29/6/15: Greece & Grexit: In Europe, what the bank does, the kings say

Couple of interesting items on on Greek crisis:

Bloomberg prints an exercise in extrapolating Greek devaluation to Mexico peso crisis. It is an interesting exercise in so far as it does indicate (imperfectly) one side of the 'pain coin' currently spinning in the air. But it does not provide for any realistic comparatives to the other side of the same coin: the side of Greece not opting out of the euro area. Suppose the estimated path in the Bloomberg chart is correct and Greece, exiting the euro does face a devaluation 'bill' of some 300 percent-odd. As Bloomberg article says, there will be pain. Huge pain. Now, suppose Greece does not opt for direct devaluation. Then what? Then - exactly the same adjustment will have to happen via internal devaluation. Absent inflation (of any significance) in the euro area (and even given the ECB target inflation), this means all of this adjustment will be carried by Greek people. Except, with devaluation and exit, Greece will still retain internal markets for adjustment: with reforms (not guaranteed by any means), and with some pain taken on the side of capital / funding, it might ameliorate the period of post-default devaluation (the 'jump' stage in the chart below). Staying in the euro clearly implies zero adjustment on capital side, with all adjustment on households' side (employment, earnings, pensions etc). In addition, staying with euro implies no imports substitution (no price effects), exiting implies devaluation-driven imports substitution. Finally, staying with the euro implies no exports boost from devalued currency.

Source: Bloomberg

So the Bloomberg exercise is fine and interesting, but one-sided ad extremum.

Which rounds us to the latest news from the ECB. With Greeks requesting EUR6 billion increase in ELA and ECB rejecting it, Reuters reports a comment from a source on the situation:

"Commenting on the expected extension of existing emergency funding, one person said: "It doesn't make sense to stop it now. The banks are not able to pay it back anyway. So if you froze it for another two or three days, it wouldn't make any difference."" Except, of course, it does make perfect sense: if the ECB were to extend ELA, there would not have been capital controls (note: I am not suggesting the ECB should have done so - that's a different matter). However, without ECB support for ELA uplift, we have capital controls. Which sends a clear message from Frankfurt to Greek voters: this is what you will have to live with if you go against us. 

And this neatly dovetails with what Jean Claude Juncker said to the Greek voters earlier: "You should say ‘yes’ regardless of what the question is.” 

Because whether Reuters wants it or not, in Europe, what the bank does, the banks' kings say.

12/2/2014: Jobless Recoveries post-Financial Crises: Solutions Menu?

Next few posts will be touching on some interesting new research papers in economics and finance… in no particular order. Please note, no endorsement or peer review analysis from me here.

To start with: NBER WP 19683 (http://www.nber.org/papers/w19683) by Calvo, G., Coricelli, F. and Ottonello, P. "JOBLESS RECOVERIES DURING FINANCIAL CRISES: IS INFLATION THE WAY OUT?" from November 2013.

The paper discusses 3  traditional policy tools to mitigate jobless recoveries during financial crises: 

• inflation
• real devaluation of the currency, and  
• credit-recovery policies. 

The nominal exchange rate devaluation tool not being available to the euro area economies independently of the ECB, we have by now heard a lot about inflation (the need for). At the same time, real devaluation tool includes fabled European cost-competitiveness measures. 

Here's the pre-cursor to the paper: "The slow rate of employment growth relative to that of output is a sticking point in the recovery from the financial crisis episode that started in 2008 in the US and Europe (a phenomenon labeled “jobless recovery”). The issue is a particularly burning one in Europe where some observers claim that problem economies (like Greece, Italy, Ireland, Spain, and Portugal) would be better off abandoning the euro and gaining competitiveness through steep devaluation. This would be a momentous decision for Europe and the rest of the world because, among other things, it may set off an era of competitive devaluation and tariff war."

Hypotheticals aside, the study starts by "digging more deeply into the relationship between inflation and jobless recovery, also considering the possible role of real currency depreciation and resource reallocation (between tradables and non-tradables)."

As authors note: "This discussion is particularly relevant for countries that, being in the Eurozone, cannot follow a nominal currency depreciation policy to mitigate high unemployment rates 

(e.g. Greece, Italy, Ireland, Spain, and Portugal)."

First finding is that there is "some evidence suggesting that large inflationary spikes (not a higher inflation plateau) help employment recovery. Even in high-inflation episodes, inflation typically returns to its pre-crisis levels…" so the effects of the induced inflation wear out quasi-automatically.

Second finding is that "(independent of inflation) financial crises are associated with real currency depreciation (i.e., the rise in the real exchange rate) from output peak to recovery. This shows that the relative price of non-tradables fails to recover along with output even if the real wage does not fall, as is the case in low-inflation financial crisis episodes. This implies that, contrary to widespread views, nominal currency depreciation may eliminate joblessness only if it generates enough inflation to create a contraction in real wages; real currency depreciation or sector reallocation might not be sufficient to avoid jobless recovery if all sectors are subject to binding credit 

constraints that put labor at a disadvantage with respect to capital." In other words, there goes Argentina's fabled hope for recovery via devaluations.

Third finding extends the second one to the case closer to euro area peripherals: "Similarly, for countries with fixed exchange rates, “internal” or fiscal devaluations during financial crises are likely to work more through reductions in labor costs than changes in relative prices and sectoral reallocation obtained through taxes and subsidies affecting differentially tradable and non-tradable sectors." In other words, internal devaluations work, and they work via cost competitiveness gains and exporting sector repricing relative to domestic.

Tricky thing, though: "However, neither nominal nor real wage flexibility can avoid the adverse effects of financial crises on labor markets, as wage flexibility determines the distribution of the burden of the adjustment between employment and real wages, but does not relieve the burden from wage earners." which means that a jobless recovery is more likely under internal devaluation scenario.

Fourth finding: "Our findings highlight the difficulty in simultaneously preventing jobless and wageless recoveries, and suggest that if the goal is to avoid jobless recovery, the first line of action should be an attempt to relax credit constraints." Oops… but credit constraints are not being relaxed in the case of collapsed financial systems and debt overhang-impacted households in the likes of Ireland.

More on this: "Only direct credit policies that tackle the root of the problem seem to be able to help unemployment and wages simultaneously. …common sense suggests the following conjectures. In advanced economies, quantitative easing operations, especially if they involve the purchase of “toxic” assets, can have an effect on increasing firms’ collateral and relaxing credit constraints that affect employment recovery." But, of course, in Ireland these measures failed to trigger such outcomes - Nama has been set up for two years now and credit restart is still missing. May be one might consider the fact that targeting of bad assets purchases is needed? May be buying up wasteful real estate assets was not a good idea and instead we should have pursued purchases and restructuring of mortgages? Sort of what Iceland (partially and with caveats) did?

Overall, tough conclusions all around.