Greece is insolvent but no-one has ever stated it officially. Some have suggested that the issue is a liquidity shortfall and lending it more money will help Greece meet its current debt service obligations and fund structural reforms that will lead to renewed growth and increased income, enabling to meet its obligations in the future. However Yanis Varoufakis, current Finance Minister of Greece, disagrese with this interpretation. He believes that Greece will never recover. The bailout programme locks it into a debt deflationary spiral which simultaneously reduces its income and increases its debt burden. Continuing to accept more loans in order to meet debt service obligations only makes matters worse.

Euro Zone’s Divergent Economies and Monetary Policy

I got this image from The Economist and used it for a recent A2 Test on Macro-Economic conflicts. Recently the OECD and the IMF have urged the European Central Bank (ECB) to cut the bank’s main lending rate from the already low 0.25% to zero. How might this effect countries in the Euro-area? It will tend to impact euro zone countries differently because of where they are in the business cycle. If you look at the unemployment and inflation figures from the graph you see the following:

Unemployment
Austria 4.9%, Germany 5.1%, well below the EU average of 11.8%.
Spain 25.3% and Greece 26.7% very high unemployment.

Some countries have had unemployment dropped significantly during the period –
Latvia approx. 22% to 11.6
Estonia approx.. 18% to 7.8%

Inflation
Highest rate Malta &Austria 1.4%, Finland 1.3%
Lowest – Greece -1.5%, Cyprus -0.9%

Euro divergent economies

The loss of monetary sovereignty has its problems

Reducing the interest to zero is an expansionary monetary policy which is a tool to increase aggregate demand, economic growth and employment. Monetary Policy, which is determined by the ECB, will have different effects in different countries. The ECB responds to aggregate levels of inflation and unemployment, not individual country levels – Unemployment is 11.8% and Inflation is 0.5%. Therefore it is a one size fits all policy. However some member states maybe experiencing rising levels of inflation and lower levels of unemployment whilst others might be the opposite – falling levels of inflation and higher levels of unemployment.

Assume an EU member experiences an asymmetric shock. It will have a different inflation and unemployment rate than the rest of the EU. With the ECB setting a common interest rate for the whole area, countries have lost an important part of their monetary policy. This is a major problem if a countries economy is at a different stage in the business cycle. For instance in 2014, Austria and Germany are growing with falling unemployment and a further lowering of interest rates may not be the best option for them. This is in comparison to other countries who need lower interest rates and a more stimulatory environment. With low interest rates and falling unemployment, Austria and Germany could experience inflation levels above the 2% target of the ECB and also a tight labour market which could put pressure on prices. Furthermore a lower interest rate affects those who want to save money in those countries.

At the other end of the spectrum Slovakia, Portugal, Cyprus, Spain and Greece are experiencing deflation and very high levels of unemployment. They therefore require more stimulus through lower interest rates to try and boost growth and employment and get out of the dangerous deflationary cycle.

Other countries with low inflation and high levels of unemployment will benefit from the cut in interest rates – Ireland has had unemployment fall from approx. 15% to 11.8% and an inflation rate of 0.3%. Therefore monetary stimulus is warranted. However the interest rate whether expansionary, neutral, or contractionary is unique to where each country is in the business cycle. The loss of monetary sovereignty clearly poses problems for members states whose economy is out of line with the euro zone norm.

Some big questions for Europe’s trade position.

EU US TradeWith Europe keen on a transatlantic deal with the US, there have also been calls for a separate EU-China trade pact. Although they have shown a lot of enthusiasm to the US deal, the pact with China has been met with scepticism.

Here are the facts:

* China has overtaken the US as the biggest single trader
* China will overtake the EU as the biggest single trader in 2020
* China will surpass the EU in global GDP by 2020
* By 2020 the biggest destination for German exports will be China
* By 2020 the second biggest destination for French exports will be China
* Italy and Germany will export more to developing markets their euro-zone partners.

Therefore if Euro countries start to trade more with countries outside Europe the commitment to a single currency may weaken. With countries less or more reliant on exports and imports the exchange rate will not satisfy all members. If it is going to work Euro members economy’s will have to become more affiliated and better equipped to withstand unbalanced shocks from external partners.

Deflation threat for Euro area

Today inflation in the Euro area is at dangerously low levels – 0.8% in the year to December. This is well below the target of 2% set by the European Central Bank. It doesn’t help that unemployment in the area is 12.1% and this will need to fall if there is to be some sort of recovery which will put upward pressure on prices. The ECB cut its Main Refinance Rate to 0.25% on 13th November last year and could be running out of options. It might be looking at imposing negative interest rates on deposits held at the ECB by trading banks.

Euro Area Inflation

Why is deflation a concern?

1. Holding back on spending: Consumers may opt to postpone demand if they expect prices to fall further in the future

2. Debts increase:

• The real value of debt rises when the general price level is falling and a
higher real debt mountain can be a drag on confidence
• Mortgage payers on fixed mortgage interest rates will see the real cost of servicing their debt increase

3. The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices

4. Lower profit margins: This can lead to higher unemployment as firms seek to reduce their costs.

5. Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence – leading to further declines in AD. Higher savings can lead to the paradox of thrift

Source: Tutor2u