Author: Awareness News

Nearly ten years have passed since the eurozone was on the brink of collapse. In a moment where enthusiasm for the euro and the European project has climbed, as Europeans find a strange form of solidarity in the face of Brexit, it is easy to forget that for a few months in 2011 and 2012, the eurozone seemed to be about to fall apart.

Although the onset was sudden, the fragilities that were exposed on the eurozone crisis went far from unnoticed until then. In fact, in the lead-up to the introduction of the euro, in 1999, many prominent economists, among them Milton Friedman, judged the move towards the single currency as a mistake. Friedman wrote that it would “exacerbate political tensions” as divergent economic shocks would lead to difficulties in setting a eurozone-wide monetary policy stance. History would only prove him right.

Arguably, the eurozone’s troubles started even before its conception, as credit conditions between its members converged in antecipation of the euro’s introduction. As can be seen in the graph below, this was reflected in the government bond yields: by 2001, Greece paid out the same interest as Germany on its newly-emitted debt. The implied probability of default for the two countries was the same.

Although this may seem preposterous with the benefit of hindsight, at the time this was not seen as such a concerning development. There was a belief that in general, governance across the eurozone was becoming more similar, with countries being subject to the same incentives.

A development that could be in particular singled out was the elimination of currency risk. As countries like Greece no longer had control over the currency their debt is denominated on, and the “No Bailout” clause of the Maastricht treaty prevented the ECB from financing any particular country’s debt, eurozone members could no longer pay off their debt resorting to the printing press. This somewhat reassured investors, as they assumed this would force governments in the single currency area to adopt responsible fiscal policies.

As credit conditions converged in the early years of the monetary union, there began an outflow of capital from the core of the euro area to the periphery. This can be seen from the graph below, which shows the current account balances of select eurozone countries in the period in question.

Source: WEO

Although it may seem surprising today, these flows of credit were contemporarily seen as success, as they were in accord with what economic theory predicted for convergence: the richer nations, where the returns on capital were lower, would lend to the poorer nations, which would catch up in terms of productivity as a result.

But any apparent real convergence was merely illusory, and these imbalances had perverse consequences.

Much of the investment in peripheral economies was squandered on non-traded sectors, such as construction, fueling housing booms, and government consumption. Since there was little build-up of export capacity, there was little hope of ever repaying external debt.

There was also a resulting widening of the competitiveness gap. As the credit boom in the peripheral countries of the eurozone resulted in an expansion of the construction industry, among others, excess demand for labour fueled above average wage inflation. Ironically, instead of promoting convergence among economies, the supposedly healthy imbalances were actually accentuating existing differences.

At this point, it might be important to note that unlike what is commonly believed, the core root of the crisis was not necessarily public debt. In fact, if we look at the figure above, we can see that in 2007 Ireland and Spain’s public debt-to-GDP ratios were actually far below Germany’s, which stood at 63.7%.

These two countries, however, saw instead excessive accumulation of private debt. This materialized in the form of excessive bank lending: for example, Irish banks had assets worth seven times the GDP of Ireland in 2007. This private debt also fueled housing bubbles, which made public debt ratios look better than the underlying conditions were, as significant chunks of GDP were based on highly speculative construction. These liabilities later overflowed into the governments’ balance sheets, as banks went bankrupt and had to be propped up by sovereigns.

In light of these excesses, it was a matter of time until all this leverage unraveled. In October 2009, the new Greek government revealed that the government deficit was much higher than previously thought. While the draft target set by the European Commission in 2008 for 2009 was a deficit of 1.8% of GDP, the final figure ended up being 15.6% of GDP. At this point, financial markets understandably started to panic about Greece’s ability to pay off its debt. The Greek spread over the German Bund started to climb.

Greece, in a last ditch attempt to save itself from ruin, agressively engaged in austerity measures, cutting spending and raising taxes, but this worked against its purpose. As the fiscal stance became more contractionary, economic growth, already feeble, slowed, and creditors started losing faith in Greece’s ability to repay. The spread kept getting higher, and the first bailout became inevitable.

But would have avoiding austerity saved Greece? It is all too easy to don a pair of rose-tinted glasses and argue that avoiding austerity would have kept growth in Greece steady and led to a sustainable debt position. But the counterfactual is not available, and it is as easy to argue that avoiding a more restrictive fiscal stance would have equally worried investors, who would be concerned about a lack of concrete steps towards debt sustainability. Eventually this would also prevent Greece from rolling over its public debt.

Restructuring the debt would also work only to a point. A significant amount of Greek debt was held by banks of other faltering eurozone countries, such as Italy and Spain, and debt relief could have brought over the edge those already fragile banking systems. Furthermore, a third of Greek public debt was held domestically, and as such a restructuring would also lead to demand-side drags on the economy.

Greece’s membership of the eurozone was critical in how the crisis escalated. If Greece still had control over its currency, it could simply devalue it, lightening the real burden of debt and bringing its current balance closer to equilibrium. Crucially, Greece also had no lender of last resort, as the ECB was bound by the Maastricht “No Bailout” clause. If the introduction of the euro were accompanied by a greater degree of federalism, this might not have been a problem, as there would be income transfers from the core of the eurozone through the action of automatic stabilisers.

Fearing the eurozone would unravel if nothing was done, the EU called on the IMF in order to provide for a first bailout of Greece in early 2010. While there were doubts from the IMF that the resulting arrangement was sustainable, it provided €30bn of financing, with other eurozone members providing a further €80bn.

As this happened in Greece, investors started to worry about the credit they were extending to other periphery countries. Their reluctance to extend financing translated into a rise in other countries’ borrowing costs. This was the so-called “sudden stop” that brought the eurozone to a halt. Portugal and Ireland soon needed bailouts of their own. Later, private sector involvement in subsequent bailouts made things even worse, as the losses forced on private bondholders increased the intensity of the capital flight.

At the core of the market panic was an apparent self-fulfilling crisis, with two internally consistent equilibriums. In the first “good” equilibrium, bondholders believe debt is sustainable, and therefore interest payments remain low, debt being then manageable. In a second “bad” equilibrium, bondholders start to doubt the sovereign’s ability  to repay, and escalating rises in interest payments might mean debt is no longer sustainable. In traditional economies, a lender of last resort, the central bank, which is always willing to buy the sovereign’s debt, ensures the “good” equilibrium is the one to prevail. In the eurozone the “No Bailout” clause prevented this.

Equally relevant was a mechanism known as the “bank-sovereign doom loop”, which was crucial in the spread of the crisis to countries that had low public debt but large current account imbalances. Through this process, illustrated in the following diagram, failing banks have to be bailed out by the government, which leads to a deterioration of its fiscal position. As domestic banks tend to hold a disproportionate amount of home country bonds, this has a negative impact on their balance sheet. Gradually, both the situation of the country’s financial system and that of its sovereign become precarious. Concerningly, this issue has hardly been solved in the wake of the crisis, even though it could be solved by the simple introduction of a joint eurozone bond, as core countries complain of moral hazard problems.

As the spreads of even supposedly safe countries like Belgium and France began to climb precipitously, Mario Draghi decided to take an unconventional turn in terms of policy. Pledging to do “whatever it takes to save the euro”, he announced the Outright Monetary Transactions (OMT) program, which allowed the ECB to purchase government bonds of countries in distress. The program implied a very strict conditionality, with any countries joining the program being required to enact domestic reforms. This was done to allay concerns by core economies that peripheric countries would be allowed to ‘free-ride’ on the ECB, avoiding doing painful reforms. Even then, the program was legally challenged in the German constitutional court, as it was believed to breach the “No Bailout” clause. Thankfully, this was unsuccessful.

Ultimately, the true testament to the OMT’s success is that it has never been used. As soon as it was announced (its announcement coincided with the “whatever it takes” speech; see graph), spreads over the eurozone area started to drop. This ended up marking the beginning of the long road to recovery.

Nonetheless, the cleavages both exposed and exacerbated by the crisis seem to be here to stay, as Friedman ominously predicted more than two decades ago. Given the recent slowdown in eurozone growth, Draghi pushed the ECB towards restarting Quantitative Easing (QE), its large-scale program of liquidity injection into the bond market. The same core economies that long have run current account surpluses have opposed the move, citing not-so-new concerns on easy money being a deterrent of reform in southern economies.

The restart of the QE program also brings new problems, as the ECB already holds significant portions of debt of eurozone countries, and is required to hold less than 33% of each. Although increasing the limit is a possibility, it might put the ECB on the difficult position of being a majority debtholder of eurozone governments. This could be easily solved if countries like Germany and Netherlands, where the ECB is closest to its imposed limits due to their low amount of debt, used the fiscal space they have available to provide a much-needed stimulus for the eurozone. But they seem loth to do so. Only recently, Annegret Kramp-Karrenbauer, Germany’s apparent chancellor-in-waiting, defended the country’s commitment to balanced budgets even in the face of an economic slowdown.

With Draghi now leaving his post, and Lagarde taking over, it is all too easy to hail this as a watershed moment where the eurozone finally casts off any lingering reminder of the crisis. But this would be a mistake. Europe’s economic dysfunction seems here to stay, and the shadow of the crisis will long hang over Europe.

This article was written in partnership with the Nova Investment Club.

It was not that long ago when development economics was underrated and not recognised by the classical economists as a worth studying field. The issue was that the macroeconomists who were interested about these subjects always focused on one specific country, such as South Korea, and tried to understand what had driven it to outperform other economies. Meaning that they acknowledged what led to each countries’ development, but they could not implement that in another place, due to the fact that the conditions in each case study were unique and intrinsic to the countries’ features, so they could not be replicated on another location.

This has changed since figures like Esther Duflo, Michael Kremer or Abhjit Banerjee stranded their position on the world of development economics.

Previous studies on development economics had a major flaw that prevented them from discovering the most efficient treatments to ultimately eradicate poverty, across all fields, such as health, education, corruption, among others. By studying a specific countries’ case, economists were never fully able to state whether an intervention had a causal effect on the combat against poverty or not, even if it such relation was heavily supported by economic theory. The reason behind that is the lack of a counterfactual effect – economists were incapable of observing the outcome in the case that individuals had not benefited from the intervention previously made. Without directly observing a counterfactual effect, conclusions on previous studies about economic research were most likely biased from previous economic theory already conducted, and no causal effect could be stated.

Aiming to overcome this handicap in economic research, these economists borrowed a key tool from clinical medicine: the Randomized Controlled Trial (RCTs).

In order to be able to conduct causal inference, they took a brand new approach to economic research that, very simply put, was characterized by the following:

• The creation of a treatment/intervention that, supported by economic theory and empirical evidence, is believed to be able to diminish poverty in a certain field

• The collection of a random sample within the same field, to which half, randomly assigned, would benefit from the treatment – the Treatment Group -, whereas the other half would perform as the Control Group, not receiving any treatment.

Basically, the creation of this control/base group of individuals was what ultimately able these economists to be Nobel Prize winners. Having a Control Group randomly assigned enables economists to observe the so wanted counterfactual effect of an intervention, giving their studies enough strength to conduct causal inference, and this was crucial for the advancements on development economics discoveries.

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“The Miracle of Microfinance? Evidence from a Randomized Evaluation” was a study conducted by Duflo, Banerjee, (two out of the three Nobel Prize Winners), Glennerster & Kinnan (2013) that perfectly exhibits the power of RCTs.

Microfinance has created big enthusiasm and hope for fast poverty eradication. Through the lending of microloans, it was believed that small enterprises would be able to grow and expand, and therefore generate welfare at an individual level in the developing world. However, the above study concluded that microcredit generated no changes in any of the development outcomes that are often believed to be affected by microfinance, including health, education, and women’s empowerment. This study was conducted on a sample of 104 slums in India, where half of it was randomly selected to benefit from a loan product from a particular microfinance institution, whereas the other half received nothing. As such, given the strength of an RCT, it was enough to ultimately refute economic theory, proving that, in reality, microfinance has no impact at all. This study is just one, among many others, that serves as an example to explain the strength that RCTs have when stating economic conclusions and results.

As such, by conducting RCTs, we are treating development economics exactly as the science it actually is. When in a sample of mice, half of it receives a drug whereas the other receives nothing, with the goal of discovering cures for illnesses, scientists and doctors are using RCTs. However, one might think: is it ethical to treat individuals, or small enterprises, merely as guinea pigs from a scientific experience?

Accordingly, many authors and researchers have been criticizing the RCTs approach to conduct economic research. One of the first studies using RCTs was done in Kenya in the 1990s, whose goal was to increase school attendance through the eradication of parasitic worms in children. Despite the great results this paper generated, one cannot forget that these results came at the expense of many children not benefiting from free deworming pills, only because they were unlucky enough to be in one of the schools which were part of the Control Group of the experiment. As such, it is fair to argue that ethics should have a higher role in economic research, and that the poorest cannot be seen from economic researchers merely as experimental subjects from their experiments.

However, the flip side of the coin regards the effectiveness of RCTs. The strength of its results is enough to compensate the unlucky parties of the Control Groups, since in the long-run the Control Group will also be better due to the intervention. They claim that, only because of the results of RCTs, the lives of the worst-off people around the world will be improved.

Nevertheless, despite the divergence of opinions that RCTs are creating, there is no doubt that this approach is truly disrupting development economics research, and the world in general. And the fact that these three development economists were finally recognised by the community is a sign of the changing times we are living.

Central banks are today some of the most important institutions in the economy, charged with regulating interest rates and the overall flow of money supply. This makes them responsible for a nation, or group of nations, monetary policy. Normally, since they have this responsibility central banks are charged with keeping inflation and prices stable, but some reserve banks have added duties, such as the FED which also has to keep unemployment low.

In order for central banks to pursue these objectives it’s generally assumed that they should be independent from political power and decision making. Nonetheless, lately central banks have seen their autonomy being challenged, such in: the US, where Donald Trump has repeatedly criticized the FED’s actions, Modi’s India where the governor resigned in December over clashes with the PJP’s leader, Turkey in which Erdogan fired the governor for allegedly refusing to lower interest rates or Argentina where Mauricio Macri’s government is hoping that the central bank will issue more pesos.

But why were central banks given more autonomy in the first place?

To answer this, we first have to go back to the 1960s and 70s when reserve banks where far more influenced or out-right controlled by government policy. Around this time, economists and specially politicians believed that you could lower unemployment by increasing inflation, a theory backed by the Philips Curve, so general wisdom demanded central banks to increase money supply to curb unemployment. This theory made it irresistible for politicians to pressure central banks to stimulate the economy ahead of an election, so as to boost their chances of winning. Everyone knows that an incumbent leader is more popular with a low unemployment rate and a bustling economy. This was what exactly happened with Richard Nixon ahead of the 1972 election in which he pressured the FED’s chairman, at the time, to increase the money supply. However, this decision is largely seen as having left the US economy vulnerable to the great increase in inflation the world saw throughout the 70s that was largely caused by the oil embargo. Nonetheless, the monetary paradigm of the time is widely seen as a reason for the prolonged inflation bubble.

It was from this point on, that the world started coming to the conclusion that giving independence to central banks could largely be a positive outcome. From the graph below, we can see that countries such as Germany and Switzerland, home to very independent central banks had lower inflation rates than countries such as the US or UK where the reserve banks were not as independent.

After all it makes sense that central banks should be independent, since chairman’s have a long-run view of the economy instead of just the next election year cycle. It’s much harder for politicians to pursue unpopular measures that might bring short term difficulties, but they are necessary to assure the overall health of the economy in the long run. To raise interest rates or cut budget deficits in an election year, are examples of those unpopular measures. Given this, the world gradually moved in the direction of giving more autonomy to central banks in the 1980s and 90s, and the results have been clear. Inflation has been far more stable as well as interest rates. This in turn has helped consumers and businesses by not having to adapt to new prices and interest rates in very short spans of time.

Times of change

Nevertheless, the 2008 global recession has changed the view of many with regards to central bank independence. Many believe that central bankers don’t have necessarily the public interest on their minds and that their actions are too secretive, pointing to the fact that they are not elected and are autonomous from public branches, and thus some believe they should have more oversight. Others point out that too much reserve bank’s independence may cause a contradiction between monetary policy and fiscal policy, which is a government responsibility. Which in turn could destabilize the economy and make it more difficult to wither recessions. Moreover, the general rise in populism has also put these institutions under threat of attacks both by the right in the case of Donald Trump and by the left, in the case of Jeremy Corbyn which criticizes the Bank of England’s actions and wants to use it as a tool to finance bigger public investment.

With this, central banks dependence or attempts to curb their autonomy, have become a good indicator of authoritarian like regimes. One such example is Venezuela, where inflation has reached 10 000 000%. Another one is Zimbabwe where inflation reached 89.7 sextillion percent year-on-year in mid-November of 2008. So, there is a tendency for authoritarian regimes to attack central bank autonomy and make reckless decisions with regards to monetary policy.

All in all, one thing is clear, central banks are going to have to change the way they operate and adapt it to the new reality. Even top figures, such as Mario Draghi, recognize that monetary policy and, therefore, central banks have to act in a more coordinated manner with fiscal policy (government) in order to allow for a more cohesive strategy when dealing with the economy and achieving more stability. The world is changing and the central banks’ operation process is too.