When the Euro Was Good for Germany

During the good years, the economic benefits of the common currency in Europe were fairly easy to recognize. The countries on the eurozone's periphery -- Spain, Portugal, Greece, and to a lesser degree Italy -- had improved access to international capital markets, enjoyed lower borrowing costs, and experienced substantial investment booms as a result. Meanwhile, the countries in the eurozone core such as Germany, France, and the Benelux countries enjoyed a surge in exports to the rapidly-growing periphery. Importantly, they also enjoyed the higher returns that they could earn by investing in companies, assets, and projects in southern Europe. The gains from the common currency were shared by north and south.

Now, of course, Germany is pondering just how much it is willing to pay to keep the currency union intact. An important part of that calculation is an understanding of what the benefits to Germany were during the good years. There's been some debate about that in recent weeks, for the most part focusing on whether and how much Germans benefited from the export boom of 2004-08. But another element of the calculation should be the higher investment income that German individuals and corporations earned from the new investment opportunities afforded by the common currency.

The following charts illustrate the surge in investment income earned by the core eurozone countries during the 2000s. The first expresses foreign investment income in billions of euro, while the second shows that income relative to GDP. (Data is from Eurostat.)





A couple of important caveats. First, this data is from national balance of payments statistics, which measures foreign income earned by each country from the entire rest of the world. We don't have an easy way to directly measure how much of the increased investment income earned by these countries was specifically from the eurozone periphery. However, given everything else we know about the pattern of capital flows within Europe during that time, and the timing of the surge in investment income (the euro was adopted in 1999, and the boom really happened right after the economic slowdown of 2001-02 ended), it seems a safe bet that the much or most of this increased investment income was from southern Europe.

Second, we don't know what the pattern of investment income earned by the core eurozone countries would have looked like in the absence of the common currency. In the absence of the counterfactual, we can only make an educated guess about the impact of the euro. In this case, however, I think there's every reason to believe that the massive capital flows from core to periphery, the associated investment boom in the periphery, and the surge in investment income enjoyed by the core during the years leading up to the crisis would not have happened without the euro. I would therefore attribute the vast majority of the increased investment income earned by the core from the periphery during the 2000s to the euro.

Given that, this data suggests that the euro enabled Germany to enjoy increased investment income of perhaps €30 to €40 billion per year, or between 1% and 2% of GDP. The Netherlands also enjoyed an income boost of up to 2% of GDP during the best years of the 2000s, while the euro helped France to earn higher investment income equal to perhaps 1% per year.

Are these figures large enough to justify substantial additional spending by Germany to keep the eurozone intact? I have no idea. Keep in mind that this does not tell us anything about the economic benefits that the core eurozone countries enjoyed thanks to their increased exports to the periphery. And most importantly, the benfits of the common currency have always been perceived to be at least as much about politics as economics, and I'm not sure how we would go about quantifying those political benefits. But this sort of analysis does at least give us some rough sense about the magnitude of one specific type of benefit that countries like Germany and France enjoyed from the euro during the good years, and therefore puts a floor on our estimate of the overall benefits of the euro to those countries that are now considering whether to save it.

Italy and Japan

Consider the following differences between Italy and Japan. Italy has a history of lower budget deficits, as well as forecast budget deficits for the next few years that are dramatically lower than those forecast for Japan:

(All data is from the OECD; figures for 2011 and 2012 are forecasts.)


Italy's debt to GDP ratio has remained roughly constant over the past 15 years, while Japan's has climbed steadily higher:



Both countries have had relatively poor economic growth over the past decade, with little difference between them:



And yet, despite all of this, yields on Japanese 10-year government bonds hover around 1.0%, while yesterday the Italian government was forced to pay nearly 8.0% to borrow money for 10 years. Given how much worse Japan's public finances look when compared to Italy's, it seems unlikely to me that investors are demanding higher interest rates from Italy simply because they are worried about excessive budget deficits or debt.

So what explains the dramatic disparity in investor willingness to lend to Italy compared to Japan? There are three crucial differences between Italy and Japan that, when put together, create a coherent story about what lies at the heart of this crisis:

1. Japan has the ability to create its own currency, while Italy does not.
2. Japan has been running current account surpluses, while Italy has had a current account deficit for the past several years.
3. Japan can borrow at 1.0% while Italy must pay much more to borrow.

Item #1 on this list has helped to cause the crisis for the reasons noted by Paul DeGrauwe: by giving up its own currency, Italy lost the important backstop on its government borrowing costs that countries that can borrow in their own currency have. This was a key prerequisite for this crisis to take hold.

Item #2 on this list is important because at its heart, this crisis can be seen as a balance of payments problem. Italy (along with the rest of southern Europe) has been dependent on capital flows from northern Europe to meet its borrowing needs, as reflected by the large current account deficits Italy has experienced in recent years. But private capital flows are notoriously fickle, and when they stop, a balance of payments crisis can ensue. What we're seeing in southern Europe right now is a variation of that.

Item #3, you'll notice, is simultaneously cause and effect. This is the self-fulfilling downward spiral that Italy has become trapped in. Once the necessary conditions were established by item #1, and once Italy became vulnerable to a stop in private capital flows thanks to item #2, the dynamics inherent to self-fulfilling crises took hold -- and events have mercilessly followed that unforgiving logic to the point in which Italy finds itself today.

On the other hand, government deficits in Italy had little to do with getting it into this mess. Which is why all of the stern talk in Europe about setting up firm and credible ways to discipline countries into being fiscally responsible will do nothing to end the crisis in the short run, and nothing to prevent it from happening again in the long run.


UPDATE: I should have mentioned that item #1 goes hand-in-hand with one additional ingredient to Italy's current predicament: the lack of a flexible exchange rate that could adjust in response to the stop in private capital flows. Such an exchange rate adjustment would improve Italy's external competitiveness and reduce its relative income, which in turn would help Italy bring its current account back toward balance. Again, the point is that this crisis is primarily a balance of payments problem, not a budget deficit problem.

Programming Note

My apologies for the light posting lately -- other commitments are keeping me busy right now, but I should be able to get back to more regular posting next week. (I'm going to trust that the eurozone will hold itself together for another week at least.)

In the mean time and apropos of nothing, I'll simply take this chance to refer you to an astronomical applet that I find unreasonably entertaining: Galaxy Crash.

Scarce Job Openings in the US

Earlier this week the BLS released new data on the number of job openings, hires, and separations in the US labor market for September 2011. The headline story from that news release was that the number of job openings in the US continued what has been a pretty solid and steady rise over the past year.

Some have interpreted this news as possible evidence that the US labor market is beset with structural unemployment problems; if the number of job openings is increasing so strongly, then the relatively slow increase in the level of employment must be due to the fact that unemployed workers are mismatched to the types of jobs that are available, right? The unemployment problem in the US, the reasoning goes, must be significantly the result of this worker-job mismatch -- which is a "structural" problem -- rather than low demand. From the FT:

High US joblessness puzzles economists

The stubbornness of high unemployment despite a steady rise in the number of job openings in the US since the end of the recession is posing a puzzle to economists as they try to understand the troubled labour market.

New data released this week show that the number of vacant jobs in the US rose to 3.4m in September – the highest in more than two years – even as the unemployment rate remains mired at 9 per cent.

The question is whether the rising rate of job openings, derived from the Job Openings and Labour Turnover Survey, is the better indicator of a steady recovery in the labour market or whether the fact that vacancies are being advertised but not filled points to an underlying malaise...

But I don't actually think that this data actually provides any support for the structural explanation of the US's stubbornly high unemployment rate. While the number of job openings has indeed risen substantially over the past year or two, that was from an abysmally low level in 2009. Even now, the total number of private sector job openings is just barely back to the level of jobs available at the worst of the 2001-03 employment recession in the US, as shown below.


The fact is that there are still terribly few jobs available relative to what is normal for the US economy. Meanwhile, the number of net new hires (i.e. total new hires minus the number of worker separations due to both voluntary quitting and involuntary layoffs) has been averaging about 100 thousand people per month recently, which is disappointingly small. But compared to the relatively small number of job openings, this is actually fairly decent performance. Dividing the number of net new hires by the number of available job openings we find that jobs are actually being filled at a decent rate -- more or less at the same rate as during the relatively good labor market years of 2004-07.


This suggests that it is not any more difficult to match people with positions today than usual. The dominant feature of today's job market is simply that there are still very few job openings; companies in the US remain reluctant to hire more people. That is not the result of any structural, skills-mismatch sort of problem. That is simply the result of firms feeling that they do not yet need to hire more workers. It's yet more evidence (see here for another type of evidence) that the US's unemployment problem is the result of plain old insufficient demand.

Italy: Illiquid-but-Solvent

Evidence for the argument that Italy is having a liquidity crisis, not a solvency crisis:

Italian Yields Top 7%

Italian bonds slumped, driving two- five-, 10- and 30-year yields to euro-era records, after LCH Clearnet SA raised the deposit it demands for trading the nation’s securities.

Two-year note yields rose above 10-year rates, with five- year debt climbing above 7.5 percent as Prime Minister Silvio Berlusconi’s offer to resign left his weakened government struggling to implement austerity measures to reduce borrowing costs.

...The yield on Italy’s five-year notes jumped 82 basis points, or 0.82 percentage point, to 7.70 percent at 11:56 a.m. London time.

The rate on Italy's ten-year bonds are currently at about 7.25%, creating a fairly sharp inversion over the 2-to-10 year portion of the yield curve. In other words, while investors are demanding a risk premium on all maturities of Italian bonds, they are now demanding a higher risk premium on shorter maturity bonds than on longer maturity bonds. This implies that market participants believe that Italy's potential difficulties in repaying its bonds are concentrated in the next couple of years, and that if Italy can get through that stretch then the risk of default diminishes.

This is not to say that there couldn't also be some concerns about Italy's long-term solvency; but those concerns are clearly being overshadowed by worries that Italy may not make it through its current liquidity crisis. Which means that no matter what steps are taken to change Italy's long-term budget picture, if Italy isn't provided with the liquidity it needs to get through the next couple of years, then long-run solutions are really rather irrelevant.

Liquidity, liquidity, liquidity.

Days, Not Weeks

Today Ryan Avent wrote the post that I had been intending to write myself. So I will simply turn things over to him (though please click through to read his entire comments):

Finito?

SILVIO BERLUSCONI'S promise to resign has done nothing to calm European bond markets. Italian bond yields are soaring today; both the 2-year and the 10-year are above 7%. There are rumours that the ECB is in the market and buying heavily. If so, it's not having the desired effect. The ECB can't hope to keep yields reasonable through brute force. It will need to make an expectations-changing announcement. Will it? Italy's yields aren't the only ones rising. Markets are ditching Irish, Spanish, Belgian, and French debt too.

...I have been examining and re-examining the situation, trying to find the potential happy ending. It isn't there. The euro zone is in a death spiral. Markets are abandoning the periphery, including Italy, which is the world's 8th largest economy and 3rd largest bond market. This is triggering margin calls and leading banks to pull credit from the European market... The cycle will continue until something breaks. Eventually, one economy or another will face a true bank run and severe capital flight and will be forced to adopt capital controls. At that point, it will effectively be out of the euro area. What happens next isn't clear, but it's unlikely to be pretty.

...I hate to get this pessimistic about the situation. It feels panicky and overwrought. I can't believe that Europe would allow so damaging an outcome as a financial collapse and break-up to occur.

I wish I didn't agree so completely with Ryan's assessment. The ECB is the only institution that can put a stop to this. And they have days, not weeks, in which to decide if they are going to do so.

Those Awful Banks

It's remarkable the degree to which so many people from vastly different countries, backgrounds, and political inclinations all share a bitter and seething rage against the world's big financial institutions. Everyone hates big banks, and today's Bank Dumping Day is only one of many signs of that deep loathing.

Given this near-universal hatred of banks and bankers, the idea of providing them with taxpayer support is pretty much intolerable to most people. The widespread disgust felt about the US's TARP bailout of banks in 2008 provided fuel for both the Tea Party movement's popularity in 2010 and the Occupy Wall Street movement of this fall. In the eurozone, banks are reviled in the troubled periphery countries, where austerity measures are seen in part as a mechanism devised to shift the pain of the eurozone debt crisis from banks to the people. And in the core eurozone countries like the Germany, the public is understandably angry at the idea of having to provide funds to restore European banks to financial health thanks to the crisis.


The Financial Sector and the 1%

There are plenty of reasons for these intensely negative feelings about financial institutions. One of the most important may be the extraordinary concentration of wealth and power that has accumulated among the world's financiers over the past couple of decades. Income inequality in the US, for example, is almost entirely a story about the richest 1% pulling away from everyone else -- and a substantial portion of that richest 1% have the financial industry to thank for it.

In the US, the compensation paid to employees in finance, together with financial sector corporate profits, added up to close to $200,000 (in constant 2005 dollars) per each person working in the finance industry in 2010, according to BEA data (NIPA, section 6). In real terms this figure has almost doubled since the early 1990s, and more than tripled since 1980. By contrast, inflation-adjusted median household income in the US is unchanged over the past 20 years.

This remarkable rise in the fortunes of people working in the US's financial industry almost perfectly matches the rise in the income share going to the richest 1% of Americans. It's certainly possible that this correlation is spurious. But it's also natural to consider that perhaps this is not just a coincidence.

(Note: data on top 1% from Emmanuel Saez.)


The Story Behind the Numbers

What has driven this impressive concentration of power and wealth into the few hands that control the world's financial system? It's hard to escape being drawn toward the conclusion that the rules of the system have indeed been subtly, slowly changed over the last 30 years, simply because no alternative explanations seem to fit.

To see this, let me make four uncontroversial (I hope) observations:

1. The US's political system is far more dependent on financial contributions from super-wealthy contributors than it used to be.
   
2. Contributors tend to give more money to political actors that will do things that they like.
   
3. Since the US is a democracy, the US's political system establishes the rules of the game by which individuals and corporations must play.
   
4. Super-wealthy individuals in the US have grown even more super-wealthy over the past two three decades, and thus more able to fund the US's political system. (See point 1.)

Of course, there could be more than one possible explanation for this series of observations; they could be completely unrelated phenomena, for example. However, it's also possible that these phenomena do indeed have something to do with each other. All we need to do is posit some mechanism by which #3 above could have led to #4, and the logical loop is complete. My candidate would be this:

3.5: The rules pertaining to the financial system have been modified over the past two decades in such a way that it has facilitated the concentration of wealth and power in the financial sector.

And now we have a complete and consistent logical story of a self-sustaining cycle in which greater concentration of wealth leads to more political influence by the super-wealthy, which leads to rule-changes to their benefit, which leads to greater concentration of wealth. And the financial sector is the arena in which this cycle has largely been played out.

Whether or not you believe this story, it is a plausible one, and it should not come as a surprise that many people believe it. And I think this is exactly what lies at the heart of the anger and frustration felt by so many toward the finance industry.


Bailouts

And now we get to the fuel that has been repeatedly added to this already hot fire in recent years: the repeated use of taxpayer money to rescue big banks, both in the US and Europe. The latest plan to end the eurozone debt crisis has, as one of its core elements, a commitment of additional taxpayer money to help keep Europe's banks afloat; the string of bank bailouts continues.

The whole idea of using taxpayer funds to support the financial system is justifiably difficult to digest. Weren't the world's biggest financial institutions exactly the cause of the financial meltdown in late 2008? Aren't they also substantially responsible for the eurozone debt crisis through their unwise lending? And in between these various crises, haven't they been earning obscene amounts of money while crying foul any time they are asked to share it through higher upper-income tax rates? So why should taxpayers lift a finger to help the world's bankers in those instances when they've bet the wrong way?

The problem is that banks are absolutely essential to our economic system. Like it or not, they are special. This is largely the result of their unique ability to make loans, create money, and direct capital toward sectors of the economy that need it. Without financial intermediation, today's economy would immediately grind to a halt. The health of the world's economy is, without exaggeration, completely at the mercy of the banking sector.

And that is the icing on the cake. It's awful to contemplate that our basic economic system, and the very livelihood of most of us who participate in world's modern market economy, are crucially dependent on institutions that are so hard to understand, have done so much to concentrate wealth and power among the privileged few, and are directly responsible for financial chaos and crisis. But it's doubly awful to be forced to repeatedly bail them out under threat of widespread economic catastrophe, which is exactly what would happen in the absence of those bailouts. It really violates every fundamental notion of fairness.

The remedies for this situation are precisely those policies that the financial industry hates the most: significantly more government oversight, and/or mechanisms through which taxpayers can share in the benefits the financial sector brings during the good times. In the absence of such measures to rectify the basic unfairness of the current system, antipathy toward the world's financial industry will only grow. And with good reason.

Italy's Future

Italy's Prime Minister, Silvio Berlusconi, is apparently going to propose some "shocking measures" in an attempt to get control of the downward spiral that the market for Italian government debt is currently experiencing. Most likely (thanks to the urging of Germany and France) these shocking measures will be composed primarily of sharp cuts in government spending.

This will fail to help. The market is not worried about Italian debt dynamics because of excessive government spending. It is not worried about Italian debt dynamics because of an excessive primary (i.e. excluding interest payments) budget deficit in Italy. It is worried about Italian debt dynamics simply and purely because of skyrocketing interest rate expenses that the Italian government is now facing thanks to the eurozone debt crisis.

In the table below I present three scenarios for the path of Italy's budget deficits and gross government debt (both as a % of GDP). Scenario 1 is the OECD's most recent forecast for 2012. To extend that baseline a bit, let's say that 2013 would look like 2012 in the absence of other changes. Note that the OECD's forecast is for Italy's debt/GDP ratio to remain roughly constant. Until very recently, there was no particular worry about the Italian debt burden getting out of hand. It is not at all obvious that under the baseline OECD forecast there is any particular urgency for Italy to reduce its budget deficit.




Scenario 2 illustrates why, even though the market is not worried about Italy's primary budget deficit (since Italy actually runs a primary surplus), it has good reason to be VERY worried about the recent rise in Italian borrowing costs. Suppose that in 2012 and 2013 Italy has to pay 250 basis points (i.e. 2.5%) higher interest rates than assumed in the OECD forecast. Suddenly Italian debt dynamics look very scary -- Italy's debt/GDP ratio, instead of remaining flat, will take off on a frighteningly familiar upward trajectory. (Hello Greece, here we come...)

Scenario 3 then supposes that the Italian government enacts dramatic cuts in government spending - let's say, cuts equal to 2% of GDP in both 2012 and 2013. Will that fix the problem?

The answer is clear: no. If anything, it will make the problem worse.

Cuts in government spending will be overwhelmed by Italy's higher borrowing costs, which are far, far greater in euro terms than any cuts in government spending that could realistically be acheived. And so Italy's budget deficit will still rise sharply. And if we assume that severe austerity will likely lead to a contraction in Italian GDP, as it has done in the UK, Greece, and elsewhere, then the trajectory of Italy's debt looks even worse with the cuts in government spending than it did without them. (I assume a government spending multiplier of 1.0 in this scenario.)

Austerity as a response to the recent rise in Italy's borrowing costs is exactly the wrong policy prescription. It misdirects attention from the real problem here, which is the self-fulfilling doom spiral in the debt market that Italy has gotten trapped in. The only way to break out of this cycle is to do something radical to change market expectations.

The ECB is the only institution that has such power right now. And yet it seems likely that they will sit on the sidelines, or even applaud Italy's austerity proposals -- the very proposals that are almost certain to make things worse rather than better.