Sunday, February 7, 2010

The Greek Problem

A storm has slowly been brewing in the press over recent weeks in regards to the state of the PIIGS (Portugal, Ireland, Italy, Greece and Spain). According to some analysts, the Euro area itself might be at risk of break up.

Before going further, it is worth mentioning that the dangers that we are now seeing are hardly unforeseen. I trawled through my own blog and found several of my own references to the problem (but probably missed many others), such as the following in a post from 2008:
Also, an interesting comment from VKP who suggests that the UK and Greece have many similarities. I am not as familiar with the details of the economy of Greece as I would like, but am aware that they are running very large deficits. I have mentioned the possibility of the abandonment of the Euro, and the state of the finances of Greece is one factor in that consideration. I am not sure how much longer Germany will play ball....
And a little later, at the start of 2009:
As an aside, I long ago suggested that the cohesion of the Euro might be strained as the economic crisis progressed, and there have been an increasing number of articles recently mirroring this view. I still believe that the Euro may not come through this crisis, and think the likelihood of either a partial falling apart, or complete abandonment of the Euro is possible. We could yet see the return of the mighty Deutsche Mark. As such, if you hold any Euros, make sure that they are held in a German bank in Germany....
More recently, I described the problems of Greece as an 'outrider' for larger economies - as a foretaste of the coming problems. I have not been alone in these early concerns for the Euro in the economic crisis, but have no references for those that were sharing them (apologies). However, the view that I shared with such Euro pessimists was that it was not possible to have a stable currency with the huge variations in individual government policy and economic structures. It was the tragedy of the commons writ large, with the Southern European states acting as free riders. With no method of effectively enforcing discipline and rules, it was possible to free ride in the system. The economic crisis would just bring these problems to the surface (though I had not imagined in such a dramatic way).

Despite this, the Euro enthusiasts have a counter argument. In a recent outing to a bar, I was speaking with a German on the subject of the risk to the Euro, arguing that Germany would not tolerate bailing out Southern Europe when confronted with its own problems. His response was to highlight the position of Germans as 'good Europeans' (including mention of Germany's troubled history) and that Germany would therefore support the integrity of the Euro area. I expressed my doubts about this, suggesting that Germany would not support profligate spending.

The attitude in Germany is of particular interest due to the economic weight in Europe, such that their agreement is essential for any bailout to proceed. This is from Die Welt:

"The EU has given Greece a long leash for far too long. Now Brussels has no choice. All that is left is the weak instrument of budgetary surveillance and a vague hope that, somehow, everything will go well. Sanctions, such as the freezing of EU subsidies, penalties to the tune of billions of euros or exclusion from the monetary zone are not feasible. Any such step would plunge the Greeks even further into the abyss and weaken confidence in the euro even more."

"Brussels is backing strict austerity measures. That is correct, but also wrought with dangers. The planned massive spending cuts and tax increases could stifle the economy of Greece and lead to deflation -- causing a vicious circle. The Greek drama is far from finished. It may well be that a few euro countries like Germany will soon have to jump in as a savior, offering billions in bilateral aid. That would be bitter pill to swallow."

Variations on these themes can be seen from other news outlets in Germany. I strongly recommend the summary contained in Spiegel Online if you would like to understand the direction of German sentiment.

I emphasise the press reactions, as the basic question that arises from the Greek crisis is not a question of economics. The EU has always rested upon compromise, upon politicians measuring their national interest against the 'great European project'. Such compromises have always been hard to sell to domestic audiences, but the problems of the Southern European states are a scale of a different order. It is very tough indeed to justify, when you have your own problems, why you might wish to bail out those whose problems are largely of their own making. Having said this, the elites within Europe have often managed to their goals in the face of opposition. Might they manage this in the face of crisis? I am really not sure.

The point I am trying to make here is that the Euro is more a political confection than it is an economic unit. The same may be said about all currency, but the existence of the Euro relies upon a continuing process of compromise and tolerance. The indications are that Germany are increasingly unwilling to bail out Greece, despite the potential for a broad crisis for the Euro itself. A search against 'Euro' and 'Greece' paints the picture of the sense of crisis for the Euro. One headline says it all, with the Sydney Morning Herald suggesting that 'Greece Trips, Euro Could Fall'.

The crisis in Europe has profound implications. I have long argued that the continuance of the massive accumulation of government debt in the 'rich world' rests upon a flimsy premise. This premise is that delusion that the Western world (and now Japan) have always been rich, and will always be rich. Iceland could be dismissed as exceptional, Dubai was still not the 'West', but the fall of Greece risks a spreading crisis that will undermine the belief in the 'rich world'. This is a Euro economy, and whatever the particular peculiarities of the Greek situation, the cracks in the edifice of belief will enlarge. As I have also long argued, the deficits of the major debtor economies are structural, and will not disappear. The cracks in belief will refocus minds on this underlying reality, and the closer the reality is examined, the greater the cracks will grow.

Will the crisis in Greece be enough to herald the denouement to the lax and unsustainable fiscal and monetary policies that have supported countries like the UK and US? Much hangs on the response to the crisis, but a response of a bailout will only serve as a delaying mechanism. Furthermore, a bailout might further stretch the economies of those that come to the rescue of the PIIGS, with Ambrose Evans-Pritchard of the Telegraph comparing the potential damage to the absorption of HBOS by Lloyds.

Chickens are coming home to roost. And for those who say that countries who have control of their own currency are in a different situation, the answer is very simple. The only way those with control of their own currency can avoid the same crisis as Greece is if they inflate away debts. However, doing so whilst raising record amounts of debt on international markets looks to be implausible. The US might get a benefit of 'flight to safety', but only for a short while. At some point, investors will realise that they have fled the bear only to hide in the bear's cave. It is an analogy I have used before, as the US is no haven of safety.

The position now is; 'wait and see'. A cobbled compromise might serve to delay the final act of the economic crisis. However, it is possible that the economic crisis is entering the last act. If Greece topples, who will follow?

Note: I have included Ireland in the PIIGS acronym, and Ireland is certainly at risk. However, Ireland is facing the fiscal problems head on, and should really be in a different category. I am not saying that it should be considered and treated as safe, but that it should be viewed as less of a risk than the other PIIGS. I have great respect for the efforts of the Irish government to reign in the deficits, and therefore will be sorry to see that their efforts might have come too late (or the crisis too early???).

23 comments:

  1. P.S. Have you seen this:

    http://www.news.com.au/business/secret-summit-of-top-bankers/story-e6frfm1i-1225827289543

    Despite the title, the meeting was pre-planned, but it would be interesting to know what the subjects of discussion will be.I suspect the fate of Greece may be decided here...

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  2. And for those who say that countries who have control of their own currency are in a different situation, the answer is very simple. The only way those with control of their own currency can avoid the same crisis as Greece is if they inflate away debts. However, doing so whilst raising record amounts of debt on international markets looks to be implausible.

    This assumes that the quantity theory of money – the idea that there is direct relationship between the money supply and the inflation rate – is correct.

    It isn't.

    One example can show how wrong it is.

    Under Ronald Reagan, for example, the US money supply doubled, as you can see in this graph, but the inflation rate fell in virtually every year until 1987, even at a time of deep government deficits.

    Western countries have large unemployment rates, and low capacity utilizaton. This will act as a break on significant inflation for the forseeable future.

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  3. I'm starting to think that, just as the 'financial WMD' were primed to bring down the big European banks, now American and China, with their unholy symbiosis, are acting in concert to explode the structural flaws in the Eurozone.

    In a world of expanding demand and diminishing resources, economically-speaking it doesn't matter what carnage you cause as long as you're the last man standing. It's a war out there...

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  4. Lord Keynes wrote:

    "This assumes that the quantity theory of money – the idea that there is direct relationship between the money supply and the inflation rate – is correct."

    xxxxxxxxxxxxxxxxx

    Have you ever considered the role cheap imports, i.e. wealth appropriation by the West allows them to print money without inflation?

    ReplyDelete
  5. A few things:-

    In your last post you expressed concern that you were "saying the same things". Can I just say that from my perspective your blog posts remain interesting, insightful and creative.

    While its true that you have limited yourself to economic matters and so there will be some repetition - every post contains a new idea or way of conveying your thoughts. I enjoy them as much as ever and I'm sure others do too.

    You asked for posts that readers might like your take on. Well, since I'm interested in politics I'd love to see some posts from that direction - though I understand why you might want to avoid that (and risk alienating some readers.)

    In particular I'd love to see a "what if" scenario where you imagine yourself as a close advisor to a new Prime Minister (of any persuasion or party). How about a "ten ways to fix the economy" post - if you had the power to make them happen. I've tried this myself and would like to see if there's any crossover.

    In regards to Greece - I suspect we'll see more EU states imploding this year as the genuine depth of economic sickness begins to force its way through the illusions that many still hold.

    I don't know about you, but I've spent the last year paying off debt, squirreling money away and trying to minimise my family's exposure to what I believe is going to be a truly horrible next couple of years for us all.

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  6. Three new Cynicus posts in almost as many days! Great stuff!

    Lord Keynes,

    I am confused. The graph you show is taken from Chris Martenson's site, however, during one of his presentations he shows a graph (@7m45s) showing that inflation "between 1975 and today" had increased near exponentially.

    Now, I don't know where he got his data from but unless I've misunderstood something (which is VERY possible!) one of you must be wrong. May I ask what your data source is for "the inflation rate fell in virtually every year until 1987"?

    Hope everyone is well.

    T.

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  7. cynicus

    As events have panned out over the last couple of years, you've been shown to have read this thing pretty well. The general thrust of what is currently happening, and has happened, seems to have played out pretty much as you predicted.

    It would be interesting to see a post from you outlining the possible scenarios we could find ourselves in over the coming few years. I mean, the real consequences of this thing panning out for employment, economic activity, taxes, public services and how long it would take to turn it around ( if thats possible at all )

    It looks very much to me that policy makers are going to keep their heads firmly in the sand and events will, in any case, reach their own conclusion now irrespective of what actions may or may not be undertaken at this late stage. A glimpse into the sort of environment we may be facing would be helpful.

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  8. Reply to Ttiberiusleodis

    You can get the inflation rates here:

    Historical Inflation Rates: 1914-2009

    A sample:

    Year Inflation
    1982 6.2%
    1983 3.2%
    1984 4.3%
    1985 3.6%
    1986 1.9%
    1987 3.6%

    You can see Reagan’s budget deficits here:

    US Budget Deficit or Surplus 1960-present

    The budget decifits reached their peak in 1983-1985, precisely when inflation was falling.

    The graph on the page you linked to looks like the money supply growth to me.

    Here is a graph of the annual change in the US inflation rate:

    Annual change in US inflation

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  9. CE,

    I've been reading economists and columnists predicting Greece could bring down the euro and possibly the whole of Europe could implode because of them. What's worring me more is you seem to be in agreement. Can you tell me if i'm missing something?

    Greece's economy is only about 2% of EU GDP. In fact in the past 12 months the "Magical Merlin King" has managed to conjour the entire value of the Greek economy out of thin air and lend it to the UK Gvt.

    It would probably take about a 20 billion loan to get the Greek economy back on track. Loose change for an economy the size of the EU. Ask Gordon Brown, he borrowed 20 billion in November alone.

    Mark, are we trying to kid ourselves or am I not seeing the true picture?

    Best Regards Mismo

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  10. Lord Keynes,

    Thanks for your response.

    There are a number of points I am still unclear on:

    Firstly, you say:

    "Under Ronald Reagan [...] the US money supply doubled [...] but the inflation rate fell in virtually every year until 1987."

    You're right that the figures you point to suggest that that only two of the six years refered to (1984, 1987) showed an increase in the inflation rate. However, since this means that the inflation rate decreased in only two-thirds of those years I am unsure why you characterise this a "virtually every year ". Futhermore (and more importantly) if we increase the range from 1981-1989 (Reagan period) then a total of half of the years saw an increased rate of inflation from that of the previous year - I can't see how this makes your general point.

    Secondly, you say:

    "The budget decifits reached their peak in 1983-1985, precisely when inflation was falling."

    I have two issues with this. Firstly I am not sure anyone is saying the relationship between money supply and inflation is as instantaneous as you seem to be implying. Secondly, I'm not sure how much sense it makes to say "inflation was falling". I wouldn't say, for example, that my car's "acceleration was falling" as this seems to implicitly describe movement in the opposite direction when what we are really talking about is a slowed rate of movement in the same direction (somewhat pedantic you might say but I think it is important to be careful with language on these matters).

    Finally, the graph you offer on here (you will have to play the video and move it to 7 mins 45 seconds. The graph is Titled "Permantent Inflation - A Recent Development" with the subheading "US Price Levels 1665 to estimated 2008".

    All the best,

    T.

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  11. The inflation rates from 1981 to 1987:

    1981 10.3%
    1982 6.2%
    1983 3.2%
    1984 4.3%
    1985 3.6%
    1986 1.9%
    1987 3.6%

    In 5 of 7 years inflation fell, yet in every year the money supply increased and there were budget deficits.

    If the quantity theory of money were true, then that should have shown up increased inflation in every year.

    It did not.

    And by 1986, the effects of the 4 years of rising money supply and deficits should have been felt in higher inflation, yet inflation fell to 1.9%.

    My point that there is no direct relationship between money supply growth and inflation as posited in the quanity theory of money stands.

    There are too many factors that influence inflation and too many variables for this theory to be correct.

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  12. Lord Keynes,

    You say:

    "If the quantity theory of money were true, then that should have shown up increased inflation in every year."

    Your comments suggests that you are either misrepresenting the quantity theory of money or not have not understood it in part. Please allow me to explain why I believe this to be the case.

    In the first instance, the quantitiy theory money states that "that money supply has a direct, positive relationship with the price level." - this is not the same phenomena as inflation rates. I believe that your misunderstanding on this point is the root of our difference.

    For example, you say:

    "by 1986, the effects of the 4 years of rising money supply and deficits should have been felt in higher inflation, yet inflation fell to 1.9%" (emphasis mine)

    In fact, according to your data the 4 years prior 1986 had seen price levels increase by approximately 18% from their 1981 levels. The inflation rate of 1.9% in 1986 is wholly irrelevant to your point - you are overlooking the fact this constitutes 1.9% of a bigger number (i.e. 1.9% increase since 1985, not since 1981).

    Likewise, you say:

    "My point that there is no direct relationship between money supply growth and inflation as posited in the quanity theory of money stands"

    However the theory instead posits a direct relationship between money supply growth and price levels - and your data shows this accurate for the data shown oppostite, There is a direct positive relationship - as one goes up so does the other. (Though of course this could be correlational and not causal). In addition, nowhere in the theory does it state that this increase in price levels must be uniform (so far as I am aware).

    (Continued below)

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  13. (Continued from above)

    If you'll allow me to make a brief analogy to explain why I think you are wrong in your treatment of these figures.

    Suppose that a 5 year old is trying to discover if there is a positive relationship between age and height (The 'Age Theory of Height'). He therefore decides to measure his height for the next 5 years:

    Age Height (cm)
    5 109
    6 115
    7 122
    8 127
    9 133
    10 137

    The data seems to support the theory - as the years go up so does the height. However lets say that instead of measuring his height for each year he simply puts down the % he has grown since the previous year and calls this is "Current Growth Rate". His chart would now look like this:

    Age Growth Rate
    6 5.5%
    7 6.1%
    8 4.1%
    9 4.7%
    10 3%

    If the child now looked at the data and said "Well for two of the years my growth rate dropped from that of the previous year so therefore I doubt the Age Theory of Height" would that be appropriate? He still is 26% taller at 10 years than he was at 5. The fact that he only grew 3% between his ninth and tenth birthday has nothing to with it. If he were testing another theory (let's say "The Age Theory of Growth Rate) this data may then be relevant - but he isn't!

    In conclusion, I would say that your treatment of the inflation figures as discreet quantities rather than rates of change is leading you to draw inappropriate conclusions from your data. The quantity theory of money deals with increases in price levels (and is generally conceded to be most accurate in the long term), short term inflation rates are a different phenomenon.

    Regards,

    T.

    PS, please take all comments in the non-confrontational tone intended - monetary theory seems to make enemies of so many!

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  14. Tiberiusleodis, I am preparing a response on the quantity theory of money for you soon.

    But, in other news, the EU will apparently give a bailout to Greece:

    Franco-German bailout of Athens expected to avert euro collapse.

    Rumours of the Eurozone's demise greatly exaggerated?

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  15. Lord Keynes,

    "Rumours of the Eurozone's demise greatly exaggerated?"

    Not necessarily!

    Angela Merkel dashes Greek hopes of rescue bid

    T.

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  16. Cynicus,

    I presume you will have seen this already, but, if not, I'd consider it a must-read:

    A Greek crisis is coming to America

    T.

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  17. tiberius,

    Many thanks for the link, but I think you entered it wrongly. It is as per below, and I would also suggest that it is a very good read:

    http://www.ft.com/cms/s/0/f90bca10-1679-11df-bf44-00144feab49a.html

    Thanks again.

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  18. Reply to Tiberiusleodis on Quantity Theory of Money 1

    In the first instance, the quantity theory money states that "that money supply has a direct, positive relationship with the price level." This is not the same phenomena as inflation rates. I believe that your misunderstanding on this point is the root of our difference.

    Yes, it does say that on Wikipedia and many versions of it refer to the price level. I am well aware of the different between the inflation rate and the price level.

    But some versions of the quantity theory of money do say that there is supposedly a relationship between rising money supply rate and a rising inflation rate.

    Take this statement by the neo-classical godfather N. Gregory Mankiw in his Essentials of Economics:

    Therefore when the central bank increases the money supply rapidly, the result is a high rate of inflation.

    N. Gregory Mankiw, Essentials of Economics (5th edn), 2008, p. 488

    Or take this in Irvin B. Tucker’s Survey of Economics:

    the evidence suggests the general conclusion that sustained levels in higher growth of money supply corresponds to the inflation rate

    Irvin B. Tucker, Survey of Economics (6th edn), 2008, p. 418

    Or M. Parkin et al. in Foundations of Macroeconomics:

    In the long run, the inflation rate equals the growth rate of the quantity of money minus the growth rate of potential GDP.

    M. Parkin, R. Bade, M. Rush et al, Foundations of Macroeconomics (2002)‎, p. 188.

    Quite clearly, mainstream neoclassical economists do connect the inflation rate with a rising money supply.

    Therefore my original point was totally correct.

    A rising price level is of course a different thing from the inflation rate. But I will deal with that shortly.

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  19. As many of you might know, I have a blog.
    Though not related to economic issues per se, my latest post discusses why scepticism about anthropogenic global warming is completed justified.

    I invite people, especially people on the left, who support AGW to read and respond:

    Anthropogenic Global Warming: Why the Left should be Sceptical

    ReplyDelete
  20. T.

    Can you explain (I seem to be in a minority of one here) of why everyone seems to agree Greece and the Euro are doomed?

    The "Mail" article states:
    "The euro slid almost 1 per cent to $1.357 yesterday, meaning it has lost 10 per cent of its value since November. The pound rose to 1.14 euros."
    There was also a screwed up picture of a 100euro note.

    I don't seem to remember these publictions printig pictures of screwed up 50pound notes when stirling fell 35% against the Euro. It's hardly "a collapse" when the Euro is still trading about 6 cents off it's all time high against the pound.

    As with my earlier post, I hope you or CE can help me understand what everyone can see that I can't.

    Regards Mismo.

    PS. There is not even a chance that the EU won't bail out Greece!

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  21. Just a quick note for tiberiusleodis to say the first of my posts on the quantity theory of money has just been posted above.
    The second will follow soon.

    Also if people want to debate climate change see my blog:

    Anthropogenic Global Warming: Why the Left should be Sceptical.

    Join the discussion!

    ReplyDelete
  22. Mismo, I don't think CE said the Euro has collapsed. He believes that the Euro will collapse. The Euro is doomed because most of the countries using the Euroare up to their necks in debt while producing little of value when it comes to international trade.

    There's a general decline in economic activity in Europe that has started since at least the 1970s.

    I put the decline back further. I'm guessing that some countries in Europe never rebuilt their industrial base back after it was destroyed in World War II and relied on colonialism. European people tend to be hard-working so what has happened to them, in my opinion, since WW II has been a brain drain. All the ambitious people went to America. The people who stayed behind tried to build socialist paradises, again not a bad thing because they have acheived some level of enviornmental sustainability, but they still like to think of themselves as capitalistic.

    ReplyDelete

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