?

Log in

No account? Create an account
 
 
05 November 2011 @ 04:16 pm
AKICOLJ: Currencies, Government Bonds and the connections between them  
B. and I have decided that we are Very Confused about Greece and the euro. So in the hopes that someone on my flist (e.g. philmophlegm or wellinghall) can help I said I'd underline our understanding of what is going on and then the flist can tell us where we're wrong and fill in the gaps.

So currencies are issued by Mints/Central banks and can be used to buy stuff. Although the international financial markets are prone to playing all sorts of silly games, the value of a currency presumably, at some level, correlates to how much you can buy with it. So if your country doesn't produce much stuff, or at least not much for export, then your currency isn't worth a great deal and vice versa. An added complication is the enthusiasm with which the central bank/mint may decide to print more money which may (or may not) have various short term benefits depending upon the economic theory to which you subscribe but long term tends to encourage inflation and means you can buy less with the money (and vice versa - we have a dim impression that Norway keeps its exchange rate high(?low) by keeping crone scarce in some way). So theoretically a country could be very productive but its currency wouldn't be worth much on international markets because of a perception that the central bank was inclined to print more money (or indulge in Quantitative Easing which is an area of mystery to B. and I but not one we are immediately urgently mystified about) at the drop of a hat. In different countries the government may have more or less control over the central bank for the currency and thus more or less direct influence over the value of the currency. For instance East Timor uses the US Dollar and presumably has precisely zero influence over any decisions over whether to print more money. We assume that the countries "in the euro" have some influence over the decisions of the European Central Bank but rather less than, say, the US government has over the Federal Reserve. Or at least we assume that Greece has less influence even if France and Germany may wield a great deal. Similarly Greece being a comparatively small and unproductive economy we assume that the presence of Greek goods among those that can be purchased with euro doesn't make a lot of difference to the underlying value of the euro and what difference it does make is largely negative.

So governments also issue bonds which, as we understand it, are a financial product in which the government borrows money at a certain interest rate in, presumably, the preferred currency of the government. We assume these operate like many such products but that they are normally considered relatively safe since governments have tax revenue and state assets with which to underwrite the bonds. Of course in a country where the government has a lot of influence over the central bank they could choose to pay the interest on the bonds by effectively printing more money, thus reducing the value of the bonds in real terms but meeting the contractual requirements. This option, presumably, isn't available to Greece. European banks may have bought a lot of Greek bonds and therefore the fortunes of those banks may be tied to the fortunes of Greece but the European Central Bank itself isn't tied to them in the same way (i.e. Germanys tax revenue isn't tacitly underwriting greek bonds because the European Central Bank has guaranteed those bonds in some way, shape or form).

If Greece were to leave the euro it would gain the option to print money and use inflation to wipe out its debts, though it would need to change its bonds from euro to drachma but presumably there is some plan for this. The end result would probably be no less painful for Greece than austerity but there would be a less obvious external scapegoat which would make life easier for a number of people involved in decision making, if nothing else. The outcomes for Greece look pretty grim either way really.

If Greece remains in the euro but defaults on its bonds what effect does this have on the euro itself? (as opposed to being generally bad for Europe but Greece going bankrupt is pretty bad for Europe irrespective of whether it is within or outside of the euro, right?) Greek government bonds are no longer something you can buy with euro (or would want to) but presumably at the moment very few people want to buy them anyway. How is the effect of Greece going, effectively, bankrupt from within the euro worse for the euro than the effect of Greece leaving the euro and then going bankrupt?

Similarly can the euro eject Greece. Obviously Greece can be refused access to decision making at the central bank but, presumably like East Timor and the US Dollar, Greece could continue to use the euro if it wished. I realise this isn't on the table but I'd be interested to know what difference this would make. Would Greece going bankrupt while using the euro as its official currency but not being "in the euro" be different to Greece going bankrupt from within the euro? Does the US Federal Reserve worry that East Timor may go bankrupt?

Lastly up until about a week ago lots of people were saying how terrible it would be if a precedent were set that a country could leave the euro. Is this just because if Greece were to leave, the option would be open for Germany to take its toys home which, obviously, would have quite a negative impact on the value of the currency since Germany has a large and productive economy or would there be investments which would lose value simply because Greece had left in some way. Have people, for instance, been buying Greek bonds on the assumption that they were, in some way, guaranteed by the Central bank or... or... what?

Why is a country leaving the euro such an option of almost unthinkable last resort? Why is a small economy within the euro going bankrupt such a disaster specifically for the euro? Why does the euro care about Greece when there is no evidence the US Dollar cares either way about East Timor?
 
 
 
Gabby: acropolisgabcd86 on November 5th, 2011 04:58 pm (UTC)
There's only point I think I have an idea about, and that's the reason people care - from what Larry Elliot (awesomest economics dude at the Guardian) says, it's a fear of contagion. If a precedent is set of eurozone countries being allowed to default on their debts, it could easily start a run on Italy, Spain, and even France, and they're too big to bail out.

Also, *insert vindicated Gabby rant here*
louisedennislouisedennis on November 6th, 2011 08:44 pm (UTC)
I strongly suspect you do not feel vindicated for the same reasons that philmophlegm does below, even though he agrees with you on the contagion hypothesis.
philmophlegm: Lego Rock Bandphilmophlegm on November 5th, 2011 08:05 pm (UTC)
Will reply later. Currently Rock Band-ing...
ewxewx on November 5th, 2011 08:26 pm (UTC)

It says here that most Greek sovereign debt is governed by Greek law so presumably the Greek state could redenominate most of it into drachma without having to lose any court cases. The effect (as measured by the creditors and anyone compelled to bail them out) would still be a default of course.

AIUI quantitative easing is just a particular mechanism by which a central bank "prints" money and refers to the way it puts it into circulation.

louisedennislouisedennis on November 6th, 2011 08:19 pm (UTC)
I was aware that Quantitative Easing mapped onto "printing more money" at some level but was somehow more respectable. philmophlegm has an explanation below. I get the impression that Greece is highly likely to default and that the result will be bad, irrespective of whether they are in or out of the euro at the time.
philmophlegm: adamsmithphilmophlegm on November 5th, 2011 09:51 pm (UTC)
Part 1

"So currencies are issued by Mints/Central banks and can be used to buy stuff. Although the international financial markets are prone to playing all sorts of silly games, the value of a currency presumably, at some level, correlates to how much you can buy with it."



Currencies are indeed issued by Central Banks and are, as you say, used to buy stuff. The price of currencies on foreign exchange markets (measured in terms of other currencies) varies according to a number of factors, but because the market is so liquid, so easy to enter and features very high levels of information on the part of all participants in the market, that it should be one of the best examples of perfect competition of any market.

However...

Central Banks intervene in the market to influence the price of their currencies. And they do this a lot. This has the effect of making the market less perfect, which allows clever speculators to make money out of it. The really big players in the market (especially if they act together) can be big enough to force devaluations in certain circumstances. Remember Sterling's forced exit from the European Exchange Rate Mechanism in the early 1990s? That was forced by speculators. The way the ERM worked was that countries were required to intervene in the market so that the value of their currency was kept within a specified range. Sterling's range was too high, so the Bank of England had to intervene (by buying up Sterling and raising interest rates) to prop it up. Speculators (remember George Soros?) realised that they couldn't keep this up (since governments with small majorities rarely win elections after making people's mortgages super-expensive). So the speculators dumped all the Sterling they had on the foreign exchange markets and Norman Lamont did the right thing and pulled Sterling out of the ERM.
philmophlegm: adamsmithphilmophlegm on November 5th, 2011 10:22 pm (UTC)
Part 2

"So if your country doesn't produce much stuff, or at least not much for export, then your currency isn't worth a great deal and vice versa."

True, although there are other factors affecting the value of a currency. The most obvious is interest rates. Everything else being equal, holding cash is more attractive to an investor if he can get a higher rate of interest on it.

In fact, working out what makes exchange rates move is a complicated area of economics. There are a number of competing theories. In truth, they are probably all factors, and interact in highly complex ways:

1. Purchasing power parity. The idea that everything else being equal, identical goods should cost the same in real terms in different parts of the world regardless of the local currency, and that exchange rates will adjust to reflect this. After all, if they didn't, then surely it would always pay to change your money to another currency and buy the product at a favourable price. In practice though, there will be few goods that are perfectly interchangeable in different countries. And even where there are, the individual markets for those goods (not the currency markets) are rarely close to perfectly competitive.

This means that to some extent, if you were to find a particular product that was easily available across many different economies, you might be able to compare its price in local currencies, translate those into one particular currency and then see if a currency is over- or under-valued. Over the years, a number of such products have been suggested from the iPod to the IKEA 'Billy' bookcase, but the most famous is the 'Big Mac Index' published every year by the Economist.

2. Balance of payments. This theory would suggests that foreign exchange rates will adjust to compensate for the balance of payments surpluses or deficits of particular countries. If a country has a balance of payments surplus (that is, it exports more than it imports), then according to this theory the country's currency would increase in value. That would mean that its exports would become relatively more expensive and hence less competitive. And of course the opposite would theoretically apply for countries with balance of payments deficits.

3. Asset market. This model sees currencies in much the same way as any other asset and hence the market price will simply depend upon supply and (especially) demand from investors to hold that particular currency as an asset in their portfolio.
philmophlegm: adamsmithphilmophlegm on November 5th, 2011 10:51 pm (UTC)
Part 3

"An added complication is the enthusiasm with which the central bank/mint may decide to print more money which may (or may not) have various short term benefits depending upon the economic theory to which you subscribe but long term tends to encourage inflation and means you can buy less with the money..."

Indeed. Economists will differ on how quickly printing of money or quantitative easing will feed through into increased inflation, but the current experience suggests that it doesn't take very long.

Which possibly begs the question "Why print money then?". But first, a quick explanation of "quantitative easing". It's not _exactly_ printing money, but it does have the effect of increasing the quantity of money in the economy. Banks will hold government bonds as a matter of course - basically the Central Bank promises to pay the holder of the bond £x on a certain date and pays interest on that bond to the bank in the meantime. The bank will have paid the Central Bank for the privilege of this when the bond was initially issued.

'Quantitative easing' is when the Central Bank says to the bank "We'll forget about that bond that pays you cash in twenty years and instead you can add a few zeroes to the amount of cash we say you have." Then the idea is that the bank uses that extra cash to lend to its customers and the economy is boosted. So it's an electronic way of printing money.

So, to return to the original question, why would you do it?

Normally, there are two methods that governments and central banks can use to boost an economy - fiscal policy and monetary policy. Fiscal measures are things like increasing government expenditure and reducing the amount of revenue raised from taxes (and thereby increasing government borrowing). Monetary policy tends to concentrate on setting interest rates. Lower interest rates encourage individuals to buy things and companies to invest in things by making it cheaper to do so.

But...

What if a government is borrowing too much already and has interest rates about as low as they will go? And what if growth is low? What can a government do to stimulate the economy? There really aren't many options left - and quantitative easing is one of those options.
philmophlegm: adamsmithphilmophlegm on November 5th, 2011 11:08 pm (UTC)
Part 4

"...we have a dim impression that Norway keeps its exchange rate high(?low) by keeping crone scarce in some way..."

I'm afraid I don't know much about the Norwegian economy and its management of the krone. I do know that it is in a very unusual situation of being a small but advanced economy that is also a major oil exporter. This means that the intrinsic value of the krone is very closely linked to the price of oil. And I imagine that causes all sorts of problems for the rest of the economy.
bunnbunn on November 6th, 2011 12:35 am (UTC)
I must confess that my mental vision of 'keeping crone scarce' involved some sort of cull at the age of, say 40...
philmophlegm: adamsmithphilmophlegm on November 5th, 2011 11:10 pm (UTC)
Part 5

"In different countries the government may have more or less control over the central bank for the currency and thus more or less direct influence over the value of the currency."

True.
philmophlegm: adamsmithphilmophlegm on November 5th, 2011 11:24 pm (UTC)
Part 6

"For instance East Timor uses the US Dollar and presumably has precisely zero influence over any decisions over whether to print more money. We assume that the countries "in the euro" have some influence over the decisions of the European Central Bank but rather less than, say, the US government has over the Federal Reserve. Or at least we assume that Greece has less influence even if France and Germany may wield a great deal. Or at least we assume that Greece has less influence even if France and Germany may wield a great deal."


Yes, I imagine that East Timor has no influence at all on the US Federal Reserve.

And yes, I doubt that the smaller governments in the Eurozone have little influence over the European Central Bank.

You could also say that Cornwall has little or no influence on the Bank of England. But there is a crucial difference between Cornwall's situation in the 'Sterling Zone' and smaller countries' situations in the Eurozone.

That crucial difference is fiscal flows. If UK interest rates and the value of Sterling don't suit the Cornish economy, there is a simple mechanism for the Westminster government to compensate - they just have to spend some money in Cornwall or make a special grant if the UK rates are disadvantageous to Cornwall, or reduce the central government grant to Cornwall Council if the reverse is true. But there's no such mechanism in the Eurozone (except in minor senses like Special Development Grants).

And in a way, that is the fundamental flaw in the Euro.
Kargicq: Neuromancerkargicq on November 6th, 2011 08:15 am (UTC)
And, I guess, there is the democracy, whereby if Cornwall is pissed off with what the Westminster government is doing, it won't vote for MPs from that party. I know that doesn't guarantee W'mstr will treat Cornwall well but I don't think there's even an equivalent structure in Europe. - N.
bunn: Logresbunn on November 6th, 2011 09:49 am (UTC)
I spose, but it's not much use if you are the only country/county in trouble, no? A symbolic form of protest, once every four years, which will be ignored by the more populous and richer areas.
philmophlegm: adamsmithphilmophlegm on November 5th, 2011 11:46 pm (UTC)
Part 7

"Similarly Greece being a comparatively small and unproductive economy we assume that the presence of Greek goods among those that can be purchased with euro doesn't make a lot of difference to the underlying value of the euro and what difference it does make is largely negative."

The problem is that while countries in the Eurozone are very different, they all have to have the same exchange rate. And while they still have different interest rates, those interest rates are affected by all the other countries in the zone, so individual countries - especially the smaller ones - often don't have an appropriate interest rate either.

Let's consider two examples. Germany has a big balance of payment surplus. Now one of those exchange rate theories I mentioned earlier suggests that its exchange rate should adjust to compensate. But because it's in the Euro, this can't happen. There's a good reason why the BMW 3-series seems better value than it used to. That's sort of good for Germany (which has enjoyed an export-led boom for a few years), except when you think that most of the countries it exports to are other Eurozone countries and the reverse is happening to them - in the medium term, their economies won't be able to afford those German imports.

Ireland had a different problem. It was able to enjoy artificially low interest rates, leading to a booming economy a few years ago, led in particular by a property boom. But when the credit crunch came, the banks that had borrowed to fund all those mortgages and property developments got into difficulty and had to be rescued by the Irish government.
philmophlegm: adamsmithphilmophlegm on November 5th, 2011 11:51 pm (UTC)
Part 8

"We assume these operate like many such products but that they are normally considered relatively safe since governments have tax revenue and state assets with which to underwrite the bonds."

Normally most governments would be rated as very safe, and some (like the UK) still are. This is what the commercial ratings agencies do - they assess how likely borrowers are to pay back their debts. They tend to get in the news for their ratings of government debt, but they also rate commercial borrowers (companies issuing debt etc).
philmophlegm: adamsmithphilmophlegm on November 5th, 2011 11:58 pm (UTC)
Part 9

"Of course in a country where the government has a lot of influence over the central bank they could choose to pay the interest on the bonds by effectively printing more money, thus reducing the value of the bonds in real terms but meeting the contractual requirements."

Yes - exactly. Printing more money leads to inflation which reduces the value of the bonds in real terms. Other measures which also lead to inflation would have the same effect.

That's good news for a government looking to pay off debt and very bad news for anyone with savings and pensions that aren't linked to inflation.
philmophlegm: adamsmithphilmophlegm on November 6th, 2011 12:02 am (UTC)
Part 10

"This option ("printing more money"), presumably, isn't available to Greece."

No, it isn't. Eurozone countries cannot unilaterally increase their money supply.
philmophlegm: adamsmithphilmophlegm on November 6th, 2011 12:08 am (UTC)
Part 11

"European banks may have bought a lot of Greek bonds and therefore the fortunes of those banks may be tied to the fortunes of Greece but the European Central Bank itself isn't tied to them in the same way (i.e. Germanys tax revenue isn't tacitly underwriting greek bonds because the European Central Bank has guaranteed those bonds in some way, shape or form)."

Also correct, although of course Germany's tax revenue would go down if Greece buys fewer BMW 3-series.
philmophlegm: adamsmithphilmophlegm on November 6th, 2011 12:28 am (UTC)
Part 12

"If Greece were to leave the euro it would gain the option to print money and use inflation to wipe out its debts, though it would need to change its bonds from euro to drachma but presumably there is some plan for this. The end result would probably be no less painful for Greece than austerity but there would be a less obvious external scapegoat which would make life easier for a number of people involved in decision making, if nothing else. The outcomes for Greece look pretty grim either way really."

I don't know if there is a plan for changing Greek bonds from Euros to drachma or new drachma or whatever their new currency would be called. And once out of the Euro, Greece would be able to inflate to reduce its debt and devalue to get to a more appropriate exchange rate. The way it'll get out of most of its debt though will I suspect be defaulting. They just won't pay large chunks of it. This week's agreement has already written off 50% of their debt. My suspicion is that they'll do what Russia did in 1998 and default on remaining domestic debt too (and possibly even take banks into state ownership, at least in the short and medium term).

I agree that the outcome for Greece looks bad either way. I'd say that they got what they deserved for years of stupidly lax fiscal policy, but that hardly seems fair as that has also been the situation in the UK since about 2000. At least the UK doesn't have Greece's hidden economy problem.

Something that would help the Greeks a little bit would be if the German government would repay all the money pillaged from the Greek central bank during the occupation in WW2. This was an interest-free loan to pay for the German war effort that Germany has never repaid. In modern terms, it's been estimated to be worth about £60billion.

philmophlegm: adamsmithphilmophlegm on November 6th, 2011 12:35 am (UTC)
Part 13

"If Greece remains in the euro but defaults on its bonds what effect does this have on the euro itself? (as opposed to being generally bad for Europe but Greece going bankrupt is pretty bad for Europe irrespective of whether it is within or outside of the euro, right?) Greek government bonds are no longer something you can buy with euro (or would want to) but presumably at the moment very few people want to buy them anyway. How is the effect of Greece going, effectively, bankrupt from within the euro worse for the euro than the effect of Greece leaving the euro and then going bankrupt?"

The answer to this is pretty much what gabdc86 said: the risk of 'contagion'. If Greece gets out this way, why shouldn't Portugal? Or Ireland? Or Italy? Or any other Eurozone country that used the artifically low interest rates offered by Euro membership to borrow beyond their ability to pay back to engineer a boom / pay for politicians' pet projects.
philmophlegm: adamsmithphilmophlegm on November 6th, 2011 12:43 am (UTC)
Part 14

"Similarly can the euro eject Greece. Obviously Greece can be refused access to decision making at the central bank but, presumably like East Timor and the US Dollar, Greece could continue to use the euro if it wished. I realise this isn't on the table but I'd be interested to know what difference this would make. Would Greece going bankrupt while using the euro as its official currency but not being "in the euro" be different to Greece going bankrupt from within the euro? Does the US Federal Reserve worry that East Timor may go bankrupt?"

Politically, no. Doing so would be a step in the opposite direction to that intended (i.e. greater political union).

Economically, possibly. I ask myself "What have the other Eurozone countries got left in terms of sticks to hit Greece with?" I don't know. So would this mean that they (I say "they", I probably mean "Germany plus maybe France") could just wash their hands of Greece. I think they could, and there's a point past which the chance of getting loans back becomes too low to keep propping up the Greeks. At that point, the sensible economic action for Germany to take would be to basically tell the Greeks to f*** off.

Politically though, very different answer.
philmophlegm: adamsmithphilmophlegm on November 6th, 2011 12:55 am (UTC)
Part 15

"Lastly up until about a week ago lots of people were saying how terrible it would be if a precedent were set that a country could leave the euro. Is this just because if Greece were to leave, the option would be open for Germany to take its toys home which, obviously, would have quite a negative impact on the value of the currency since Germany has a large and productive economy or would there be investments which would lose value simply because Greece had left in some way. Have people, for instance, been buying Greek bonds on the assumption that they were, in some way, guaranteed by the Central bank or... or... what?

Personally, I don't think it would be terrible for any country to leave the Euro, but then I've always thought that the Euro was a bad idea in economic terms. As far as I can see it has always been about the politics rather than the economics. I was in the minority who thought that ERM was a bad idea back in the late 80s and early 90s and I've thought that the Euro was a bad idea since then. I may have been right both times, but that's scant consolation when you're working in a ruined economy.

People will have been buying Greek government bonds (in preference to say German ones) basically because they could get a better rate of interest on them.
philmophlegm: adamsmithphilmophlegm on November 6th, 2011 01:02 am (UTC)
Part 16

"Why is a country leaving the euro such an option of almost unthinkable last resort?"

It isn't, it really isn't, at least not in economic terms. But it probably is to the advocates of closer political union.

There are costs to switching currencies, and it wouldn't be easy, but it is possible. After all, every country in the Eurozone has switched currencies fairly recently.

philmophlegm: adamsmithphilmophlegm on November 6th, 2011 01:11 am (UTC)
Part 17

"Why is a small economy within the euro going bankrupt such a disaster specifically for the euro? Why does the euro care about Greece when there is no evidence the US Dollar cares either way about East Timor?"

Partly the political versus economic thing mentioned in parts 15 and 16. Partly the amount of Greek debt compared to East Timorean debt and the fact that it is concentrated in European banks (both commercial and central). French commercial banks hold over $40billion of Greek debt. Take that away, and we may very well be in the situation we were in a couple of years ago with governments having to rescue banks.
wellinghallwellinghall on November 6th, 2011 08:18 am (UTC)
After philmophlegm's 17-part essay, any comments of mine would appear superfluous! But I may still chip in with my own thoughts at some point.
bunn: Bunglesbunn on November 6th, 2011 09:36 am (UTC)
Oh go on. It does him good to be argued with. Otherwise he becomes bumptious.
louisedennislouisedennis on November 6th, 2011 06:04 pm (UTC)
Thanks for all this. At the risk of making you "bumptious" it's been really useful. In particular we'd not really thought about the effect that exchange rates would have on everything, nor had we realise that the interest rates set by the Central European Bank meant that Greece could borrow money at more beneficial rates than it would have been able to otherwise.