Author: Karl Whelan

A Yes or No Referendum on Euro Membership?

I wrote this post last night for the IIEA blog. I concluded it by discussing what I view as the likely upcoming referendum

Quoting myself(!):

It will be very important that other Eurozone member states be careful when discussing the problems faced by countries such as Ireland, for whom ratification of a new treaty will be politically complex.

For all the temptation to present such an agreement as a “yes or no” moment on euro membership (a temptation last seen with Mrs. Merkel’s “ya oder nein” moment) the truth is that there is no clearly defined way to expel a country from the single currency. Beyond the potential of a bullying approach back-firing with the Irish public, a focus on a referendum as a decision about euro membership risks triggering a massive bank run as depositors take flight to avoid the redenomination that is being threatened.

Needless to say, what happens today? Our own Minister for Finance comes out with the following:

FINANCE Minister Michael said today that any referendum here on the new EU deal would essentially be a vote on the country’s continued membership of the eurozone.

“It really comes down on this occasion to a very simple issue, do you want to continue in the euro or not,” Mr Noonan said in an interview with Bloomberg Television.

“Faced with that question, I think the Irish people will pass such a referendum.”

I think this is a very poor way for the government to approach this issue and I would hope they reconsider it.

The Irish public have a history of responding poorly to threats as a motivation for voting for EU treaties. And if Mr. Noonan is keen on triggering another disastrous bank run (this time also involving retail depositors) then he should keep talking this way and linking the probability of Ireland being in the euro with the latest polls on how likely the referendum is to pass.

The truth is that, whether people like it or not, the debate about this referendum will have many parallels with the Lisbon Treaty debate. It wasn’t true that voting no on Lisbon meant leaving the EU. But it was true that the rest of the EU could have decided to form some new agreement, something which would have required a complex legal and political process.

Similarly, there is simply is no expulsion route from the euro. If Ireland voted down the new intergovernmental treaty but the government wished us to stay in the euro, then there is nothing that could be done to eject Ireland from what is legally a fixed and irrevocable currency union.

It is possible for other countries to move on after an Irish No vote to set up their own currency union. However, this would require them to leave the euro, which would very likely involve them leaving the EU. Legally and economically, such an approach would be hugely difficult for the EU, certainly more difficult than going on to apply the Lisbon changes to some inner core EU.

So a “No” vote would likely leave the EU with a legal and political mess similar to that which occurred after the failure of the Lisbon vote in Ireland in 2008. From the point of view of the core EU countries, this is all very undesirable. They hardly want to admit that any country that doesn’t like the proposed treaty should go around asking for changes on an a la carte basis. If this were the case, then there probably would be no treaty at all (no bad thing, some might say).

But that’s where things stand and it wasn’t a situation schemed up by Irish politicians.

Government ministers should say there is simply no question of Ireland leaving the euro and that’s the end of it. Then they should enter treaty negotiations reminding everyone in Europe of the terrible nuisance that is their constitution and of the huge decline in the popularity of the EU in Ireland since Lisbon and Nice were voted down.

While I don’t necessarily want to endorse Fintan O’Toole’s language about causing trouble, the legal situation is what it is and the government need to make the most of a bad situation. (This issue was also discussed on Monday’s edition of The Frontline).

It’s time to argue for a better treaty and a better deal on the IBRC debt.

It’s not time to bully the public about signing up to whatever is put in front of them or face being booted out of the euro.

Another Day, Another Target 2 Story

Today’s FT Alphaville carries another story by Izabella Kaminska on why the Bundesbank’s Target credit and its low level of private securities owned, em, loans to German banks may be a source of problems.

Thankfully, the Bundesbank flogging off the family silver, em, gold, has disappeared from sight. This time, Izabella cites two potential problems. Taking them out of turn, there’s the argument of Perry Merhling on factors affecting the “collateral crunch” in the banking system:

A second source of demand for collateral is the discount lending by national central banks to their own private bank clients. And a third source is the Eurosystem lending between national central banks, which takes place more or less automatically through the operation of the TARGET2 payments system.

Except that the TARGET2 credits and liabilities don’t involve the use of any collateral, so this is not, in fact, a source of collateral crunch.

Izabella’s other mechanism for concern isn’t accurate either but does have a bit more plausibility about it. She notes about the process of deposits flowing to Germany that

every time the German Bundesbank attracts commercial liabilities (deposits) via this process, in an ideal world it would want to sterilise them to keep its bond market in check with ECB policy.

In order to do that, it would be inclined either to offer domestic assets into the market outright or unwind the number of bank loans it has extended against domestic collateral

In other words, Izabella reckons that to implement ECB policy on interest rates, the Bundesbank needs to control the money supply in Germany. If this was true, and the Bundesbank had no loans to German banks, then it couldn’t cut back on these loans as a way to control this supply of money and thus influence interest rates.

This is an interesting idea but it’s also pretty far from an accurate description of how European monetary policy works. A couple of points.

First, you’ll be very hard pressed to find a real-world central banker familiar with operational issues who believes that the short-term money market rates targeted by central banks depend in some predictable way on controlling some definition of the money supply. Here and here are two good papers that discuss this issue in detail. And here and here are my own teaching notes where I discuss these issues.

To summarise, the ECB influences money market rates in the Euro area via a “corridor system” determined by the interest rates on its range of instruments (deposit facility, marginal lending facility and refinancing operations) rather than via the quantity of money supplied.

Second, in an “ideal world” (i.e. a fully functioning monetary union) the supply of money in Germany should have no influence whatsoever on the rates at which German banks borrow from each other. A bank can borrow funds from any other bank in the Euro area or directly from the ECB. Even in the ideal world that preceded the crisis, the Bundesbank wasn’t attempting to hit some target for the German money supply, so there’s no loss of control for the Eurosystem relative to what prevailed before and no loss of control over price stability.

Now, of course, the absence of an ideal world means that all sorts of other complications are affecting European money markets. The super-low rates that Izabella notes here are likely related to factors such as fears about the end of the Eurozone and the drastic reduction in the amount of assets viewed as truly safe. They’re not due to the Bundesbank losing the ability (which it wasn’t using anyway) to control the German money supply.

VoxEU Piece on Target 2

I know we’ve devoted too much time to this already but, for the anoraks out there, here‘s a VoxEU piece that I’ve written responding to the earlier article by Tornell and Westermann.

One of the funny aspects of this debate is it tends to trigger comments from German residents that say something like “phooey to you and your technical details, you know that Sinn is right that we’re getting ripped off”.  Forget the facts, feel the truthiness.

Gerlach Speech at ZinsFORUM, Frankfurt

Here‘s an interesting speech titled “Ireland’s Road Out of the Crisis” by Central Bank Deputy Governor, Stefan Gerlach.

Fiscal Rules: Stocks, Flows and All That

Today’s Euro summit document commits all members to a fiscal rule in which “the annual structural deficit does not exceed 0.5% of nominal GDP.” It also commits to “The specification of the debt criterion in terms of a numerical benchmark for debt reduction (1/20 rule) for Member States with a government debt in excess of 60%.”

I’m on the record as being in favour of numerical benchmarks for debt reduction. Indeed, I argued for a more stringent one than the one-twentieth rule that has been proposed by the Commission and has been adopted today.

However, I wonder whether those proposing the limit of 0.5% of nominal GDP on the structural deficit have thought about what this implies for debt ratios. I take this proposal to mean that the average deficit, going through the cycle, should not be more than 0.5% of GDP.

Now suppose a country consistently ran a deficit of exactly 0.5% of GDP. What would happen to its debt-GDP ratio?

Here’s a little note describing the dynamics of the debt-GDP ratio in a simple world with a constant deficit ratio, d, and a constant growth rate of nominal GDP, g. It shows that the debt to GDP ratio converges over time to (1+g)*d/g. (One could add random fluctuations in the growth rate or the deficit ratio and then the debt ratio would cycle around this long-run average value. Also, the timing assumption could be changed so that the current-period debt is determined by last period’s deficit, in which case the (1+g) would dissappear, but that wouldn’t make much difference to the calculation.)

Let’s assume a modest long-term growth outlook for the Euro area of 3 percent nominal GDP growth, i.e. 2 percent inflation and 1 percent growth in real GDP. In this case, the long-run implication of a 0.5 percent of GDP deficit ratio is a debt-GDP ratio of 1.03*0.005/0.03 = 0.172.

Since 0.5 percent of GDP is to be a maximum for the average deficit, this is a fiscal rule that would see long-run debt-GDP ratios below 17 percent of GDP in all Eurozone member states.

This is, of course, a long way from where we are now in most member states. Many countries currently have excessive debt ratios and there is a need to get debt and deficit ratios down over the medium term. It would take a very long time for countries like Ireland to end up with this very low debt ratio, so these limits may work fine as a medium term rule for high debt countries.

However, taken on its own merits, this rule doesn’t seem to make much sense as a long-run legally binding rule. As an alternative, an average deficit of 1.5 percent of GDP could combine with a nominal growth rate of 3 percent to produce a stable and manageable average debt-GDP ratio of 51.5 percent. This would seem like a more sensible benchmark.

Of course, if a government followed such a policy, normal cyclical fluctuations would likely take the economy above a 3 percent deficit fairly often without in any way jeopardising long-run fiscal stability. So the elevation of a three percent deficit limit to sacred cow status (“As soon as a Member State is recognised to be in breach of the 3% ceiling by the Commission, there will be automatic consequences unless a qualified majority of euro area Member States is opposed”) has little grounding in the actual economics of fiscal stability.

There is little doubt that Europe needs to act to reduce debt levels over the medium term and better institutional fiscal frameworks are required. However, these rules, however much they may appeal to the Swabian housewife instinct, are overly restrictive and have little connection to fiscal arithmetic. They are all the more likely to be flouted in future because of their poor design.