The euro is driving Finland to depression
The Finnish economy has been hit by three shocks over the past decade:
- Nokia has more or less disappeared;
- The paper industry is in crisis;
- And recently the Russian crisis has hurt Finland's economy too.
These have all caused a very significant change in Finland's current account balance, which over the past 15 years has gone from a sizeable surplus (around 9% of GDP in 2001) to a small deficit (around -1% of GDP in past four years).
This would under normal circumstances require a (real) exchange rate depreciation to restore competitiveness. However, as Finland is a member of the euro such adjustment has not been possible through a nominal depreciation of the currency and instead Finland has had to rely on an internal devaluation through lower price and wage growth.
However, Finland's labour market is excessively regulated and non-wage costs are high, which means that the internal devaluation has been very sluggish. As a result growth has suffered significantly.
In fact, Finland's real GDP level today is around 5% lower than at the onset of the crisis in 2008. This makes the present recession – or rather depression – deeper and longer than the Great Depression in 1930 and the large Finnish banking crisis of the 1990s. Rightly we should call the present crisis Finland's Greater Depression.
European Central Bank policy obviously has not helped. First of all, the 2011 rate hikes from the ECB had a significantly negative impact on Finnish growth. Second, the shocks that have hit the economy are decisively asymmetrical in nature. This means that Finnish growth increasingly has come out of sync with the core Eurozone countries - such as Germany, Belgium and France.
Hence, Finland is a very good example that the eurozone is not an "Optimal Currency Area", where one monetary policy fits all countries.
Concluding, the crisis would likely have been a lot shorter and less deep had Finland had its own currency. This would not have protected Finland from the shocks – Nokia would still have done badly, and exports to Russia would still have been hit by the crisis in the Russian economy, but a currency depreciation would have done a lot to offset these shocks.
To illustrate this, compare the pegged economies (in red in the graph below) of Finland and Denmark with the free-floating economies of Sweden, Iceland and Norway (in green).
Should Finland leave the euro now? It's hard to say, but it seems clear that Finland shouldn't have joined in the first place.
Are there other options? Yes. Significant labour market reforms that weaken the power of labour unions and reduce non-wage costs would make internal devaluation easier. But such reforms are notoriously hard to implement politically and the discussion and the response from the Finnish government to the Greek crisis has shown the Finnish governing coalition is extremely fragile. This is hardly a government, which should be expected to be able to push through the needed reforms.
See also my three earlier blog posts on Finland:
http://marketmonetarist.com/2014/11/16/great-greater-greatest-three-finnish-depressions/
http://marketmonetarist.com/2015/07/23/peggers-and-floaters-the-story-of-five-nordic-countries/
Lars Christensen is a Senior Fellow of the Adam Smith Institute and blogs as the Market Monetarist.
Perhaps this isn't really the Greek solution
The assembled professors of the Alma Mater have given us their collective wisdom on the Greek crisis:
The institutions have to agree to a relaxation of fiscal austerity, at least until Greece is on the recovery path. Austerity during a recession is the wrong policy as it deepens the recession. Continuation of the stringent austerity measures implemented by Greece is delaying recovery. More fiscal austerity could fail the creditors too, if recovery is so slow that the fiscal deficit increases. Public investment has collapsed completely and providing more funds for investment projects that can improve the infrastructure and create jobs should be given priority. Although some progress has been made, further structural improvements are necessary, including pensions and VAT, anti-corruption, tax compliance, and institutional reform of product and labour markets. It is important that the Greek government acknowledges that there is still a lot to be done and comes up with credible proposals. The Greek economy is not likely to recover as long as there is still significant uncertainty about the future and there is no credible path towards a situation in which the Greek debt is sustainable. It is essential to achieve an early agreement to get Greek debt levels to sustainable levels, even if it is to be conditional on progress elsewhere. Conditionality on structural improvements is a good way forward.
Well, yes, OK. Greece should do all of those supply side reforms, lower the relative wages and thus get the economy booming again. Or we could heed the wisdom of Milton Friedman in the quote there. Instead of having to have this internal devaluation, this heavy austerity needed to bring down sticky prices like wages, we could just have a change in one single price in the economy, the external value of the internal money. You know, a devaluation.
Amusingly, this is one of the times that Friedman agrees with Keynes, even with the New Keynesians of today: prices are sticky, notably downwards, and wages especially so. Thus an economic policy which depends upon pushing down wages is going to require a great deal of pain to work.
Better, by far, not to have had the euro in the first place.
Yes, your humble writer here is extremely biased on this subject. But also correct.
If you want to know why rule by the Great and the Good doesn't work
Consider this from Simon Jenkins as an example of why rule by the Great and the Good doesn't work.
But such is the political arthritis now afflicting Europe’s “technocratic” rulers that they ignored the fact. They concentrate on their one concern: somehow extending Greece’s repayments so German, French and British banks could have even larger loans underpinned. It is bankers, not Greeks, who are being “bailed out”. They want Greek taxpayers to go on paying interest even if the principal is as beyond reach as a tsarist bond.
No Sir Simon, just no.
Of Greece's some €320 billion in debt a couple of percentage points is owed to foreign banks. That's actually what the problem here is: there's no bankers that anyone can go and steal the money from.
The debts are owed to: the IMF, which in effect means the governments of the countries that own the IMF. The ECB, which means the countries that own it (ie, the eurozone governments). The EFSF, which is guaranteed by the eurozone governments. Then there's bilateral loans from ...yes....the eurozone governments.
The Greek banks do own Greek Treasuries, both bonds and bills: and these are all pledged to the ECB as collateral for the cash they need to remain open. This is actually what the problem is in the negotiations. If there were any rapacious capitalists holding any appreciable amount of the debt then they would be haircut without anyone caring in the slightest. That near all of the money is owed to taxpayers of other countries is the problem.
This would have been a valid criticism of the 2010 to 2012 actions, where the banks' debt holdings were largely unloaded onto those taxpayer guarantees. But it's simply incorrect to claim that banks have anything beyond the most minimal exposure today. Whatever this is this isn't a crisis about protecting bankers.
And that, of course, is why that rule by the Great and the Good, by the wise Solons, by a technocracy, doesn't in fact work. For the obvious reason that all too many of them haven't a clue about whatever it is that they're supposed to be managing or making public policy upon.
This is not to say that they're all idiots, of course it isn't, but rule by the ill informed isn't a great step forwards now is it?
Apparently the euro is a neoliberal plot: who knew?
The blame game for the Greek disaster is in full voice over on the left. Apparently it's really all the fault of the neoliberals. Yes, that's us, the people who argue for less government intervention, markets work and so on, we're responsible for the idiocy that a supra-national bureaucracy has erected. Here's Georgie Monbiot as one of the cheerleaders for this argument:
The Maastricht treaty, establishing the European Union and the euro, was built on a lethal delusion: a belief that the ECB could provide the only common economic governance that monetary union required. It arose from an extreme version of market fundamentalism: if inflation were kept low, its authors imagined, the magic of the markets would resolve all other social and economic problems, making politics redundant. Those sober, suited, serious people, who now pronounce themselves the only adults in the room, turn out to be demented utopian fantasists, votaries of a fanatical economic cult.
So let's look at what a real market fundamentalist, Milton Friedman, said about it all:
The drive for the Euro has been motivated by politics not economics. The aim has been to link Germany and France so closely as to make a future European war impossible, and to set the stage for a federal United States of Europe. I believe that adoption of the Euro would have the opposite effect. It would exacerbate political tensions by converting divergent shocks that could have been readily accommodated by exchange rate changes into divisive political issues. Political unity can pave the way for monetary unity. Monetary unity imposed under unfavorable conditions will prove a barrier to the achievement of political unity.
Friedman was of course far too polite to put it this way, but that's clearly a claim that the idiot politicians are about to impose something that won't work, either economically or politically, and something thus that market fundamentalists (or as we like to style ourselves, liberals) simply should not be supporting.
George's basic problem here, as with that gathering chorus over on the left, is that they've got confused. They're against neoliberalism, they know that. And they're against the implosion of the Greek economy. At least one of those is a sensible thing to be against. But because they're against both they insist that one is a facet of the other. When in this case, neoliberalism, market fundamentalism, has been saying all along (and some of us have been shouting this for two decades now) that the euro as constructed simply will not work. Because it doesn't contain enough market, because it's a political construct built without reference to sensible economics.
And we're right of course. Far from neoliberalism being the cause here it's the cure.
But this is impossible under modern monetary theory!
Or perhaps we should revise that to a "this is impossible under a deeply deluded understanding of modern monetary theory". For there's a certain segment of the populace who insist that banks just make up money out of thin air. So, therefore, this can never happen:
Ordinary Greeks rushed to withdraw cash from ATMs in the early hours of Saturday morning. Greece's Alpha Bank stopped all online transactions according to its website on Friday night.
If banks do just create money ab nihilo then this cannot possibly happen. There is no possibility of a bank ever running out of money, is there? But this is happening. Therefore it cannot be true that banks do indeed just create money out of nothing.
The confusion comes from the way in which credit is created: this is indeed done by the banking system in a fractional reserve banking system. You or I go to borrow money and the money we borrow is indeed simply created, as a ledger transaction, by that bank at that time. So, to some that seems the end of the matter. But at 4 or 4.30 that afternoon, that bank has to balance its books. It must have sufficient deposits to fund all of its loans, and if it does not through its branches it must go out into the more general market and solicit some more deposits. So, that effortless creation of money only lasts until that daily point at which it must balance the books.
And, of course, the same occurs in reverse when people are reducing their deposits at said bank. It must either claw back the loans it has made (something that takes time) or it must collect more deposits from the wholesale system or it must deny people the right to extract their deposits. Because, once a day at least, those books must balance.
In a world where banks effortlessly print or make as much money as they wish banks runs cannot happen. We are seeing a bank run: therefore banks cannot effortlessly print or make all the money they wish. Monetary theory's just great but even that has to be checked against reality occasionally.
Why the Bank of England should end its stress tests: ‘No Stress’ in a nutshell
In December last year the Bank of England reported the results of its first set of annual stress tests of the capital adequacy of the UK banking system. Its message was reassuring: our banks are safe.
Don’t believe a word of it. The banking system is actually highly vulnerable and the stress tests merely hide that fact. Indeed, they even make the banking system less safe than it already is, by pressuring banks to take hidden risks that the risk models cannot see.
The stress tests are flawed in three distinct ways.
The first is methodological. The tests are based on one scenario and cannot possibly give us confidence the system is safe against all the other possible scenarios they did not consider. They are based on a ‘risk-weighted’ asset metric that is unreliable because it is dependent on gameable risk models that under-estimate banks’ risks – and the system incentivizes banks to game the models to get lower capital requirements and thence higher distributions of false profits. They create systemic instability by pressuring banks to use the same models that are blind to the same risks. They lack credibility because even if the central bank thinks there are major banking problems, it cannot publicly admit to them – to do so would undermine confidence and lead to questions about its own past competence in rebuilding the banking system. The results then have all the credibility of a rigged election.
Even if we ignore these problems, the stress tests are fatally flawed because they use a very low ‘pass’ standard, a 4.5 percent minimum ratio of capital to risk-weighted assets. This minimum is well below those coming through under Basel III. Had the Bank carried out a test using these latter minima, the banking system would have failed the test: same exercise, higher safety standard, opposite result.
The Bank also failed to carry out any tests based on a minimum ratio of capital to leverage – a test that would have been more reliable because it is much less dependent on unreliable risk models. Even the most undemanding such test – one based on a minimum leverage ratio of only 3% - would have revealed that the banking system was very weak. The Bank’s failure to apply this latter test is all the more puzzling because the Bank expects UK banks to meet this minimum standard. Thus, the Bank asks us to believe the banking system is sound, despite the fact that a 3 percent leverage ratio test based on what it currently expects from banks and based on its own stress scenario would have suggested otherwise. One might add that many experts recommend a minimum leverage ratio of 15 percent, five times larger than the leverage test that the Bank did not conduct, or at least report. You can imagine the results.
One can only speculate why the Bank did not report the results of these alternative tests, but one thing is sure: the comforting headlines last December would have been rather different had they done so.
Overseas experience also indicates that stress tests are useless as indicators of bank vulnerability and can go catastrophically awry. Recent stress tests failed to notice the impending collapse, not just of one but of three national banking systems: Iceland in 2008, Ireland in 2010 and Cyprus in 2013, all of which collapsed shortly after being signed off as safe by regulatory stress tests. The European stress tests missed the latter two collapses, but also have a history of being captured by powerful banks and the Euro elite – and of using very unstressful stress scenarios to produce loss projections that turned out to be dramatically short of subsequently realized losses.
The most recent European stress tests would appear to be no exception: the ECB party line was that all was well in the European core despite problems in the fringe countries, but these were dismissed on publication by a variety of experts who pointed out that it was the big French and German banks that were most vulnerable. However, the European stress tests overlooked their vulnerability because they used ‘risk-weighted’ asset measures that were blind to their main risks instead of leverage measures that would have revealed them – the same mistakes that were made by the Bank of England.
Stress tests operate like a radar that cannot see any hazards. We wouldn’t dream of sending out a ship or plane reliant on a radar that didn’t work. We really shouldn’t do that with our banking system either: the Bank of England should abort its stress testing program forthwith.
Kevin Dowd is the author of the Adam Smith Institute's most recent report 'No Stress', which is available here.
The seriously fascinating opening to a European Union report
We find ourselves near helpless with laughter at this opening to the latest European Union report. It's the one about how the eurozone should be deeper, have a common treasury and so on. And it opens with this:
The euro is a successful and stable currency. It is shared by 19 EU Member States and more than 330 million citizens. It has provided its members with price stability and shielded them against external instability. Despite the recent crisis, it remains the second most important currency in the world, with a share of almost a quarter of global foreign exchange reserves, and with almost sixty countries and territories around the world either directly or indirectly pegging their currency to it.
Europe is emerging from the worst financial and economic crisis in seven decades.
At least one of us around here is known to be deeply eurosceptic, but even given that isn't this just the most delightful piece of political prose?
For there's not a single economist who wouldn't add a "therefore" to the beginning of that second paragraph. Yes, the recession was not caused by the euro itself, but the existence of the euro most certainly made it worse than it would otherwise have been. As that same single currency made the boom beforehand even more frenzied. And then the actual monetary policies followed made matters even worse: the ECB was still raising interest rates when unemployment was soaring past 20% and more in some countries.
We can't help thinking that, well, observe the following:
This report has been prepared by the President of the European Commission, in close cooperation with the President of the Euro Summit, the President of the Eurogroup, the President of the European Central Bank, and the President of the European Parliament.
.... This report reflects the personal deliberations and discussions of the five Presidents.
Five presidents might be four or more too many for an organisation but leave that aside. But do we really desire the governance of an entire continent to be in the hands of those who could violate Poe's Law so grievously?
New report: No Stress – The flaws in the Bank of England’s stress testing programme
In 2014, the Bank of England commenced a stress testing programme in an effort to test the capital adequacy of major UK-based banks. It concluded that its results demonstrated the resilience of the banking system. No Stress, a report from the Adam Smith Institute, suggests that we should be extremely sceptical of the Bank’s conclusions.
The report is by Kevin Dowd—Senior Fellow of the Adam Smith Institute, professor of finance and economics at Durham University, and author of three books, ten book chapters, and dozens of journal articles on risk modelling—who presents a powerful and rigorous indictment of the Bank’s stress testing programme.
Dowd makes the case that the stress tests are significantly methodologically flawed and worse than useless, giving policymakers unreliable information about the strength of the UK banking system, providing false risk comfort, and creating systemic instability by forcing banks to converge towards the Bank of England’s models.
The Bank of England (BoE) uses just one stress test scenario, which attempts to predict what would happen in the event of a major recession to the UK's major banks: Barclay's, the Co-op, HSBC, Lloyds, Nationwide, RBS, Standard Chartered and Santander. Using just one scenario is extremely limited – an economic downturn can take many forms, and a combination of unemployment, inflation and negative economic growth that was substantially different to the Bank's scenario could hit the banks in a completely different way. The BoE can say that the banks are safe under its scenario, but not that they are safe in general.
The BoE's use of risk-weightings, as opposed to leverage ratios favoured by many international authorities, to calculate banks' assets is extremely questionable. These risk-weightings are easy to game by banks, giving a rosier picture of their health than alternative measures would show. This also distorts the bank's investment strategy.
The BoE's approach forces a standardisation of banks' risk models, effectively putting all the British banks' eggs into one basket. By misleadingly reporting that the financial sector is safe, the BoE's stress test has provided false risk comfort to politicians and consumers.
For these reasons and more, Dowd concludes that we should end regulatory risk modelling and re-establish strong bank governance systems that make decision-makers personally liable for the risks they take. The report is available to download here.[gview file="http://www.old.adamsmith.org/wp-content/uploads/2015/06/No-Stress.pdf"]
There's a lot of ruin in a nation
But ruin is not something in infinite supply in any nation:
From Monday, customers who held Zimbabwean dollar accounts before March 2009 can approach their banks to convert their balance into US dollars, the governor of the Reserve Bank of Zimbabwe, John Mangudya, said in a statement.
Zimbabweans have until September to turn in their old banknotes, which some people sell as souvenirs to tourists.
Bank accounts with balances of up to 175 quadrillion Zimbabwean dollars will be paid $5. Those with balances above 175 quadrillion dollars will be paid at an exchange rate of $1 for 35 quadrillion Zimbabwean dollars.
The highest – and last – banknote to be printed by the bank in 2008 was 100tn Zimbabwean dollars. It was not enough to ride a public bus to work for a week.
The bank said customers who still had stashes of old Zimbabwean notes could walk into any bank and get $1 for every 250tn they hold. That means a holder of a 100tn banknote will get 40 cents.
At some point simply running the printing presses does run into real problems. Our favourite little story from this whole disastrous episode comes from the final end days of the printed currency. Normally, currency printing is a very profitable occupation. Bit of paper, the price of some ink, and a banknote that is worth whatever the government says it is is created. Right at the end there it's said that the final decision to stop printing was taken because....no one would accept a bank note of any denomination at all, or any number of them, in return for supplying the ink with which to print the banknotes.
There have been hyperinflations before and it's a near certainty that it will happen again, somewhere. But this is the only example we know of where seigniorage was ridden all the way down to the bottom, to the bitter end.
UK loss on RBS sale: so what
Bygones are bygones. Or as economists call them, 'sunk costs'. If you invest in something that doesn't pay off, you can kiss your sunk costs goodbye. Just sell for what you can get. Today we are being told that UK taxpayers are going to take a £7bn loss when the government sells its stake in the the mega-bank RBS. Add fees and costs, and it might be £14bn. So what?
When the UK's Labour Chancellor Alastair Darling spent £45bn of our money bailing out RBS – and another £63bn on Lloyd's, Bradford & Bingley, Northern Rock and the rest – he wasn't going through the Financial Times with a highlighter to pick good investments to enrich taxpayers. He was trying to rescue Britain's financial services sector during the financial crash.
For a sector that brings in £66bn a year in taxation, that was a pretty good deal. Yes, you can argue that if he had done nothing, the market would have sorted it out. Or that the government should have simply lent the banks more money. But at the time it was all pretty hair-raising. Banks exist on trust, because if all their customers pull out at the same time the banks don't (usually) have enough cash on hand to repay their deposits. They have lent out that cash to help grow businesses, jobs and prosperity. So when 20,000 queued up to take their savings out of Northern Rock, and the RBS said its cash machines were going to run out of cash in 48 hours, it wasn't unreasonable to do something.
Actually, when you look at that £108bn went, taxpayers are already in pocket. Slices of Lloyd's have already been sold off, and Northern Rock is looking like a really good business again. It depends on your predictions of what the remaining bits are worth, but taxpayers could already be £14bn up on the deal. That's no surprise: the same happened in Sweden when its banking sector was bailed out years ago.
So what of RBS? Bygones are bygones. The bank grew bloated in the boom years, and has had to spend hundreds of millions restructuring. And being involved in just about sort of financial business known to humanity, it has picked up more regulatory penalties than most. So it is trading well below the 502p share price that Alastair Darling bought it at.
But that money was spent, not on buying a bank as an investment, but on buying a bank to save it from utter collapse. Money spent, job done. Bygones are bygones, let's move on.
Should we wait until things improve, so that taxpayers get all their money back? No. After all, as they keep telling us, shares can go down as well as up.