• A Kiwi Haircut?

    We have grown accustomed to treating crises in the euro zone as having little to do with us. So, there will have been a restrained response to the news of yet another crisis, even one that has provoked “outrage and panic” in Cyprus where it has arisen. But we should perhaps take a closer look, because what has happened in Cyprus could – in essence – happen here as well; and, if it does, we too would respond with outrage and panic.

    This particular crisis does of course involve issues that are specific to Cyprus. Like many other euro zone economies, Cyprus is in urgent need of a bailout; and, as a condition of that bailout, European finance ministers are proposing that a somewhat unusual contribution to the cost of the bailout should be made by those who have placed their cash for safekeeping in Cyprus banks.

    European finance ministers have announced (after markets closed last weekend) that the $25 billion bailout (Europe’s fifth) will come with a huge twist – a levy of 6.75% on deposits in Cyprus banks of less than $190,000 and 9.9% on deposits greater than that. The measures will raise, from those with deposits in Cyprus banks, about $10 billion.

    The finance ministers are playing a dangerous game. They have their eye on the huge deposits kept in Cyprus banks by Russian oligarchs who apparently (but not for much longer) see Cyprus as a safe haven where not too many questions are asked.

    But the risk they are taking is huge. If depositors find that their savings are not safe in Cyprus banks, there will not only be a mass withdrawal of funds from those banks (as is already happening), but from banks in other “bailout” countries as well. The euro zone crisis is on track to return with a vengeance.

    What has this got to do with New Zealand, you may ask? The answer may surprise you. Our own Reserve Bank is well-advanced on just such a measure that would, in certain circumstances, present a similar threat to New Zealand depositors as well.

    The “Open Bank Resolution” policy being proposed by the Reserve Bank is well-advanced and is framed in terms of settling in advance the question of who should bear which liabilities in the event of a banking collapse – whether of a single bank or on a much wider scale.

    The current options in the event of a bank failure are limited – liquidation, government bail-out or takeover by another bank. The post-GFC history of the impact on government finances of bailing out failed banks has obviously reduced the appetite for such operations, and in most such cases there will not be a long queue of institutions willing to take over the failed entity.

    The remaining option – liquidation – however, would immediately threaten the security of customers’ deposits, a political risk that governments would be reluctant to take. The Reserve Bank argues that in these circumstances the main priority should be to keep the failed bank afloat and functioning. They therefore propose that the bank should close for just 24 hours while a statutory manager is appointed and an assessment is made of the bank’s financial position.

    A calculation should then be made of the proportion of customers’ deposits with the bank that would be needed to cover the bank’s liabilities and that proportion would then be frozen. The bank would then re-open, but the frozen deposits would be retained for the statutory manager’s use so that the bank’s financial situation could be stabilised. Any unused portion of the deposits could then be returned to the depositors. The balance (an as yet undetermined proportion) would be retained and lost to the depositor. Similar processes would be applied to shareholdings in the bank.

    This proposal for what is popularly called a depositors’ “haircut”, on which the government and commercial banks are currently being consulted and which could well take effect this year, is presented in terms of a response to the failure of a single bank. But the measure would have its most significant impact in the event of a banking sector meltdown, such as might be triggered by a renewed global financial crisis – and who would bet against that?

    As in the case of Cyprus, the New Zealand proposal is an astonishing assault both on the property rights of depositors and on confidence in the banking system. The mere fact that such a proposal is even being contemplated should ring alarm bells, even for a typically complacent New Zealand public – and if they were, like the Cypriots, actually denied access to their savings as they disappeared into the banks’ coffers, that would certainly be enough to trigger Cyprus-style “outrage and panic”.

    The supposed need for such a draconian measure arises entirely because banks not only enjoy the unique privilege of creating money out of nothing but are also entitled to use their customers’ deposits for their own trading purposes. There can surely be no more compelling case for a fundamental review of the way banks operate in our economy. Shouldn’t we know more about this proposal and be consulted about it before it is too late?

    Bryan Gould

    18 March 2013

  • Ending The Euro Crisis

    The Spanish bailout last week was initially greeted as evidence of the determination to protect the euro and as a step towards much-needed European economic stability. Yet, as subsequent events have quickly shown, what really happened was merely a further staging post in a slow-motion and ultimately inevitable disintegration of the eurozone as we currently know it.

    The first signal that the bailout was not the triumph proclaimed by the Spanish Prime Minister is that the need for it was repeatedly denied, right up till the last minute – and denied largely because it was recognised that it represented a defeat for the policies pursued both by the Spanish government and by the European authorities. The attempt to argue that the bailout vindicated those policies must be regarded as simply putting a brave face on a serious reverse.

    There are, however, much more substantial reasons for reservations about the bailout. Once again, the measures put in place in order to avert disaster have done nothing to recognise, let alone address or remedy, the underlying issues. Those issues, for as long as they remain unresolved, will continue to throw up crises which seem increasingly likely to drive the European economy into recession and the eurozone into a failure that will threaten the whole European project.

    What are those underlying issues? There are probably two that warrant particular attention. The first is what might be described as a fundamental flaw in the initial design of the euro which made it unlikely that it could ever succeed; and the second is the determination to continue with economic policies, particularly in response to the global financial crisis, that have made recovery from that crisis more difficult than it should be.

    As to the first issue, I was not alone in arguing from the outset (as I had argued about the euro’s two predecessors – the European Monetary System and the Exchange Rate Mechanism) that the euro could not possibly work. I argued this because it seemed clear to me that in a hugely diverse European economy, (and that diversity has surely now been demonstrated beyond doubt), it was beyond belief that all parts of that economy could be equally well served by the single monetary policy which a single currency would require.

    In particular, it seemed inevitable that that single monetary policy would be dictated by and would serve the needs of the most powerful parts of the European economy, which inevitably meant Germany. A monetary policy that was congenial to the Germans would almost certainly be less appropriate for weaker parts of the European economy – and today we can see that those weaker parts would necessarily include countries like Greece.

    The Greeks were of course misled into believing that their membership of the eurozone was the entry ticket to the prosperity that the stronger members enjoyed. They were encouraged by the apparent guarantee of support from those stronger members – the sense that “we’re all in this together” – to take advantage of the asset inflation (what can now be seen to have been a “bubble”) created by easy Europe-wide credit, and were allowed not to worry too much about the potentially damaging concentration of productive capacity in Europe’s industrial heartland that a single economy made inevitable.

    It was not just Greece, of course, whose interests were put at risk in this way. Other stronger economies – Spain springs to mind – also suffered in due course from the same combination of apparently risk-free expansion and consumption on the one hand and the weakening of their productive base on the other – both the inevitable consequences of throwing in their lot with much stronger core economies in the wider Europe.

    In due course, even those stronger countries – Germany and its more or less satellite economies – which were the immediate beneficiaries of the single currency and the single monetary policy began to suffer a downside. In the longer term, when the periphery of the wider European economy began to slow down – even to close down – this was inevitably bad news even for the central core, whose markets would be less buoyant and whose obligations to weaker members would be likely to increase.

    It was precisely because the euro would eventually handicap the whole European economy, as well as individual potential members like Britain, that I opposed it so strongly. Sadly, any such stance was dismissed at the time by most commentators as being simply “anti-Europe”.

    The adverse impact of the euro on the European economy began to come to a head, as luck would have it, just as the global financial crisis burst upon us. We need not pause to dissect the global causes of the GFC, other than to observe that they included factors that were already at work in Europe. What has mattered, however, is the response that has been made by the eurozone to the difficulties created by the GFC.

    In line with, and illustrative of, the economic dominance of Germany in the eurozone, the measures adopted to help Europe escape from recession have been largely dictated from Berlin and reflect a particularly German view of what is required. Those measures focused on the suddenly revealed vulnerability of governments in weaker countries to rapidly increasing public sector deficits – deficits made inevitable by the constraints imposed by euro membership and by the impact of the GFC on the relatively loose policies pursued by those countries within the apparent comfort of the eurozone.

    The reduction of those deficits became the main and essentially short-term goal of German policy. The Germans were increasingly nervous that they would be required to finance any rescues that might be needed; and the German government’s own domestic political and ideological preferences (themselves now increasingly challenged within Germany itself) pointed strongly to austerity as the correct response to recession. The consequence has been that the travails of eurozone, and particularly of its weaker members, have been exacerbated by the inevitable consequences of austerity.

    In most circumstances, an economy that discovers that it has become uncompetitive, as evidenced by a trade or public sector deficit, or in the longer term by falling comparative living standards, will respond with a range of measures that will usually include the devaluation of the currency. A devaluation will have the merit of improving competitiveness across the board and doing so in a fair and impartial way, so that everyone bears some share of the short-term burden of the necessary adjustment. It also has the advantage of underpinning and launching an obvious and well-tested strategy for overcoming problems of lack of demand by promoting growth and expansion.

    The devaluation option was not of course open to eurozone members. Without it, they could grow themselves out of recession – which by definition occurs because of a deficiency in demand – only with the aid of a policy framework, in terms of both monetary and fiscal policy, that would encourage greater rather than less economic activity.

    That, however, is precisely what has been denied them by the proponents of austerity. The insistence that Greece and Ireland, Portugal and Spain, and perhaps eventually Italy as well, should cut spending and reduce demand in order to eliminate deficits has ensured that recession becomes persistent and almost impossible to shake off. As the experience of Spain shows most recently, slamming on the brakes means immediately higher unemployment, falling production, a slump in living standards, decimated public services, social unrest and – most significantly for the proponents of austerity – larger, not smaller, public deficits off the back of lower tax revenues. The Spanish bailout is the price being paid by the Spanish people for that mistake.

    Even within in its own terms, the policy is doomed to failure. Austerity is meant to provide an escape route from debt; but it has ensured instead that the bailouts provided to Greece, Spain and others constitute an increased debt burden that they have little hope of repaying while they are going backwards. Little wonder that the money markets immediately saw the Spanish bailout for what it was – a postponement of the inevitable.

    The threat to the future of the eurozone, which may also engulf the global economy, is therefore the outcome of policy mistakes, both in terms of deficiencies in the project itself and in the response to recession. If the measures taken so far have made matters worse, what should now be done to offer better prospects?

    The answer to that question from Europe’s leaders is not encouraging. Because they, and in particular the “troika” of the European Commission, the IMF and the European Central Bank have, through a failure of analysis, ignored the actual causes of the eurozone crisis, they have accordingly continued to press for exactly the wrong remedies. As one eurozone country after another succumbs to the burdens of both euro membership and austerity, the remedies proposed are simply an intensification of both of those burdens.

    It is simply not admitted that the burdens of euro membership have been too much for many members. No attempt has been made to distinguish between those countries that have prospered and those that have not, or to suggest refinements of the rules that might help those that have not. Those that have already demonstrated by falling into economic difficulties that they find membership burdensome, if not impossible, are now being told that if they want help they must accept still tougher rules within a banking union. This would make it even less possible for them to grow and repay debt and would require them of course to concede what remains of their economic sovereignty.

    Even if this proved politically possible (and elections in France and elsewhere seem likely to throw doubt on this), it is hard to see how such a “remedy” would do anything other than bury the root causes of the problems even deeper and make them even more difficult to resolve in the long term. It is the equivalent of plastering over the cracks while the foundations are crumbling. Reality is not averted simply by denying it.

    What is the alternative? The first step must be to recognise the reality that Europe as a whole is handicapped rather than benefited by the current breadth of the eurozone, and that it cannot possibly function well with such diverse membership. There should be a negotiated process for identifying those countries that would benefit from being, or that wished to be, released from the burdens of membership and for helping them to make an orderly withdrawal. Such a process would be complex and difficult, but by no means impossible, and in any case would be less disruptive than a disorderly break-up that otherwise seems inevitable.

    Those countries that chose and were able to remain within the eurozone would no doubt proceed to create what would be in effect a greater German economy. Even so, some of those might well baulk at the prospect of being absorbed into such an entity.

    Countries which chose to leave the eurozone would be able to return to their individual currencies, devalue to the appropriate level, abandon austerity in favour of a strategy for growth, and re-negotiate their obligations with creditors on the basis of a credible prospect of improving tax revenues. No one would pretend that this process is without problems, still less choose to start from here, but other countries, such as Brazil and Argentina, have negotiated similar issues and come out on the other side with improved prospects.

    The numbers of countries choosing to take this option might swell in due course once the practicality and advantages of opting out of the euro became clear. They could then set about, together both with the eurozone and actual and potential European Union members who are not members of the eurozone, the task of building a new kind of European cooperation – what might be described as organic or functional cooperation, in which the process of ever-increasing convergence in the pursuit of common interests did not get too far ahead of the political and economic realities.

    In economic terms, Europe would be much stronger as an entity if the constituent parts were able to apply monetary and exchange rate policies that were more suited to their needs and in particular to their different stages and rates of development. A Europe made up of economies each enjoying optimal macro-economic policy settings, trading with each other on special terms and negotiating trade arrangements with the rest of the world as a single entity, consciously pursuing convergence across the whole field of regulation , co-ordinating and aligning policy development wherever possible, increasingly working together in pan-European deliberative and eventually legislative bodies, would serve Europe’s economic interests much more effectively and do more to promote a genuine sense of European identity than the current abortive attempts to impose from above a European super-state that only a tiny elite has ever wanted.

    To acknowledge that there is not yet a United States of Europe, with a single political identity that makes it possible to accommodate without undue strain a range of divergent economic interests, is not to admit defeat but to recognise the need to build a Europe on the basis of democracy and popular will if the result is to be sustainable. The eurozone crisis may in the end be a blessing in disguise.

    Bryan Gould

    14 June 2012

    This article was published on the NewNations website on 18 June – at http://www.newnations.com/specialreports/theeuro.html

  • Learning the Lessons

    As the world-wide recession seems to be bottoming out, one question is being asked with increasing frequency and urgency. Have we learnt the lessons so that it will not happen again?

    The answer – at least in the US and the UK – is not a reassuring one. As the hard-pressed taxpayer, already burdened with the threat to homes and livelihoods, is left to pick up the bill for market failure – a bill in the billions which will not be paid for years, not to say decades – those whose recklessness and greed caused the crisis have already returned to the bad old ways.

    We see the same outrageous bonuses, the same disregard for prudence, the same confidence that the price of failure will always be paid by someone else. It is almost as though the publicly financed bail-out has provided the fat cats with a renewed belief in their own infallibility, by convincing them that they will always be protected because they are too big and too important to be allowed to fail.

    In New Zealand, where the financial sector is too small to exhibit these attitudes, we have nevertheless seen our own somewhat paradoxical response to market failure. It might have been thought that, in an economy where public finances had been unusually well and prudently managed over recent years, the public sector would be the last place that would be required to bear the brunt of recessionary retraction.

    In other countries (notably Australia), and in line with the revival around the world of Keynesian insights into how to respond to recession, the public sector has been seen – not as the problem – but as an important part of the solution. We, however, seem to have become obsessed with the size of the government deficit, which is still relatively low in historical and international terms, with the result that the salami slicer has been applied with very little discrimination across the whole range of public spending.

    No one can cavil at an increased drive to ensure value for money in public spending. The suspicion must remain, however, that the recession has been a not unwelcome excuse to rein back the public sector on ideological rather than economic grounds.

    There is, however, a more significant respect in which we seem to have decided not to apply the lessons we should have learned. We should not forget that we have been in recession since the end of 2007 – long before the financial crisis broke. That home-grown downturn was the direct consequence of the policy directions we had been following for 25 years having finally run into the buffers.

    Inflation then was still enough of a worry to lead the Governor of the Reserve Bank to keep interest rates at an internationally very high level. That in turn, through pushing up the exchange rate, had destroyed the competitiveness of our industries, created a current account in serious imbalance, increased our need to borrow to finance the gap between what we earned and what we spent, pushed up the exchange rate and stoked inflation still further as “hot” money flowed in to take advantage of the high interest rates, and so on round an increasingly vicious circle.

    As we contemplate the post-recession scenario, those fundamental problems are no nearer solution. Indeed, some are a good deal worse; the overvalued dollar is destroying our productive economy with every day that passes. Our only response to these pressing problems seems to be that “there is nothing we can do.”

    But there are things we can do. We could acknowledge that the strategy of defining macro-economic policy in exclusively monetary terms, and of directing the whole force of that policy to the single goal of controlling inflation, using a single instrument in the hands of a single unelected official, has failed – both as an effective way of controlling inflation, and in terms of its disastrous impact on our overall economic performance.

    If we want to do better, and in particular, if we want to raise our poor productivity levels, we have to do things differently. If we go on with the same policy prescriptions as we have applied for the last 25 years, we will get the same disappointing results as we have endured over the last 25 years.

    What is needed is a fundamental shift in perspective. It would mean, in line with the revival of Keynesian thinking, re-defining macro-economic policy so as to include the whole range of fiscal as well as monetary measures. It would mean setting the goals of macro policy (including interest and exchange rates) in terms, not of inflation, but of competitiveness, as the Singaporeans do. It would mean, rather than clobbering the whole economy with a poorly focused counter-inflation strategy, continuing the battle against inflation with specific micro measures directed at defined inflationary pressures, such as excessive bank lending and the favourable tax treatment of housing, and encouraging saving by strengthening the incentives to save.

    It probably won’t happen. It is amazing that an orthodoxy that has been so thoroughly discredited by experience still has such a hold on official thinking. The government might be encouraged, however, to undertake an “agonising re-appraisal” by the thought that a change of tack might produce a better outcome, not least for their own pet preoccupation. Nothing, after all, would do more to get the government deficit down in a hurry than a newly buoyant economy.

    Bryan Gould

    26 September 2009

    This article was published in the New Zealnd Herald on 1 October.