Breakin’ Up Is Hard To Do

Don Alexander
RSD Solutions Inc.
NYU

A big question is whether the Economic and Monetary Union (EMU) will survive. Too often, analysts discuss a possible departure of one or several countries from the euro area as little more than a devaluation, any country’s exit from the euro area could have potentially adverse consequences. These are some of the issues examined by Anders Aslund in Why a Breakup of the Euro Area Must be Avoided: Lessons from Previous Breakups (Peterson Institute, August 2012).

The author suggests a breakup of a currency zone is far more serious than devaluation. When a monetary union with huge uncleared balances is broken up, the international payments mechanism within the union breaks up, impeding all economic interaction. It is easier to establish a monetary union than to break it up.  There are three potential problems to address. Firstly, the devastating event a possible collapse of the EMU with its large uncleared imbalances could be. Default need not necessarily lead to departure from the euro area. Greece has already defaulted on its official debt to reduce its total public debt to a more sustainable level, but it has not left the euro area. A risk is a Greek exit would not be merely devaluation, but would unleash a domino effect of international bank runs and disrupt payment mechanisms.

Second, the critical argument for a domino effect is that the EMU already has large uncleared interbank balances in its so-called Target2 system.  Exit of any country is likely to break this centralized EMU payments mechanism.  These rising uncleared balances are a serious concern because nobody knows how they will be treated if the EMU broke up.

Third, if the impermissible happens and the euro area breaks up, the damage will vary greatly depending on the policies pursued. All the economic problems in the current crisis can be resolved within the EMU with proper policies. Devaluation may be only a palliative or a postponement of resolution of the real problem, while the costs of the dissolution of the euro area could be truly monumental.

From the outset, many prominent economists Milton Friedman, Robert Mundell and Martin Feldstein, took the view that the euro area could never work. The original arguments are straightforward. First, the euro area did not comply with the original conditions formulated by Robert Mundell “that the optimum currency area is the region— defined in terms of internal factor mobility and external factor immobility.” Second, “all successful monetary unions have eventually been associated with a political and fiscal union”.

These arguments are valid, but supporters of the EMU have countered that the optimum currency area conditions as well as the political and fiscal union—that is, a federalization of the European Union—could evolve over time and should come to fruition in this crisis. Hopefully the fundamental problems of euro area governance are now being resolved with the formation of a stricter fiscal union, a banking union, and a sufficiently large bailout fund. The EMU has not been credible with regard to fiscal discipline and hard budget constraints, and the market has rightly presumed that all national sinners would be bailed out. The current crisis has enhanced the fiscal credibility of the EMU but has instilled new fears of sovereign defaults and currency risks.

Two major problems in the euro crisis have aroused new calls for the breakup of the euro area. One is sovereign default. Many presumed that an EMU country that defaulted would have to leave the euro area, but that is not true.  The other problem is that some peripheral countries are not sufficiently competitive to balance their current account with other members of the EMU.  In every emerging market financial crisis, growth was restored by a move to flexible exchange rates—and unavoidable—on top of official liquidity, austerity and reform, and in some cases, debt restructuring and reduction.” While beneficial in some cases, devaluation is by no means necessary for crisis resolution.

Any choice of economic policy must be based on a realistic comparison between the alternatives. The EMU was designed to be irreversible, which means that it comes with a number of very costly poison pills. By Maastricht standards, it was a mistake to let Greece into the EMU, but that is not relevant, because the decision to leave would have high costs.

The Economic and Monetary Union must be maintained at almost any cost. All the economic problems in the current crisis can be resolved within the EMU. A devaluation may be only a palliative or a postponement of resolution of the real problem, as has so often been the case, while the costs of the dissolution of the euro area could be truly monumental. There the many current questions about crisis management, financing, and governance of the EMU that are not addressed in the policy brief, but breakin’ up is hard to do.

Breakin’ Up Is Hard To Do

Don Alexander
RSD Solutions Inc.
NYU

A big question is whether the Economic and Monetary Union (EMU) will survive. Too often, analysts discuss a possible departure of one or several countries from the euro area as little more than a devaluation, any country’s exit from the euro area could have potentially adverse consequences. These are some of the issues examined by Anders Aslund in Why a Breakup of the Euro Area Must be Avoided: Lessons from Previous Breakups (Peterson Institute, August 2012).

The author suggests a breakup of a currency zone is far more serious than devaluation. When a monetary union with huge uncleared balances is broken up, the international payments mechanism within the union breaks up, impeding all economic interaction. It is easier to establish a monetary union than to break it up.  There are three potential problems to address. Firstly, the devastating event a possible collapse of the EMU with its large uncleared imbalances could be. Default need not necessarily lead to departure from the euro area. Greece has already defaulted on its official debt to reduce its total public debt to a more sustainable level, but it has not left the euro area. A risk is a Greek exit would not be merely devaluation, but would unleash a domino effect of international bank runs and disrupt payment mechanisms.

Second, the critical argument for a domino effect is that the EMU already has large uncleared interbank balances in its so-called Target2 system.  Exit of any country is likely to break this centralized EMU payments mechanism.  These rising uncleared balances are a serious concern because nobody knows how they will be treated if the EMU broke up.

Third, if the impermissible happens and the euro area breaks up, the damage will vary greatly depending on the policies pursued. All the economic problems in the current crisis can be resolved within the EMU with proper policies. Devaluation may be only a palliative or a postponement of resolution of the real problem, while the costs of the dissolution of the euro area could be truly monumental.

From the outset, many prominent economists Milton Friedman, Robert Mundell and Martin Feldstein, took the view that the euro area could never work. The original arguments are straightforward. First, the euro area did not comply with the original conditions formulated by Robert Mundell “that the optimum currency area is the region— defined in terms of internal factor mobility and external factor immobility.” Second, “all successful monetary unions have eventually been associated with a political and fiscal union”.

These arguments are valid, but supporters of the EMU have countered that the optimum currency area conditions as well as the political and fiscal union—that is, a federalization of the European Union—could evolve over time and should come to fruition in this crisis. Hopefully the fundamental problems of euro area governance are now being resolved with the formation of a stricter fiscal union, a banking union, and a sufficiently large bailout fund. The EMU has not been credible with regard to fiscal discipline and hard budget constraints, and the market has rightly presumed that all national sinners would be bailed out. The current crisis has enhanced the fiscal credibility of the EMU but has instilled new fears of sovereign defaults and currency risks.

Two major problems in the euro crisis have aroused new calls for the breakup of the euro area. One is sovereign default. Many presumed that an EMU country that defaulted would have to leave the euro area, but that is not true.  The other problem is that some peripheral countries are not sufficiently competitive to balance their current account with other members of the EMU.  In every emerging market financial crisis, growth was restored by a move to flexible exchange rates—and unavoidable—on top of official liquidity, austerity and reform, and in some cases, debt restructuring and reduction.” While beneficial in some cases, devaluation is by no means necessary for crisis resolution.

Any choice of economic policy must be based on a realistic comparison between the alternatives. The EMU was designed to be irreversible, which means that it comes with a number of very costly poison pills. By Maastricht standards, it was a mistake to let Greece into the EMU, but that is not relevant, because the decision to leave would have high costs.

The Economic and Monetary Union must be maintained at almost any cost. All the economic problems in the current crisis can be resolved within the EMU. A devaluation may be only a palliative or a postponement of resolution of the real problem, as has so often been the case, while the costs of the dissolution of the euro area could be truly monumental. There the many current questions about crisis management, financing, and governance of the EMU that are not addressed in the policy brief, but breakin’ up is hard to do.

Breakin’ Up Is Hard To Do

Don Alexander
RSD Solutions Inc.
NYU

A big question is whether the Economic and Monetary Union (EMU) will survive. Too often, analysts discuss a possible departure of one or several countries from the euro area as little more than a devaluation, any country’s exit from the euro area could have potentially adverse consequences. These are some of the issues examined by Anders Aslund in Why a Breakup of the Euro Area Must be Avoided: Lessons from Previous Breakups (Peterson Institute, August 2012).

The author suggests a breakup of a currency zone is far more serious than devaluation. When a monetary union with huge uncleared balances is broken up, the international payments mechanism within the union breaks up, impeding all economic interaction. It is easier to establish a monetary union than to break it up.  There are three potential problems to address. Firstly, the devastating event a possible collapse of the EMU with its large uncleared imbalances could be. Default need not necessarily lead to departure from the euro area. Greece has already defaulted on its official debt to reduce its total public debt to a more sustainable level, but it has not left the euro area. A risk is a Greek exit would not be merely devaluation, but would unleash a domino effect of international bank runs and disrupt payment mechanisms.

Second, the critical argument for a domino effect is that the EMU already has large uncleared interbank balances in its so-called Target2 system.  Exit of any country is likely to break this centralized EMU payments mechanism.  These rising uncleared balances are a serious concern because nobody knows how they will be treated if the EMU broke up.

Third, if the impermissible happens and the euro area breaks up, the damage will vary greatly depending on the policies pursued. All the economic problems in the current crisis can be resolved within the EMU with proper policies. Devaluation may be only a palliative or a postponement of resolution of the real problem, while the costs of the dissolution of the euro area could be truly monumental.

From the outset, many prominent economists Milton Friedman, Robert Mundell and Martin Feldstein, took the view that the euro area could never work. The original arguments are straightforward. First, the euro area did not comply with the original conditions formulated by Robert Mundell “that the optimum currency area is the region— defined in terms of internal factor mobility and external factor immobility.” Second, “all successful monetary unions have eventually been associated with a political and fiscal union”.

These arguments are valid, but supporters of the EMU have countered that the optimum currency area conditions as well as the political and fiscal union—that is, a federalization of the European Union—could evolve over time and should come to fruition in this crisis. Hopefully the fundamental problems of euro area governance are now being resolved with the formation of a stricter fiscal union, a banking union, and a sufficiently large bailout fund. The EMU has not been credible with regard to fiscal discipline and hard budget constraints, and the market has rightly presumed that all national sinners would be bailed out. The current crisis has enhanced the fiscal credibility of the EMU but has instilled new fears of sovereign defaults and currency risks.

Two major problems in the euro crisis have aroused new calls for the breakup of the euro area. One is sovereign default. Many presumed that an EMU country that defaulted would have to leave the euro area, but that is not true.  The other problem is that some peripheral countries are not sufficiently competitive to balance their current account with other members of the EMU.  In every emerging market financial crisis, growth was restored by a move to flexible exchange rates—and unavoidable—on top of official liquidity, austerity and reform, and in some cases, debt restructuring and reduction.” While beneficial in some cases, devaluation is by no means necessary for crisis resolution.

Any choice of economic policy must be based on a realistic comparison between the alternatives. The EMU was designed to be irreversible, which means that it comes with a number of very costly poison pills. By Maastricht standards, it was a mistake to let Greece into the EMU, but that is not relevant, because the decision to leave would have high costs.

The Economic and Monetary Union must be maintained at almost any cost. All the economic problems in the current crisis can be resolved within the EMU. A devaluation may be only a palliative or a postponement of resolution of the real problem, as has so often been the case, while the costs of the dissolution of the euro area could be truly monumental. There the many current questions about crisis management, financing, and governance of the EMU that are not addressed in the policy brief, but breakin’ up is hard to do.

Risks of Unconventional Monetary Policy at the Zero Lower Bound

Don Alexander

RSD Solutions Inc.

NYU

The role and risk of unconventional monetary are widely debated by central banks and government policymakers.  Ben Bernanke is a leading proponent of the policy since most central banks have limited policy options at zero rates.

There are a number of critics such as Michael Woodford, who delivered a critique at Jackson Hole of how the Federal Reserve has gone about monetary easing.  He remains skeptical of the efficacy of quantitative easing and prefers a central bank target path for nominal GDP.

A recent BIS study by Leonardo Gambacorta, Boris Hofmann & Gert Peersman examines the role of unconventional monetary policy during the financial crisis (The Effectiveness of Unconventional Monetary Policy at the Zero Lower Bound: A Cross-Country Analysis BIS WP, August 2012) This study examines the macroeconomic effectiveness of unconventional monetary policies adopted during the financial crisis by exploring the shock effects to the central bank balance sheet on output and the price level. 

The author’s use a panel vector autoregressive approach (VAR-a statistical technique measuring the casual linkages between variables) estimated from eight advanced economies.  The authors found an exogenous increase in central bank balance sheets leads to a temporary rise in economic activity and the price level. The qualitative response pattern of output is very similar to previous studies on interest rate shocks, while the price level reaction is weaker.  The estimations suggest that the panel results do not obscure considerable cross-country heterogeneity in the macroeconomic consequences, despite differences, possibly reflecting the fact that central banks implemented these policies according to specific needs.

These results suggest that the unconventional monetary policy measures adopted by central banks in the wake of the global financial crisis provided temporary support to their economies. However, this does not imply that an expansion of central bank balance sheets will in general have positive macroeconomic effects. The set-up of the analysis is specifically tailored to the crisis period, when unconventional monetary policy measures were actively used to counter financial and economic tail risk. The results therefore do not in general pertain to the possible effects of central bank balance sheet policy in non-crisis periods.

Finally, there are a couple of caveats for consideration. Firstly, the analysis does not explicitly assess the effectiveness of different types of unconventional monetary policies. The individual country results do not indicate that such composition effects are a major distorting factor, but a more careful analysis could be done in future research. Secondly, the analysis does not capture the announcement effects of unconventional monetary policies.  The approach taken by the authors focuses on identifying the effects of central banks unconventional monetary policy actions, which could be seen as an assessment of the overall "stock effect" of central bank balance sheet policy on the macroeconomy.

The study only answers the basic question that unconventional policy does work when limited policy options are available.  However, the concerns about how it works and the risks it may create remain unanswered.

www.bis.org/publ/work384.htm

Risks of Unconventional Monetary Policy at the Zero Lower Bound

The role and risk of unconventional monetary are widely debated by central banks and government policymakers.  Ben Bernanke is a leading proponent of the policy since most central banks have limited policy options at zero rates.

There are a number of critics such as Michael Woodford, who delivered a critique at Jackson Hole of how the Federal Reserve has gone about monetary easing.  He remains skeptical of the efficacy of quantitative easing and prefers a central bank target path for nominal GDP.

A recent BIS study by Leonardo Gambacorta, Boris Hofmann & Gert Peersman examines the role of unconventional monetary policy during the financial crisis (The Effectiveness of Unconventional Monetary Policy at the Zero Lower Bound: A Cross-Country Analysis BIS WP, August 2012) This study examines the macroeconomic effectiveness of unconventional monetary policies adopted during the financial crisis by exploring the shock effects to the central bank balance sheet on output and the price level. 

The author’s use a panel vector autoregressive approach (VAR-a statistical technique measuring the casual linkages between variables) estimated from eight advanced economies.  The authors found an exogenous increase in central bank balance sheets leads to a temporary rise in economic activity and the price level. The qualitative response pattern of output is very similar to previous studies on interest rate shocks, while the price level reaction is weaker.  The estimations suggest that the panel results do not obscure considerable cross-country heterogeneity in the macroeconomic consequences, despite differences, possibly reflecting the fact that central banks implemented these policies according to specific needs.

These results suggest that the unconventional monetary policy measures adopted by central banks in the wake of the global financial crisis provided temporary support to their economies. However, this does not imply that an expansion of central bank balance sheets will in general have positive macroeconomic effects. The set-up of the analysis is specifically tailored to the crisis period, when unconventional monetary policy measures were actively used to counter financial and economic tail risk. The results therefore do not in general pertain to the possible effects of central bank balance sheet policy in non-crisis periods.

Finally, there are a couple of caveats for consideration. Firstly, the analysis does not explicitly assess the effectiveness of different types of unconventional monetary policies. The individual country results do not indicate that such composition effects are a major distorting factor, but a more careful analysis could be done in future research. Secondly, the analysis does not capture the announcement effects of unconventional monetary policies.  The approach taken by the authors focuses on identifying the effects of central banks unconventional monetary policy actions, which could be seen as an assessment of the overall "stock effect" of central bank balance sheet policy on the macroeconomy.

The study only answers the basic question that unconventional policy does work when limited policy options are available.  However, the concerns about how it works and the risks it may create remain unanswered.

www.bis.org/publ/work384.htm