"Kee" Points with Jim Kee, Ph.D.

Europe dominated the news last week, largely for two reasons. First, the European Central Bank announced that it will begin its own asset purchase program to the tune of 60 billion euros per month. Secondly, elections in Greece on Sunday should give at least half of the seats in parliament to the Syriza opposition party and its leader Alexis Tsipras, who ran against stringent fiscal reforms. Here’s how I think of Europe and the euro:

 

Minimum necessary background: The establishment of the euro was intended to bring about the benefits of a fixed exchange rate not unlike those experienced by the 50 United States. For example, instead of individuals and businesses having to calculate and anticipate/hedge the values of “Oklahoma dollars verses Massachusetts dollars versus Texas dollars,” etc., they use just one, the US dollar. And there is only one central bank, the Federal Reserve, rather than 50 different central banks. That also means that member states can’t spend more than they have for long because they cannot print money (no central bank) to make up for the short fall. Indeed, that is why state governments have historically had much tighter budget requirements than the federal government.

 

So it is with the countries in Europe that adopted the euro. Anytime a country or group of countries adopts a fixed exchange rate, they give up monetary authority. That means that if they have fiscal problems (i.e. budget deficits and unfunded liabilities), those problems sooner or later will come to light under fixed exchange rates, without exception. If you adopt a fixed exchange rate, you better have your fiscal house in order!

 

The euro: This was all well-known prior to the creation of the euro, which is why the original conditions for entry into the euro monetary union (under the Treaty of Maastricht-1992) required that a country’s government debt-to-GDP ratio not exceed 60%, and that the annual government deficit-to-GDP ratio not exceed 3%. Several countries did not meet these criteria (e.g. Italy, Belgium, Greece) but all were eventually qualified for membership. Interest rates in countries whose currency credibility was questioned (in part because of indebtedness) fell dramatically as that concern was removed with the adoption of the euro. Predictably, these countries could now borrow more and did. When the Great Recession occurred in 2008, some of these countries were technically insolvent (unable to pay their obligations or close to it). The European Central Bank under Mario Draghi pledged to help, and some say he succeeded too well, allowing member countries to postpone the hard work of fiscal reform. Back in 2011, I wrote in Kee Points

 

“IMF Managing Director Christine Lagarde has made the point that solutions to Europe’s debt problems are mainly political. An expanded ESFS (European System of Financial Supervisors) is needed - and quickly - to backstop the European financial system, but at the same time countries that are on an unsustainable debt-path have to reform. Doing one (expanded lending facilities) may delay the other (PIIGS facing reality). That is today’s dilemma as I see it. Nevertheless, disorderly default from Greece and others to the banks that hold their debt (German and France and UK, et al) is IN NO ONE’S BEST INTEREST IN EUROPE, so I do not think it will happen.”


And as for a Greek exit, I wrote in Kee Points at the time:

 

“A currency union is an alliance - shedding a small member with more liabilities than assets can make the union stronger. Yes, Greece can’t devalue without its own currency. But Greece’s problem is not an overvalued currency. The problem is an excess of debt and budget deficits. Greek debts are now denominated in euros. If Greece created a new currency in order to devalue, its debts would still be in euros and devaluation would not change that fact. Of course, Greece could repudiate its debts in euros but if it were going to take that Draconian step it could do it without creating a new currency. Should Greece follow the path of Argentina? That would result in a horrendous drop in the standard of living and social benefits and, if that were politically possible, why not do it inside the euro?”


That’s more or less where we are today. I’m a fan of Mario Draghi. And there is less risk of financial contagion today because European banks are stronger and the European Central Bank’s role and intentions are clearer. But the hard work of fiscal reform remains elusive, and that is reflected in the recent Greek elections and the rise of the Syriza party – which opposes most of these reforms. These “non-centrist” parties are sprouting up all over Europe…a guarantee of headline risk over the next 12 months and longer.

 

Also of mention last week, China reported GDP growth of 7.4% for 2014. That was the weakest in 24 years, though largely in line with official targets. China has been slowing for years. That’s partially according to plan, and partially a function of a much larger base – 7 percent growth this year is equivalent in absolute terms (total increase in output) to 10 percent growth a couple of years ago (Financial Times). Plenty of obstacles ahead for China, but that is another Kee Points!