Monday 2 February 2015

Grexit Gloom or QE Delight?

Dave


I haven't written for a while, sorry, I've had more important things on than saving your bacon. However, Europe is heading for the abyss again, and you might be able to use this to help, and in the process win a few brownie points.


The Greek situation and all the Grexit talk is all very 1930's to me. More politics than monetary or fiscal policy, it still has huge financial implications for all concerned, including us and not least my Portuguese holiday plans.


As we all know, the trouble has been caused by a single currency which has removed the ability of exchange rates to buffer an individual country against it's economic performance without tying their economies together in fiscal harmony. Germany has done extremely well exporting at an artificially low exchange rate for its currency, while the less efficient members of the Eurozone have suffered with an artificially strong currency relative to their own situation. Germany are obviously very pleased with the situation and keen to support the status quo while the others scratch around hoping for some fiscal largesse.


The most that Angela seems prepared to do is authorise some QE, to stave off deflation, so at least the debt of the poorer countries don't grow in real terms while they are struggling. A bit like taking your foot off the windpipe of a man you have parked your car on. What is needed is something more like the UK, where the lower performing bits, economically speaking, are supported by the rest, er, London. Clearly this would make Merkel turn in her groove, and so something more creative is needed.


It is my belief that there is a startlingly simple solution which may well be acceptable to all, and which is only possible thanks to modern technology, therefore it has never been tried or thought of as far as I know. To me, most of the current solutions seem to be out of the Great Depression, some, like QE, with a modern flavour, but they are still grapeshot in approach. What is needed is a more targeted effort and here's how it's done in a way in which QE solves the problems of the Euro as a single currency at the same time.


Put simply, create a new 'Euro' for each member of the zone, and create holdings for this in the ECB. Manage these national currency accounts like investment banking accounts, and include all sovereign debt, bonds etc. Each country's Euro should then have an internal exchange rate against the ECB central 'group' rate, using a formula based on underlying economic performance and designed to mirror the behaviour of a floating currency. Use this or any similar mechanism to inflate or deflate an individual economy as required, and use the imaginary QE money for the exercise. This targets the QE exactly where it is needed. Using modern technology it would also be possible to compute the flows of capital in and out of an individual member economy, and to use these alongside the currency performance formula to calculate the level of QE to be applied to the country account. Therefore if an economy performing badly would have been expected to suffer/enjoy a 20% devaluation of a free floating currency, increase it's euro holdings by 20% of the capital flows.


Of course, the reverse ought to also be the case, for high performing economies, but Angela will hate it and QE money will do just as well.


For Greece, this is not writing down of debt, or waiving bail out terms, it is simply restoring the spending power of the government/country to closer to what it would have been had they kept a floating currency, what it spends it on must be for negotiation, but clearly anything that restores competitiveness would be ideal, and could be spun as equalling an end, or part-end, to austerity. I'm especially thinking of corporate and even personal taxation reductions, to put money directly into the economy.


This is obviously imperfect in that it doesn't in itself make an economy more competitive internationally in a downturn, but it does provide the financial firepower for individual governments to make sensible (agreed) interventions in their own markets with that aim in mind. It therefore uses the QE to solve the Greek question (and the inevitable Portuguese, Italian and Spanish ones which would otherwise follow). And, although it doesn't give Angela much on the surface, it provides future stability for the Euro, and therefore keeps the exchange rate for the group as a whole artificially low in German terms, which is just what she really wants.


As the value of the overall currency holding of each member state can now float, the poorer ones will always have a mechanism to restore competitiveness, so the final caveat is obviously that a system needs to be designed to ensure that the targeted gains in each economy are captured, and not simply used as grant aid to bail it out. To this end, the ECB can, I'm sure, also build in balancing items which will move the interest rates and/or the absolute value of the debts in the member's accounts, according to how they use the largesse and the results that they achieve.


This will be complex to negotiate but once agreement is reached a trouble-free system is surely possible which removes some of the core disadvantages of a single currency when it is not accompanied by complete fiscal unity.


Best regards


Gareth