Monday, 14 November 2011

A Reply to 'How to Dismantle the Euro. . . . '

I have received the following critique of the piece from Don Hanna, currently MD of Fortress Investment, and previously an economist with Goldman in Hong Kong during the 1990s. He has kindly given me permission to post it, for which I thank him. He also suggests reading this and this.  Don's words follow: 

Michael’s diagnosis of Italy’s problem isn’t right.  Italy did grow fast enough, at low spreads to Bunds, to lower net D/Y from 101% on entrance to 87% in 2007 (using IMF WEO numbers).  The subsequent rise back to 100 (net) is largely the recession.   Italy would be in much better shape if its GDP growth had been higher than the 1.5% it managed in the nine years before the crisis.  But the current problem is, given that growth rate, 100% in net debt and a nominal interest rate of 6.5% is unsustainable.

Nor is Michael’s solution.  Committing to a currency board after stiffing your creditors to the tune of the devaluation times their claims on you is inherently not credible.  A risk premium gets immediately priced into the yield curve of the currency-board country, slamming growth and undermining Michael’s logic.  It’s also not correct to envision a world in which the creditors have already written down their claims and are, therefore, glad to see the devaluation so long as it’s lower than current secondary market prices.  Many creditors won’t be fully provisioned or will continue to strive for restitution in full in the original currency (there is also a legal question of the jurisdiction of the original debt contract and, hence, the ability of Italy to arbitrarily recontract).

The simple analogy for moving from a currency union to a currency board that illustrates the logical flaw is the alcoholic who’s been on the wagon, but asks to go on a binge for old time’s sake after which he promises future sobriety.   

An economy that uses a devaluation as a solution to growth is unlikely to be able to foreswear using the same solution again in the future, which is what, in principle, a currency board requires.  As Michael himself notes, it’s not current excesses—monetary or fiscal—that are the basis for Italy’s woes.  Hence, the added discipline of a currency board isn’t the solution. 

The solution is a set of reforms:
·         that promotes factor market liberalization, so that resources can be used more effectively
·         that boosts the effectiveness of government through lowering corruption and enhancing the rule of law; and
·         that provides a “good housekeeping seal of approval” from the ECB as a buyer of last resort above a yield of say 4.5% (the planned nominal growth of Italy in the next three years) so that the new Italian government has the time (and still the incentive) to implement these growth-oriented measures. 

There is much in this with which I agree: notwithstanding his initial paragraph, it's plain our diagnosis  of Italy's problem is identical.  Also, I agree that  the supply-side reforms which he mentions are, without doubt, essential to raising the underlying sustainable growth rate of the Italian economy, without which Italy's debt problem will be unmanageable. Part of the attraction of putting in a currency board would be precisely that it would discipline to encourage those reforms. Devaluation is no replacement for those reforms. 

So what do I disagree with? Well first, there's a tedious question of data: Don is evidently working with a set of net debt data (IMF WEO) which calculates Italy's government debt/GDP at sharply lower levels than the one I'm using the gross government debt data provided by the European Commission (via Eurostat), used to calculate the (ignored) Maastricht criteria. The difference matters, since Don's data has Italy's debt a 87% of GDP in 2007, whereas Eurostat data shows it at 103.1%.  Since at the crux of the problem is Italy's ability to achieve regularly a level of growth equal to or greater than debt/GDP multiplied by the medium/long term interest rate,  Don's hurdle for Italy is rather lower than mine. 

Then there is Don's repeated critique that Italy adopting a currency board is 'inherently not credible.' This argument is repeated three times: i) a risk premium immediately gets priced; ii) Italy being 'unlikely to be able to foreswear using the same solution in the future' and iii) his analogy about a recovering alcoholic. 

Actually, Don's a lucky man, because he evidently has never been forced to find out how 'recovering alcoholics' are actually treated.  If he had, he'll know that generally alcoholics are not forced off 'cold turkey' because that 'treatment' is more likely to kill them than cure them.  They get alcohol until their system is well enough to foreswear it. 

And consider the proffered alternative. I have to say that planning to have the ECB buying all your bonds above 4.5% as a 'good housekeeping seal of approval' is a step towards dismantling pricing signals which I would have thought unlikely to improve the allocation of capital. Rather, it's state planning pure and simple. Indeed, the combination of the ECB/GdF's oversight (implementation of the ECB/GdF Plan), coupled with state control of bond yields wouldn't give me comfort as an investor (though I'd participate in the initial ramp). As for Italy sustaining  a 4.5% nominal growth any time soon. . . . . well, the last time Italy managed a single quarter of such growth was back in 2Q 2001, six months before the introduction of the Euro. 

Finally, Don's probably right about banks not welcoming  the devalue/peg/don't default strategy, and for the reasons he gives.  But I reckon whilst he's right de jure, if the Peg stuck, I'd be right de facto. Eventually. 

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