Saturday, 11 July 2015

The Age of Migration - debt, migration and flawed architecture

With Eurozone Finance Ministers discussing suggestions ranging from a temporary Greek exit from the Euro, to a request for the Greeks to come up with 'more' (more austerity, more evidence that proposed measures actually will be carried out?), there's a long day of negotiations ahead in Brussels. But that Greek debt crisis has now opened up a debate on the notion of debt restructuring within the single currency area.

There is growing pressure for Greece's creditors to allow more formal restructuring of Greek debt, which would inevitably lead to acceptance that debt restructuring, re-profiling or relief may need to be seen across the Euro Area at times. Many people who have been looking at the mountains of debt accumulated by Eurozone governments in recent years have long believed repayment of that debt is unlikely, so what's the big deal? Even a casual glance at the history of sovereign debt shows that defaults happen more often than many people realise, often occur in clusters, and the risk of them is underpriced. Furthermore, default is, by and large, forgiven faster for sovereigns than for others, understandably.  A defaulting individual or company can be cast away, never to be seen again. Literally, in the case of debtors the English sent to the other side of the world in the 19th century. But a country won't go away. Russia defaulted and then sat there on the same bit of land as before until we all decided to do business with it again.

History, furthermore, tells us that punishing a country's people too harshly and demanding they repay the debts accumulated by their parents, leaders or even themselves, is counter-productive. At worst, it builds enmity. At best, it means an economically weakened trading partner.

So if we accept that default is occasionally necessary, why be bothered about doing it in Europe? The answer, I think, is that the idea that sovereign default is impossible in the Euro Area is a big part of the architecture of the system, put there to cope with one of its very biggest structural flaws - the fact that while national central banks do not have the ability to run independent monetary policies, national governments have a lot of autonomy over fiscal policy. This is a huge flaw, 'managed' with the rules on deficits and debt. Weaken those and the flaw is exposed, and will either bring the system crashing down or be resolved itself through adoption of a new fiscal structure.

Here's a description of the conditions for a strong monetary union, which I took from the late Victor Argy:  "A strong monetary union is assumed to have a common currency and a common central bank. Capital markets are unified and independent monetary policy becomes impossible. Some independent fiscal policy continues to be feasible. And he goes on to list the conditions which make the costs of joining a union smaller, or the benefits larger. They are 1) that differences in growth rates and labour productivity are not large; 2) that intra-union trade is large; 3) that there is no long-run trade-off between inflation and unemployment; 4) the differences in propensities to inflate are relatively small; 5) differences in degree of domestic instability are relatively small; and 6) there is a significant degree of labour mobility." Grapes of Wrath. A better read on currency unions than anything I've written can be found here, in a discussion by Milton Friedman of the Euro in 1997. Some of the weakness he outlines have been tackled since then, but not all. 

'Some independent fiscal policy continues to be feasible'.  That is absolutely not what European fiscal policy looks like. Consider this. US State and Local debt totals 1/6th of Federal debt and less than 20% GDP.  So when California over-borrows, despite being the biggest state, it still doesn't cause a huge national crisis. Imagine California having a debt level of 120% GDP, and then asking smaller states to forgive a share of that debt based on their own share of US GDP. It doesn't happen because the US allows 'some independent fiscal policy'.

This problem of local control over debt and Federal control over monetary policy is a really, really issue. When I write that sovereign debt default is relatively common, I should differentiate between default on domestic debt, and default on foreign debt. There's a brief discussion of the top in this week's Economist here, Buttonwood. Domestic debt default is often counter-productive because of the damage it does to the domestic banking system, so default usually happens via the means of inflation.  Historically this was done through the effortless means of debasing the currency, more recently it's been done with the help of a monetary policies than boost inflate and weaken the currency. And most recently of all, global disinflationary forces have made it hard to do at all. Defaulting on foreign currency debt is more straightforward, and therefore more common. But in Europe, the domestic routes to de facto default through devaluation and inflation, simply don't exist. All debt is foreign because no single country controls the Euro printing press. And worse still, since more and more of any single country's debt is now held by that country's banks, this is now de facto foreign debt but defaulting will still cause havoc in the domestic banking system.

I still don't know how this weekend will play out, let alone how long the Greek debt can can be kicked down the road before we're back talking about debt. But I do know that Greece isn't the only European country whose debt won't ever actually be repaid in full and I know that changing the rules to accept that reality will either bring about the collapse of the Euro system or lead to a change in the way that European fiscal policy is operated.

Finally, a quick word about Puerto Rico. A very different debt crisis but one which really is a sign of the times. Puerto Rico's $72bn of debt is close to 3/4 of GDP and either huge compared to any US State (which Puerto Rico isn't) or manageable if it were an independent country with (which it isn't either).

What really makes Puerto Rico's debt unsustainable, and is both a cause and result of GDP shrinking in 7 of the last 8 years,  is the fact that its population is falling. Faced with a weak economy and poor prospects, people, especially young workers, are leaving the country. Check out this link  from the Pew research centre if you want some scary charts of where this is heading. When I first wrote about the Grapes of Wrath, I thought that labour mobility in the US in the 1930s (which resulted in huge numbers of displaced Oklahoma farmers heading down Route 66 in search of jobs in California) was both a sign of a monetary union working properly and yet, evidence that even in the US there was huge social strife caused by migration. I wasn't really wondering what would have happened to Oklahoma's ability to repay debts if it had been an independent country. Nor was I thinking forwards to a world where would have the degree of mobility in people, job and technology that we have now. In a technologically joined-up world, skills will spread globally and people will move to where those jobs are, as well as moving away from places with political or economic problems. This may 'the Age of Migration'. The politics of migration/immigration are increasingly important and for the countries they leave, while the economics of debt with shrinking populations will be equally important.

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