A Gravity Test for the Euro

Kenneth Rogoff


 CAMBRIDGE – Although I appreciate that exchange rates are never easy to explain or understand, I find today’s relatively robust value for the euro somewhat mysterious. Do the gnomes of currency markets seriously believe that the eurozone governments’ latestcomprehensive package” to save the euro will hold up for more than a few months?

The new plan relies on a questionable mix of dubious financial-engineering gimmicks and vague promises of modest Asian funding. Even the best part of the plan, the proposed (but not really agreed) 50% haircut for private-sector holders of Greek sovereign debt, is not sufficient to stabilize that country’s profound debt and growth problems.

So how is it that the euro is trading at a 40% premium to the US dollar, even as investors continue to view southern European government debt with great skepticism? I can think of one very good reason why the euro needs to fall, and six not-so-convincing reasons why it should remain stable or appreciate. Let’s begin with why the euro needs to fall.

Absent a clear path to a much tighter fiscal and political union, which can lead only through constitutional change, the current halfway house of the euro system appears increasingly untenable. It seems clear that the European Central Bank will be forced to buy far greater quantities of eurozone sovereign (junk) bonds. That may work in the short term, but if sovereign default risks materialize – as my research with Carmen Reinhart suggests is likely – the ECB will in turn have to be recapitalized.

And, if the stronger northern eurozone countries are unwilling to digest this transfer – and political resistance runs high – the ECB may be forced to recapitalize itself through money creation. Either way, the threat of a profound financial crisis is high.

Given this, what arguments support the current value of the euro, or its further rise?

First, investors might be telling themselves that in the worst-case scenario, the northern European countries will effectively push out the weaker countries, creating a super-euro. But, while this scenario has a certain ring of truth, surely any breakup would be highly traumatic, with the euro diving before its rump form recovered.

Second, investors may be remembering that even though the dollar was at the epicenter of the 2008 financial panic, the consequences radiated so widely that, paradoxically, the dollar actually rose in value. Although it may be difficult to connect the dots, it is perfectly possible that a huge euro crisis could have a snowball effect in the US and elsewhere. Perhaps the transmission mechanism would be through US banks, many of which remain vulnerable, owing to thin capitalization and huge portfolios of mortgages booked far above their market value.

Third, foreign central banks and sovereign wealth funds may be keen to keep buying up euros to hedge against risks to the US and their own economies. Government investors are not necessarily driven by the return-maximizing calculus that motivates private investors. If foreign official demand is the real reason behind the euro’s strength, the risk is that foreign sovereign euro buyers will eventually flee, just as private investors would, only in a faster and more concentrated way.

Fourth, investors may believe that, ultimately, US risks are just as large as Europe’s. True, the US political system seems stymied in coming up with a plan to stabilize medium-term budget deficits.

Whereas the US Congress’ssupercommittee,” charged with formulating a fiscal-consolidation package, will likely come up with a proposal, it is far from clear that either Republicans or Democrats will be willing to accept compromise in an election year. Moreover, investors might be worried that the US Federal Reserve will weigh in with a third round of “quantitative easing,” which would further drive down the dollar.

Fifth, the current value of the euro does not seem wildly out of line on a purchasing-power basis. An exchange rate of $1.4:€1 is cheap for Germany’s export powerhouse, which could probably operate well even with a far stronger euro. For the eurozone’s southern periphery, however, today’s euro rate is very difficult to manage. Whereas some German companies persuaded workers to accept wage cuts to help weather the financial crisis, wages across the southern periphery have been marching steadily upwards, even as productivity has remained stagnant. But, because the overall value of the euro has to be a balance of the eurozone’s north and south, one can argue that 1.4 is within a reasonable range.

Finally, investors might just believe that the eurozone leaders’ latest plan will work, even though the last dozen plans have failed. Abraham Lincoln is credited with sayingYou can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time.” A comprehensive euro fix will surely arrive for some of the countries at some time, but not for all of the countries anytime soon.

So, yes, there are plenty of vaguely plausible reasons why the euro, despite its drawn-out crisis, has remained so firm against the dollar so far. But don’t count on a stable euro-dollar exchange ratemuch less an even stronger euroin the year ahead.
Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.

Last updated:November 1, 2011 5:30 pm

Time for us to challenge the idols of high finance

Pinn illustration

It has sometimes been said in recent years that the Church of England is still used by British society as a stage on which to conduct by proxy the arguments that society itself does not know how to handle. It certainly helps to explain the obsessional interest in what the Church has to say about issues of sex and gender. It may help to explain just what has been going on around St Paul’s Cathedral in the past fortnight.

The protest at St Paul’s was seen by an unexpectedly large number of people as the expression of a widespread and deep exasperation with the financial establishment that shows no sign of diminishing. There is still a powerful sense around fair or not – of a whole society paying for the errors and irresponsibility of bankers; of impatience with a return to ‘business as usual – represented by still-soaring bonuses and little visible change in banking practices.

So it was not surprising that initial reactions to what was happening at St Paul’s and to the welcome offered by the Cathedral were sympathetic. Here were peopleprotesters and clergy too, it seemedsaying on our behalf that ‘something must be done. A marker had been put down, though, comfortingly, not in a way that made very specific demands.

The cataract of unintended consequences that followed has been dramatic. The cathedral found itself trapped between what must have looked like equally unpleasant courses of action. Two outstandingly gifted clergy have resigned. The Chapter has now decided against legal action. Everyone has been able to be wise after the event and to pour scorn on the Cathedral in particular and the Church of England in general for failing to know how to square the circle of public interest and protest.

There will be plenty of postmortems no doubt. But before we indulge in yet more satisfying indignation, we should keep two things in mind. First, the Church of England is a place where the unspoken anxieties of society can often find a voice, for good and ill. If the Church cannot find ways through, that is not an index of its incompetence so much as of the sensitivity of such matters. Second, we are at risk of forgetting the substantive questions that prompted the protest.

As I said, the demands of the protesters have been vague. Many people are frustrated beyond measure at what they see as the disastrous effects of global capitalism; but it isn’t easy to say what we should do differently. It is time we tried to be more specific.

There is help to be had from a bold statement on our financial situation emerging last week from the Vatican. This document, from the Pontifical Council for Justice and Peace, is entitled ‘Towards Reforming the International Financial and Monetary Systems in the Context of Global Public Authority’. It contains, with sharp critical analysis, a rather utopian vision of global regulation. But, more important, it offers recommendations that seek not to change everything at once but to minimise the damage of certain practices and assumptions.

One is something we have now heard clearly from many sources – a plea endorsed by the Vickers Commission that routine banking business should be clearly separated from speculative transactions. The rolling-up of individual and small-scale savings into high-risk and high-return adventures in the virtual economy is one of the more obvious danger areas. Early government action in this area is needed. A second plea is to recapitalise banks with public money. Banks should be obliged in return to help reinvigorate the real economy.

The third suggestion is probably the most far-reaching. The Vatican statement strongly backs the proposal of a Financial Transaction Tax – a Tobin Tax” or, popularly, a “Robin Hood Tax in the form in which it has been talked about most recently. This means a comparatively small rate of tax (0.05 per cent) being levied on share, bond, and currency transactions and their derivatives, with the resulting funds being designated for investment in the “realeconomy, domestically and internationally. The modest rate of taxation conceals the high levels of return that could be expected (some $410bn globally on one estimate).

This has won the backing of significant experts who cannot be written off as naive anti-capitalistsGeorge Soros, Bill Gates and many others. It is gaining traction among European nations, with a strong statement in support this week from Wolfgang Schaüble, the German finance minister. The objections made by some who claim it would mean a substantial drop in employment and in the economy generally seem to rest on exaggerated and sharply challenged projections – and, more important, ignore the potential of such a tax to stabilise currency markets in a way to boost rather than damage the real economy.

The UK government prefers the model of a direct taxation of bank assets. It looks as though that will be their position at the impending summit of the group of 20 leading economies. But we need robust public discussion enabling us to assess the advantage of a co-ordinated approach across Europe, and to inquire into how far the government’s preferred option will guarantee the domestic and international development goals central to the “Robin Hoodproposals.

These ideas, which have been advanced from other quarters, religious and secular, in recent years, do not amount to a simplistic call for the end of capitalism, but they are far more than a general expression of discontent. If we want to take seriously the moral agenda of the protesters at St Paul’s, these are some of the ways in which we should be taking it forward. The Church of England and the Church Universal have a proper interest in the ethics of the financial world and in the question of whether our financial practices serve those who need to be served – or have simply become idols that themselves demand uncritical service.

The best outcome from the unhappy controversies at St Paul’s will be if the issues raised by the Pontifical Council can focus a concerted effort to move the debate on and effect credible change in the financial world. If religious leaders and commentators in the UK and elsewhere could agree on these three proposals, as a common ground on which to start serious discussion, questionings alike of protesters and clergy will not have been wasted.
The writer is Archbishop of Canterbury
Copyright The Financial Times Limited 2011.


NOVEMBER 2, 2011

A Greek Lesson in Democracy
A referendum in Athens would be instructive for all of Europe.

George Papandreou became the most unpopular man in Europe on Monday by announcing that his government would put the terms of last week's EU-IMF bailout package to a referendum, so that Greeks can decide their economic future for themselves. The Prime Minister's announcement sent markets tumbling world-wide, took Italian government-bond yields to a near euro-era high, and had German officials privately denouncing his behavior as un-European.

An alternative view is that Mr. Papandreou has done his own people, and all Europeans, a considerable favor. Who would have thought the Greeks had something to teach the world about democracy?

Since the euro-zone crisis began in earnest early last year, European policy makers have been placing Jon Corzine-sized bets on a series of rescue packages for insolvent nations and troubled banks, without much input from the taxpayers who are ultimately on the hook for these ever-more-expensive bailouts.

It's a method of governance that betrays the contempt of European elites for the views of their own people, who don't always like where those elites propose to take them. Recall the overwhelming rejection by French and Dutch voters of a proposed EU Constitution in 2005.

For Greeks, their stake in last week's euro-zone deal could hardly be higher: Their choice is either to sign up for a decade of EU- and IMF-imposed austerity or face the prospect of immediate default and the possible loss of the euro as their currency. That is at least partly why Mr. Papandreou, who has a parliamentary majority of two seats and faces another no-confidence vote on Friday, chose to go for a referendum, currently scheduled for January.

Should Greeks vote yes, Mr. Papandreou's hand will be strengthened politically. If they vote no, the Greeks will at least be taking responsibility for the consequences. That sounds better than Greeks rioting in the streets against politicians in Berlin or Brussels over whom they have no influence.

As for the rest of Europe, they may eventually come around to thanking Mr. Papandreou and the Greeks, even for a no vote. Today's conventional wisdom is that a Greek default would spread contagion, never mind that past bailout packages for Athens haven't exactly contained it.

While nobody can doubt that an Athenian default would be damaging for Greece's creditors, particularly French banks, these creditors will face a reckoning sooner or later. The real political purpose of the deal agreed in Brussels last week between French President Nicolas Sarkozy and German Chancellor Angela Merkel is to postpone that reckoning past their own (and President Obama's) elections.

A Greek default would provide a lesson in what happens to countries that can't live within their means.

The sight might even be enough to terrify lawmakers in Italy to get serious about fixing their unfunded pension promises and other antigrowth policies. The serial bailouts sure aren't doing the job.

Even nowtwo years into the crisisfew of Europe's elites are talking about the need to restore growth by means of economic liberalization. Consider Greece: The World Bank recently published its latest annual "Doing Business" survey, and for all of its alleged reforms Greece rose all of one spot to 100th this year in the world rankings in the ease of doing business. That's just behind Yemen, though still ahead of Papua New Guinea. When it comes to investor protections, Athens ranks 150th.

The only good news in those figures is that Greece has plenty of room for improvements if only its political class had the courage to undertake them. However the Greeks vote in a referendum, this is the only route to an economic future that offers something better than penury or permanent indebtedness.
Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

November 2, 2011
Euro Crisis Threatens Banking System


FRANKFURT — In March 2009 about 40 bankers and government officials crowded into a classroom at an economic institute in Vienna to talk about how they might save Eastern Europe from financial Armageddon.

In the months that followed they forged a pact that became known as the Vienna Initiative, which is widely credited with preventing a bank run and economic catastrophe in new members of the European Union like Hungary and Romania.

Now some officials and economists are beginning to ask whether it’s time for those bankers and officials to hold a reunion. The sovereign debt crisis in the euro area, as well as a looming recession, is spilling into countries like Poland that do not belong to the currency union but are heavily dependent on Western Europe for trade and capital. Once again, the banking system is threatened.

The source of stress is different this time, emanating from within Europe rather than from the United States. But there are some alarming similarities, including a continued dependence by East European businesses and consumers on loans denominated in euros or Swiss francs. These loans can become ruinously expensive for borrowers when their local currencies lose value, as has been the case in Poland and Hungary, among others.

“I am very worried about what is going on around our region,” said Erik Berglof, chief economist of the European Bank for Reconstruction and Development and one of the leaders of the Vienna Initiative.

While the circumstances are different today, Mr. Berglof said, there is again a need for coordination among banks, central bankers, regulators and government policy makers.

In 2009, the fear was that the West European banks that dominated in Eastern Europe — including Société Générale in France, UniCredit in Italy and several Austrian institutionsfaced intense market pressure to take money out of the region. If one bank bolted for the exit, the thinking went, a panic might ensue. All the banks would abandon their subsidiaries rather than risk being the last ones out.

As part of the Vienna Initiative, 15 banks got together with officials from the International Monetary Fund, the E.B.R.D. and the European Union and promised to continue investing in their East European subsidiaries. The E.U. reciprocated by committing more than €50 billion, or $70 billion, in loans and other aid to the region, while the I.M.F. and E.B.R.D. pledged additional billions to the stricken countries as well as local subsidiaries of banks like UniCredit. Many East European countries suffered steep recessions in 2009, but the initiative probably averted a deeper catastrophe.

This time around, the fear is not so much that bankers will dash for the lifeboats, but rather that problems in their home offices could compel them to starve their units in Eastern Europe of capital, creating a credit crunch and an economic downturn.

Bankers say that won’t happen, and that fears for the region are overblown. “I do not see a great value” in a second Vienna Initiative, said Herbert Stepic, chief executive of Raiffeisen Bank International, a bank based in Vienna that is among the most active institutions in Eastern Europe.

The bank “will keep its affiliates in the form we have them now,” said Mr. Stepic, who was a key figure in organizing the first Vienna Initiative. “We don’t see any danger that we have to deleverage in one or the other country.”

But many of the foreign banks with the biggest presence in Eastern Europe are under severe stress at home, notably Greek institutions like Alpha Bank and Piraeus Bank. They were among the first to expand into neighboring countries like Albania and Bulgaria after the fall of communism, but now are suffering severe collateral damage from their country’s debt load and plummeting economy.

Other banks face pressure from regulators to reduce risk and raise their capital reserves, making it harder for them to invest in their foreign operations. These include UniCredit, a major presence in Poland and many other countries in the region, and Société Générale, which is particularly active in the Czech Republic and Romania.

UniCredit will need to raise more than €6 billion to comply with demands by European political leaders that banks increase their reserves, while Société Générale will need to raise more than €3 billion, according to estimates by analysts at Nomura.

Austrian banks, which exploited their historical ties to the former Austro-Hungarian empire after the fall of the Berlin Wall, are also under pressure.

Erste Group, a bank in Vienna that is another of the big players in Eastern Europe, shocked markets in October with a €1.5 billion quarterly loss and the disclosure that it had a €5.2 billion portfolio of risky derivatives known as credit-default swaps, a form of insurance on government or corporate bonds. The bank has sold most of the swaps, at a loss of €205 million this year.

The loss at Erste Bank illustrated how Eastern Europe, once a beacon of growth, has become a more difficult market for banks. The rate of bad loans in many countries is double or triple the level in Western Europe, accounting for more than 10 percent of total credit in countries like Romania, Bulgaria and Hungary, according to I.M.F. data.

Just like in the United States, large numbers of bad loans are poisonous for economic growth, depressing consumer and business spending and amplifying the risks of a larger credit crunch. Banks with highly impaired loan portfolios are likely to engage less in new lending,” the I.M.F. warned in September.

One reason there are so many bad loans is that consumers and businesses in most East European countries still borrow heavily in foreign currencies. That is an old problem, one that played a huge role in the first phase of the financial crisis and provoked a need for the Vienna Initiative in the first place.

High levels of foreign currency lending may have systemic consequences for the countries concerned as well as potential for cross-border contagion,” the European Systemic Risk Board said in October. The warning was the first issued by the newly formed panel overseen by Jean-Claude Trichet, then president of the European Central Bank, an indication of the level of concern among top policy makers.

Despite efforts by the E.B.R.D. to encourage lending in local currencies, loans in francs or euros remain seductive for many East Europeans. Subdued inflation in Switzerland and the euro zone mean that loans denominated in francs or euros carry much lower interest rates than credit in Hungarian forints or Polish zloty.

Another reason for the continued popularity of foreign currency loans is that most East European countries do not have large local capital markets where banks can raise funds to lend on to their customers. By going abroad, banks have access to a much larger pool of capital.

But when the local currencies lose value relative to the euro or franc, borrowers find themselves faced with much higher monthly payments. That is exactly what happened in 2008 and is happening again now. In Hungary, where more than 60 percent of existing loans are in foreign currencies, the government of Prime Minister Viktor Orban is forcing banks to allow borrowers to pay off their franc debts in forints at a discount to the market exchange rate.

Banks say such policies will ultimately hurt Hungary, by discouraging banks from lending and investing. “We do not expect in the next couple of years to have a very profitable business in Hungary, to say the least,” Andreas Treichl, the chief executive of Erste Group, said during a conference call with analysts last week.

He and other bank executives say they remain optimistic about the long-term potential of Eastern Europe, which continues to have faster economic growth than Western Europe.

Mr. Stepic of Raiffeisen said, “We are among the ones that made the transformation from former communist regime countries into free economic zones possible. This is what we will continue to do.”

But Mr. Berglof, the E.B.R.D. economist, said it was hard to imagine that West European banks would be able to continue to support their East European units as energetically as they had in the past.

In the worst case, governments might need to take over distressed local subsidiaries, reversing two decades of post-communist privatization. “At the end,” Mr. Berglof said, “it raises the issue of what is the future of cross-border banking in Europe.”