The apparent weakness of the Euro (please define "weak")

In today's Financial Times, Wolfgang Munchau writes about "Why the Euro will continue to weaken". He makes an argument that we have heard before: the political tensions, the economic tensions created by the Greek debt problem make it clear that a monetary union without a political union cannot be successful.

I will ignore the general question on whether a monetary union can succeed without a political union so that I keep this entry short, but I want to challenge his reading of exchange rates.

Let me start with the areas where I agree with the FT article: Is the Euro getting weaker? Yes, relative to the US dollar. Is this caused by the perception that some of the economic troubles in Greece and other European countries could cause instability in the Euro area? Yes.

Here is where I disagree: Is the Euro a weak currency? To be honest, I cannot answer this question unless we agree on a definition of "weak". If by "weak" we mean that its current value is low relative to some benchmark (and we also need to agree to a benchmark), the answer is NO. The Euro remains overvalued according to purchasing power parity (PPP), which is the most fundamental theory we have about exchange rates (I am aware that there are more sophisticated models to think about over/undervaluation of currencies but at some point they need to rely on some notion of purchasing power parity as a long-term anchor).

The current value of the Euro (about 1.36 USD/EUR) is higher than what most PPP estimates indicate. Those tend to be in the range 1-1.2, depending on the basket of goods that you use. If any, the Euro remains overvalued. We reach a similar conclusion is we look at the historical evolution of the USD/EUR exchange rate (see chart below) where the German Mark is being used as the Euro in the pre-1999 period.

My second disagreement with the article is about the connection between political and economic turmoil and exchange rates. Why should the current European environment lead to a depreciation of the currency? The informal argument is that the currency reflects the "strength" of an economy. This sounds ok but it is not right - you first need to define "strength" and then be clear about the exact economic mechanisms through which the exchange rate is affected. Wolfgang Munchau argues that Europe needs to go through a major fiscal adjustment and this implies an increase in public saving. Given that the sum of public and private (net) saving have to be equal to the current account, and assuming that we do not want private saving to fall, we need to see the current account going up (exports growing faster than imports). For this to happen, you need to see a depreciating Euro. This logic is not right either. If we apply the same logic to the US or the UK we will reach the same conclusion: we need a depreciating US dollar and a depreciating UK Pound. But this is impossible! We cannot have the three currencies depreciating at the same time (at least relative to each other).

The argument that the political tensions in the Euro area will lead to a weaker Euro are not new. They were in fashion during the early years of the Euro when the Euro was getting weaker (as low as 0.85 USD/EUR). Funny enough, those theories became irrelevant in the period 2003-2007 when the Euro appreciated by close to 100% relative to the dollar. And this was at the time when the political and institutional weaknesses of the Euro area became really apparent. It was during the 2003-07 period when the stability and growth pact collapsed, it was during that period when several countries did not live by the deficit and debt limits that they had agreed to and the confidence in the Euro-institutions was seriously damaged. But during those years the Euro got stronger, not weaker.

Theories about why exchange rates move need to be tested over several episodes. Otherwise we are simply looking for an ex-post rationalization of the changes we see.

Antonio Fatás

Greek debt woes will remain (CNBC interview with Ilian)

Maybe the Euro was not such a bad idea.

The current budgetary crisis in Greece has led to concerns about the stability of the Euro zone as a single currency area. There have been talks about the possibility of some countries leaving the Euro area and some see this as a clear signal that having a single currency among such a diverse group of countries was a bad idea. A few academics in the US have reopened the debate on whether the Euro zone is indeed “an optimal currency area” and their conclusion tends to be that it is not and the crisis with Greece is a proof of that analysis.

Their logic of those who believe that the Euro was a bad idea is the following: if today countries such as Spain, Greece or Portugal (or Italy) had their currency, they could have devalued it (or depreciated it) and this would have helped them to get out of the crisis because of the positive effect on exports. They point out to the fact that in recent years some of these countries have lost competitiveness through high inflation and this could be easily corrected with a devaluation while the alternative of deflation (or lower inflation) is more painful.

Their argument is a standard textbook analysis of the costs and benefits of keeping your own currency (where we are looking at just the benefits). This is an argument that I bring up regularly in class when I teach macroeconomics and it is easy to explain to my students. However, one needs to go beyond the theory and what is difficult is to assess whether the logic applies to this case and indeed these benefits outweigh the costs of having your own currency and exchange rate.

My reading of the current situation is that it does not reflect at all on the weaknesses of the Euro zone as a currency area and that if any of those countries had kept their currencies they would be in much more trouble today.

Here is a long list of arguments of why the textbook argument does not apply to this case:

1. This is a global crisis. The current recession is global in nature. While some countries are hurting more than others, this is not an asymmetric shock that is affecting just one country. While the exports of Greece could benefit from devaluation, this would hurt the exports of other countries. While it is true that some countries like Germany have kept a surplus in their current account, it is also true that their exports have collapsed and their GDP has been affected as much or even more than some of those other countries. Why shouldn’t be Germany the one who devalues?

2. Is competitiveness a problem? A potential answer to the question in point #1 above is that Germany does not have the same problems of competitiveness than the Southern European countries. It is Spain, Portugal, Greece the countries that have seen their real exchange rate appreciating because of higher inflation than in Germany. They are the ones that need the correction. This is true but we have to be careful not to use Germany as an example of all other countries. The chart below (from a presentation by Jose Manuel Campa, from the Ministry of Economy and Finance in Spain), Spain has not seen a deterioration of competitiveness relative to France, the second largest economy in the Euro area. It is Germany the one that looks like an outlier.

In addition, inflation was higher in Spain mainly because of the evolution of prices in the non-tradable sector (the one where competitiveness is not an issue). Below is another picture from the same presentation by Jose Manuel Campa where we see that the evolution of unit labor cost in manufacturing in Spain (relative to Germany) are much more moderate.

If this is not reassuring enough we can look at the evolution of Spanish exports (as a share of world exports) during these years, Spain has done better than countries like France or the US and its performance is similar to that of Germany.

Yes, Spain had a large current account deficit during these years but it was mainly the result of increasing imports due to the strong expansion in the economy. A phenomenon that we observed in other countries (such as the US) that have a flexible exchange rate.

3. Exchange rates are not a magical tool. If having your own currency is such a powerful tool to deal with crisis like the current one, why is it that countries such as the UK, Sweden or the US are suffering through very deep recessions? Both the UK and Sweden, despite having witnessed a depreciation of their currencies, are also struggling with a deep recession that seems to be lasting as long as in some of the Euro countries. In the case of the US, the currency has moved in the “opposite” direction and appreciated since the beginning of the crisis. The current account has been reduced but mainly because of the collapse in demand that comes from the recession.

4. We cannot forget the costs of having your own currency. While the idea of manipulating the exchange rate to increase exports might seem at times attractive, there is no doubt that if any of the Southern European countries had their own currency today, they would be in a much deeper recession (we can go back to the early 80s in Spain when there was also a banking crisis to see how much the Spanish peseta helped). It would be very likely that these countries had accumulated during the boom years liabilities in foreign currency that now, with a devaluation, they would not be able to pay back. The government of Greece would be facing a much higher interest rate because of exchange rate risk, which would make the probability of default even higher.

Finally, a reminder that one needs a longer perspective to assess the benefits and costs of a monetary union. Yes, countries like Spain are going through a deep recession with very high unemployment rate but partly this is the result of the “excesses” of the previous years. Below is a picture of real GDP that shows the very-high growth rates that Spain enjoyed during the previous years. While it might be the case that there was some loss of competitiveness relative to Germany, the growth rate of Spain remained very high, higher than that of Germany or the UK who had the flexible exchange rate to adjust (if needed). Yes, the current recession will erase some of these gains, but not all of them.

So maybe the Euro was not such a bad idea after all and it deserved a less dramatic 10^th anniversary.

Antonio Fatás

An insider's view on the financial crisis (Interview with Sir Win Bischoff)

Here is a video of an interview I conducted recently at INSEAD with Sir Win Bischoff. He is the current chairman of Lloyds Banking Group and was the chairman of Citigroup in the Fall of 2008, during the worst of the financial crisis. We talked about the days around the fall of Lehman Brothers and his views on the current debate on financial regulation.

Click on this link to access the video (which is hosted at the INSEAD YouTube channel).

Antonio Fatás

Labor markets and the current cycle (and the death of Okun's Law)

There are growing concerns about the labor market performance in the US during the current crisis, concerns that might extend to the recovery phase. Unemployment has risen faster than in any previous recession, even taking into account the depth of the recession. As Brad DeLong, Robert Gordon and many others have pointed out, 2009 is a clear outlier in the relationship between unemployment (changes) and output growth, known as Okun's Law. See chart below borrowed from Brad DeLong's blog.

Here is an alternat

ive view of the labor market dynamics during this time but focusing on employment growth rather than unemployment rate changes, which are affected by decisions regarding labor market participation (this is also the US economy).

The year 2009 remains an outlier in this chart: employment growth was much lower than what GDP growth would suggest, based on the historical relationship captured by the red (regression) line. Of course, this means that productivity was growing faster than normal that year, at least as measured as GDP per employee.

It is also interesting to see that 2007 and 2008 were normal years - so it cannot be an argument that prior to 2009 companies were hiring "too many" workers.

The chart also shows how the last recovery (2002 and 2003) are also outlier years where employment growth was below what was suggested by GDP Growth.

Why is employment growth being so weak in these years? Are there significant structural changes in terms of sectoral composition that can explain the weak behavior of employment growth? For 2009, did restrictions on access to credit cause an abnormal behavior by companies when it comes to hiring and firing? If we are talking about structural changes, we cannot expect a fast recovery in the labor market. If it is all a matter of credit availability then there is some hope that as the economy recovers we see a quick recovery in employment that will feed into faster GDP growth.

Antonio Fatás

Using a hammer or a wrench to pop asset price bubbles?

In a recent speech Adam Posen (recently appointed a member of the Bank of England's Monetary Policy Committee) argues that monetary policy should not be used to deal with asset price bubbles. His main argument, which has been expressed before by different central bankers, is that monetary policy is the tool to deal with price stability and it is not appropriate to deal with asset price bubbles. Quoting from his speech:

"Just because we want there to be a policy response to a problem does not mean that the problem can be solved with the tools at hand. Again, if I have a hammer, it can be useful for all sorts of household tasks, but useless for repairing a leaky shower head – in fact, if I take the hammer to the shower head, I will probably make matters worse. I need a wrench to fix a pipe leak, and no amount of wishing will make a hammer a wrench. This is the essential reason why central bankers are now looking around for what has been called a ‘macroprudential instrument’, that is a tool suited to the job – and a tool additional to the one that we already have in our toolkit."

I am very sympathetic to this argument, interest rate is probably not the right tool to deal with asset price bubbles and using regulation or a 'macroprudential instrument' is the right thing to do.

However, we still need to ask the question: What if those instruments are not available or are simply failing to do their job? Is there a role for monetary policy? He cites the example of Spain as a country where the central bank was stressing the importance of dynamic provisioning for banks and still went through a real estate bubble. It might be that the Bank of Spain was not aggressive enough, but how do we know that the systems that we are setting in place now will take care of the next bubble or financial imbalance?

One can argue that interest rates should not be used to deal with an imbalance in financial markets, because this is not part of their mandate, but I think this is a very narrow view of the role of central banks. There is no doubt that imbalances in financial markets spread to the real economy. In fact, there were many signs of a macroeconomic imbalance prior to the crisis such as excessive consumption, current account imbalances. Aren't interest rates the tool to deal with macroeconomic imbalances?

If we apply Adam Posen's logic to some of the previous recessions, we could come up with the conclusion that central banks should never use the interest rate as a stabilizing tool. We could always claim that previous recessions originated in a specific sector of the economy and it would be better to deal with these developments using 'sector-specific' tools. Adam Posen uses as an example a procyclical tax on real estate that might avoid real estate bubbles like the one we just went through. We could apply the same logic to the internet bubble of the 90s and argue that a tax on internet-related companies would have avoided that bubble. This might be true but how do we know where the next bubble will come from so that we set up the right 'procyclical tax' to avoid it? In my view, if the next bubble generates a macroeconomic imbalance, then it is the role of monetary and fiscal policy to deal with it. The next business cycle, the next bubble is likely to be different from the current one and we will learn from it and set up additional policies to make sure that it does not happen again, but until we figure out policies to avoid any potential bubble or imbalance that can cause a recession, monetary policy still has a role to play. And yes, using a hammer to fix a pipe leak will be a challenge...

Antonio Fatás

Central Bank Transparency

Here is an excerpt from an interview by Jean-Claude Trichet, President of the ECB with De Tijd and L'Echo (the full interview can be found at the ECB web site).

Q. For some financial assets, such as gold, we are seeing a return to risk-taking on the part of investors. Is this a parameter that the ECB takes into account in its strategy?

A. I will not make any specific comments regarding gold.

Generally speaking, one of the fundamental lessons of the crisis is that when we underestimate financial risks and focus only on the short term, we set the stage for a future catastrophe. The new principles for bank remuneration, which the international community have agreed within the framework of the Financial Stability Board, were established precisely in order to ensure that there is no incentive for operators and traders in particular to favour the most risky attitudes and decisions, leading to illusory profits in the short term at the expense of the long-term interests of the financial enterprises concerned and the stability of the financial system as a whole.

It is always interesting to see how central bankers tend to start their answers by saying that they will not make any specific comment on a market or an asset price and then make a broad statement about how financial markets need to be careful and not create bubbles. This reminds me of the famous question by Alan Greenspan back in December 1996: "How do we know when irrational exuberance has unduly escalated asset values?" Great question and I would like to know the answer!

Should central banks provide more guidance to help us answer our questions and doubts about asset prices (or other financial market developments)? Should they share their views and forecasts on the evolution of asset prices as they do for other financial variables, such as interest rates? I do not know what the right answer to these question is but I find the current communication style from central banks ("no specific comment on that question but...") unsatisfactory.

Antonio Fatás