Tuesday, 27 April 2010

Let the Euro fall? [Edited]

[OK i admit i was wrong - after a German Social Scientist pointed out Merkell had a HUGE election to fight, which she lost , partly due to the massive aid package announced last week. I leave the article here, but i realise that my position is wrong]

As far as I am aware no one has understood why Germany seems to be giving mixed messages over the possible bailout of Greece. As a result Greece is constantly being destabilised: every time the Papandreou government tries to find ways to stabilise the short term situation, the German government pretends to "act tough" sending the Greek bond spread to record levels.

The issue here is not the regional elections in Germany, which Merkel can afford to loose. The issue is not the cheating of the previous Greek leadership that landed Greece in the hot water that is is now.

The real issue is that the German government is trying to deflate the euro in order to initiate German recovery - irrespective of the cost to other European member states

The situation is quite simple: when the ECB was established Germany insisted that the organisation would act tough on inflation and keep the Euro strong. Germany had the strong Deutschmark and it was unwilling to allow its unreliable southern European neighbour to debase the new currency by running unsustainable budget deficits. Thus the ECB was established in a way that it very anti inflation - even at the cost of development.

Ten years later a pesky southern European state, Greece, does exactly what Germany feared - it run into trouble through unsustainable overspending. But this works to Germany's advantage. Germany has been increasingly frustrated by the reluctance of the ECB to pursuse expansionary monetary policy, which would aid its attempts of industrial recovery.

The fears about Greece affected the Euro - its has been falling against the dollar for some time now. This worked to Germany's advatage as it made its exports much more attractive - german exports in February were up 42.5% (!) from the exports last year.

So the German government seems to have devised a new plan: present a strong anti-inflation Euro currency and support the ECB outwardly, while at the same time drive the Euro even lower by "acting tough" against Greece. This will lead to the Euro becoming cheaper against other currencies, thus making German exports even more attractive. In the short term its a win-win for Merkell - she acts tough against Greece (and gets votes in Germany), she gets the Euro deflated (and gets more exports), and she does not have to admit that ECB pro-cyclical policy, that was demanded by Germany more than ten years ago, is not appropriate during a global slowdown.

However this policy - if it is the deliberate policy of the German government, is very dangerous as it is capable of spitting apart all the hard work that led to a united Europe. Greece is the thin edge of the wedge - with Portugal, Spain and Italy and France are next on the line. Their destabilisation can lead to serious consequences to the Euro, that can lead to states opting out of the currency. Worse Spain, France and Italy are significant trading partners to Germany, and a prolonged recession to either country would lead to significant reduction to German exports. In addition any subsequent decrease of Spanish and Italian wages vis-a-vis German wages might lead to a second round of exodus of German manufacturing. So in the medium to long run this policy is the worst the German policy can choose, not just for Europe but for future German welfare.

Unfortunately the long-run is just a long way away for politicians. Greece gave Ms. Merkel the rope by their silly policies, but Merkel is letting them swing on it for purely German-centred reasons - and the whole of Europe might pay for her myopia.

Saturday, 24 April 2010

A rare interview with the New York Fed Chairman

Planet Money - a public radio show that deals with issues in economics - has managed to secure a radio interview with the Chairman of the New York Fed, William Dudley.

The event is quite significant: prior to this interview, only Federal reserve's system's chairman, Ben Bernankie, made his views public. The head of the new York fed has only spoken to the media twice more in the bank's 103 years.

The New York Fed is by far the largest of all the reserve banks of America - in the latest crisis it played a very active role in saving the Investment house of Bear Sterns - that was a New York Fed bail out.

This interview breaks new ground as it shows that the American regulatory system is beginning to allow more public scrutiny of its actions, while at the same time reaching out and explaining to the public why some decisions were taken.

The interview is starling in other ways as well. It destroys Greenspan, the ex-Fed reserve system chairman. Greenspan argued that the Central bank should not meddle in the financial system as is terrible is spotting financial bubbles. Dudley argues that maybe the reason is that the Fed system never tried to spot and then deflate such speculation bubbles before it was to late. The new York Fed is now thinking of changing its charter so speculation bubble deflation is added to its list of duties (which include supporting the banking system, keeping an eye on inflation and maintaining the exchange rate).

Very positive news indeed - lets hope the fed system takes Dudley's ideas on board - and maybe the inflexible Eurozone also moves this way.