Paulson’s subprime mortgage borrower bail out
The Bush administration appears to have converged on a plan to help financially challenged subprime mortgage borrowers sucked into their state of indebtedness through adjustable rate mortgages with very low, up-front borrowing rates, so - called teaser rates - which re-set after two or three years to a much higher level - up to three percent or more above the introductory teaser rates. Many of these subprime mortgage borrowers would no longer be able to afford their monthly mortgage payments following the interest rate resets, and would stand to lose their homes as a result.

The Bush administration proposal, put together in negotiations of Treasury Secretary Henry Paulson with the mortgage industry, freezes the introductory teaser rates for subprime borrowers that are still just about afloat (roughly current on their mortgages, i.e. at most a little bit pregnant), but have credit scores below 660. The proposal prevents the low introductory teaser rates for these subprime borrowers from resetting to higher rates for five years.. Subprime borrowers with a credit score of 660 or higher, who are more likely to be refinanceable with new loans on commercial terms, will be fast-tracked. Josh Rosner, a consultant at Gram Fisher was quoted in the Financial Times of 7 December as saying: “This modification of existing contracts without the full and willing agreement of all parties to those contracts, risks significant erosion to 200 years of contract law”. He is right. By offering a higher ex-post subsidy for those with a lower credit score, it also piles moral hazard on top of moral hazard.

This proposal is a classic example of a politically attractive, economically ugly quasi-fiscal window dressing exercise.

Quasi-fiscal policy measures
Quasi-fiscal measures are government actions that are economically equivalent to taxes or subsidies but are not formally classified as such. They are off-budget taxes and subsidies, often administered by entities other than the general government. I would include in the quasi-fiscal category also all forms of off-budget and off-balance sheet financing by the government, that is, all financial arrangements that increase the net indebtedness of the government but do not, for technical reasons, show up (at least not in the short run) in the conventional government financial accounts. 

Examples of quasi-fiscal measures are non-remunerated reserve requirements imposed by central banks. To the extent that minimal reserve requirements exceed the quantity of reserves that would have been held voluntarily in their absence, they represent a tax, equal in magnitude to the quantity of reserves held involuntarily multiplied by the financial opportunity cost of holding these involuntary reserves. Other examples include price controls on food, which amount to a subsidy on food, requirements to surrender foreign exchange earned from exporting to the central bank at an unfavourable exchange rate, which amounts to a tax on exports or export quotas which depress the domestic price of the exportable good below the world price, which amounts to a tax on the producer and a subsidy to the consumer. Government guarantees provided at less than their opportunity cost are another popular quasi-fiscal instrument.

In the US, quasi-fiscal measures have long distorted the housing market and the market for housing finance. The deductibility of mortgage interest from the Federal income tax is a quasi-fiscal subsidy. With inflation positive and likely to remain so, a further distortion is introduced by the fact that it is the nominal interest cost that is deductible.

Freddie Mac and Fannie Mae, the two Government Sponsored Entities – notionally private listed companies but de-facto Federally guaranteed, engage in securitisation of eligible mortgages and insuring mortgages. Their combined balance sheets at the end of 2006 was about $1.65 trillion, $843bn for Fannie Mae and $813bn for Freddie Mac. The total mortgage credit book of these companies is, however, much larger than their balance sheets. In the case of Fannie Mae, in addition to a mortgage portfolio of $729bn (the unpaid principal balance of mortgage loans and mortgage-related securities held in its portfolio) there also were Fannie Mae Mortgage-Backed Securities held by third parties worth $1,777bn and $20bn worth of other guarantees. The corresponding numbers for Freddie Mac were $704bn for its mortgage portfolio and $1,477bn for its Mortgage-Backed Securities outstanding. The total amount of mortgages and mortgage-backed securities outstanding of the two GSEs is therefore around $4.5 trillion. 

On December 7, 2007, the 10-year US Treasury yield was 4.01 percent and 10-year Freddie Mac and Fannie Mae bonds yielded 4.64 percent. A-rated corporate bonds yielded 5.83 percent and high-yield or junk yielded anything over 7.5 percent. Recently, City Group borrowed $7.5bn from the Abu Dhabi Investment Authority at 11 percent. Let’s be generous and assume that, without the de facto guarantee of the Federal government, the two GSEs would have to borrow from the markets at terms slightly better than Citigroup, say, 10 percent. The annual subsidy provided by the tax payer to the GSEs, and through them to American mortgage borrowers is therefore 5.36 percent of $4.5 trillion or $241 bn. Even if you halve that, it’s still a nice figure. 

To this massive subsidy benefiting households borrowing against eligible residential property, the Treasury now proposes to add a further subsidy, whose amount is as yet unknown, but which will be small compared to the massive subsidy provided through the two GSEs. For those fortunates whose teaser rate get extended for five years, the subsidy is the difference between the level that would have been effective following the reset and the teaser rate. There is a corresponding tax on the lending institution or on the current owners of securities backed by the mortgages whose rates have been frozen. The subsidy on borrowers whose refinancing will be fast-tracked (and the corresponding tax on the lender or the investor in mortgage-backed securities) cannot be determined until we know the actual terms of the fast-tracked re-mortgaging and find a way of computing the counterfactual mortgage cost without the government-imposed fast-tracking. 

I can see little justification for these interventions in housing finance. There may be positive externalities associated with home ownership and with owner-occupation of residential dwellings. That would provide an argument for subsidizing home ownership or owner-occupancy. It would not provide an argument for subsidizing borrowing secured against residential homes. 

If the information provided to the financially distressed subprime borrowers was incomplete, misleading or outright dishonest, there should be recourse to the criminal justice system. For those subprime borrowers who bet on being bailed out by ever-rising house prices, the adagium: “you break it, you own it” applies. They gambled and they lost. There is no argument based on fairness or efficiency for allowing them to stay in homes they cannot afford without a subsidy. Foreclosure and repossession were designed for just such occasions. The fact that we are approaching an election year should have no bearing on this. Unfortunately it does. This bailout of the imprudent and the short-sighted is unfair to the prudent and far-sighted. It also creates terrible incentives for future overborrowing. 

Conclusion
The bailout proposed for the subprime market is wrong for two reasons. First, because it is a bailout. Second, because it is a bailout implemented with quasi-fiscal instruments rather than with explicit fiscal instruments: a tax on investors in subprime mortgages (or securities backed by them) and a subsidy to subprime mortgage borrowers. Quasi-fiscal instruments are opaque and non-transparent. They serve and are intended to hide the true nature and the real cost of what the government is up to. They kill accountability for the use of public resources. It redistributes not through explicit taxes and transfers but by interfering with the price mechanism. That is why it is so popular with opportunistic politicians everywhere. 

Every politician wants to finance his or her pet projects and hobby horses in an off-budget and off-balance-sheet manner. The public sector knew and applied most of the tricks performed by corrupt and criminal private sector outfits like Enron long before Enron became a household word. Take, for instance, Gordon Brown’s International Finance Facility. This is an off-budget and off-balance sheet arrangement or special purpose vehicle (SPV) that securitises future development aid commitments of the UK government.

The off-balance-sheet vehicle borrows against these future aid commitments to finance development today. Whether it is a good idea to rob future poor Peter to pay today’s poor Paul is an important issue, but not the one I wish to focus on here. What the SPV permits the government to do, is to borrow today without having it show up as borrowing in the government’s financial accounts. The earmarking of future aid commitments will, of course, constrain future government budgetary elbow room, but for myopic and opportunistic politicians, there is no difference between 10 years from now and the next millennium.

The quasi-fiscal measures proposed for the subprime borrowers and lenders have the advantage of never showing up in the government budget. The implicit Federal government guarantees for the debt of Fannie Mae and Freddie Mac are a contingent liability. Even if they are not priced and accounted for in today’s government balance sheet, they could pop up in tomorrow’s Federal Budget and balance sheet should default threaten the GSEs. Of all the governments I know, only New Zealand attempts a comprehensive accounting for contingent assets and liabilities. That remarkable country indeed provides most of the information required for a construction of a comprehensive government intertemporal budget constraint.  Many of the financial shenanigans of governments would become much harder to perpetrate if they were forced to take the long view in the presentation of their accounts. Unfortunately, the kind of quasi-fiscal raid proposed by Mr Paulson for the US subprime market would not be captured even by a New Zealand-style comprehensive balance sheet of the government. Through direct government interference in price setting and through the government-imposed rewriting of long-term contracts, fiscal policy is conducted without leaving a trace in the government’s budget, today or tomorrow.

Argentina and other emerging markets dominated by populist governments are frequent users of government-created price distortions in the pursuit of electoral and other political advantage. In Argentina, the authorities rolled back and capped utility prices. In the US, the authorities prevent interest rate resets in the subprime mortgage markets. Is Argentina the new economic model for the Bush administration?

Tapir relief

Like many other animal lovers, I support tapir relief.  All four species of tapir are endangered.  Subsidising the bodily functions of this prehensile-snouted odd-toed ungulate (closest living relatives horses and rhinoceroses) is obviously a worthy use of public funds.

True animal libertarians may argue that tapirs can perfectly well relieve themselves, without government assistance or special incentives. The sign below, found in the Belize City Zoo, supports this argument.

Nevertheless, I am convinced that a sound utilitarian case for tapir relief can be made. There are bound to be positive tapir externalities meriting a subsidy or regulatory intervention (e.g. tapirs are considered cute, and not just by other tapirs).  In the unlikely case  that  an externalities-based case for granting fiscal favours to the tapir cannot be made, the proponents of the new (or indeed the old) paternalism can no doubt find failings in the cognitive skills of the tapir, or weaknesses in his capacity for long-term commitment, that would warrant a tax break.

Taper relief

There is, however, no case in fairness, efficiency or paternalism for the continuation of taper relief in the UK capital gains tax regime.  Chancellor Alistair Darling deserves brownie points (he won’t get any Brown points) for attempting to simply the unholy mess that is the UK income tax and capital gains tax regime.  Taper relief is a singularly pointless and distortionary feature of the UK capital gains tax, one which benefits not the tapir, but a different collection of mammals, ranging from owners of small businesses to owner/managers of private equity funds. Although, like the tapir, often pig-like in shape and keen to put their snouts in the trough, they are in no way endangered or in need of special tax advantages, either for efficiency reasons or because of fairness concerns.

I have argued elsewhere that, because of considerations of fairness, efficiency, tax compliance, tax administration, evasion and avoidance, the only  income tax, capital gains tax and corporate profits tax regime that makes sense would have the following features: (1) It adds all labour income, capital income (dividends, interest etc.) and capital gains together and applies a single tax schedule to this total, regardless of its composition; (2) It abolishes corporation tax or makes it into a pure withholding tax.  This means that taxes paid at the level of the company can be fully offset against the personal capital income (interest, dividends) tax liability. 

I would add the following: (3) It fully indexes the entire income tax structure (allowances, bands and capital gains); (4) It consolidates employers’ and employees’ national insurance (social security) contributions into the personal income tax; this could both raise the average income tax rate (across all income tax payers) and lower the highest marginal income tax rate;  national insurance contributions themselves would, of course, no longer exist as a separate tax; (5) It makes all interest income taxable, and allows all interest paid (on mortgages, credit cards, other loans) to be deducted from taxable income (in view of (3), only real interest payments should be deducted); and (6)  It imputes the implicit rental value of owner-occupied accommodation as income.

It would be possible, by deducting the value of inflation-corrected saving from taxable income calculated according to (1) through (6), to turn this into a consumption tax, but I would be happy with either.

Chancellor Darling’s proposals unfortunately took one step backward at the same time that he took a step forward by proposing the abolition of taper relief and its replacement by a single 18 percent capital gains tax rate. That is because he also proposed the abolition of the last remaining bit of indexation of capital gains, which means that you now pay capital gains taxes even if the nominal capital gains that are taxed do no more than make up for the erosion by inflation of the real value of your assets. 

But the abolition of taper relief can be viewed as a helpful first step on the road towards a promised land where all income is taxed according to the same tax schedule.  If nothing else changed, this means that in a sensible world, the highest marginal tax rate on capital gains would be the same as on labour income and dividends (assuming corporation tax is abolished).  Currently this would be 40 percent, but with the other changes I am proposing, the highest common marginal rate could be lower.

The two key features of taper relief are that the capital gains tax rate is (1) lower the longer an asset has been held and (2) lower for business assets than for other assets.  Neither feature makes any sense.

Should the owner of an asset be encouraged to hold it as long as possible?
The answer is a clear and unambiguous: ‘no’.  Especially when it comes to business assets whose effective deployment requires entrepreneurial and managerial skills, there is no presumption that the current owner is the best owner/manager.  Bad owners (that is, owners who either are poor entrepreneurs and managers themselves or who are poor at selecting good managers) should be encouraged to sell as soon as possible.  Good owners should hang on to their assets.  Governments have no way of knowing who the good or bad owners are.  There is no presumption that the current owners are the best possible owners -  something that is a necessary condition for encouraging long-term ownership of (business) assets. I would have thought that when the current owners are bad owners, both they themselves and the market of possible interested buyers of their business assets would be at least as likely to figure this out as the government or some government-sponsored agency.  The presumption underlying taper relief that, left to their own devices, owners of assets, and especially owners of business assets, would dispose of these assets too soon is not based on a single thread of evidence.

Should business assets be taxed more lightly than non-business assets?
The answer is again a clear and unambiguous ‘no’, based on the absence of any efficiency or equity argument in favour of this feature of taper relief.  A building owned by a small firm owned by an owner-entrepreneur  is not more or less  valuable from a social point of view that a similar building owned by  a ‘natural’ person, or indeed that same building owned by an investment fund specialising in property.  This feature of the tax system distorts investment decisions and decisions on whether or not to incorporate.

A number of other spurious arguments in favour of the continuation of taper relief have been made:

"We were promised….".
The then Chancellor Gordon Brown introduced taper relief in 1998 with the declared purpose of encouraging entrepreneurship, long-term investment and risk-taking in the UK.  Abolishing it now would be unfair, a breach of promise, and amounts to confiscation of profits resulting from a commitment to investment that took place only because the investor trusted the promise of the Chancellor.

Well, tough luck and/or more fool you.  Clearly it would be better if the structure of taxation, benefits, regulations and other factors relevant to investment decisions and under the government’s control were (a) sensible and (b) stable over time.  Stability of tax structures matters.  Sometimes it is better to have a second-best tax system that is stable over time than a first-best one that is at risk of getting changed frequently.  However, the distortion associated with taper relief is such that its elimination makes welfare-economics sense, provided that it is not followed by a sequence of further changes in the opposite direction.   

Furthermore, governments act on behalf of the sovereign. This means, in non-legal language, that they can do what they jolly well like.  A government cannot credibly commit itself to a specific course of future actions.  It can certainly not commit its successors.  Anyone who believes that any particular government decision or legislative act is irreversible, is terminally naive and should not be in business.  In the case of the 1998 Chancellor Gordon  Brown, this applies with special force.  Gordon Brown was pretty good at ensuring overall macroeconomic and financial stability.  He was also a maniacal micro-structural tinkerer.  There wasn’t a single economic or social problem or Gordon Brown was addressing it with a handful of tax incentives, a few subsidies and some regulatory measures.  Each budget would contain literally hundreds of such micro-tinkering measures.  And there would be different ones each budget, often reversing or neutralising other measures contained in the same budget or in earlier budgets. 

Any change in any feature of the tax system, the subsidy system or the regulatory framework will be, at least in part, a surprise to the private economy.  It will benefit some and hurt others, including persons, households, small and large firms, that had made investment decisions on the basis of guesses about the future tax, subsidy and regulatory regimes that were falsified by the government’s subsequent actions.  Unfortunate, painful and inefficient, perhaps unfair.  But an intrinsic feature of the the political landscape since the beginning of time.  The notion that the UK small business community is entitled for the rest of time to the most favourable tax treatment bestowed on it at any time in the past, is rather silly.

Encouraging risk taking
Then there is the notion that low rates of capital gains taxation encourage risk taking and that risk taking needs to be encouraged.  Let’s take the last one first.  Risk is bad.  Other things being equal, we want less of it.  More risk makes sense only if it is offset by a(n at least) compensating increase in expected returns.  To say that the government should encourage risk-taking is as silly as to argue that the government should encourage the pursuit of lower expected returns.

Is there too little risk taking in the UK economy?  Features of the corporate legal environment, especially limited liability, create incentives for excessive risk taking, because losses that would, with unlimited liability, result in negative equity, are not in fact borne by the entrepreneur under a limited liability regime,  Do businesses  overestimate risk and underestimate expected returns?  Entrepreneurs are congenial optimists who tend to overestimate returns and underestimate risk.  Managers of quoted companies that have but a limited equity stake in the firm, face a large number of incentives affecting their behaviour towards risk, not all of which point towards excessive caution.  The net effect will depend on the capital structure of the firm, the governance structure of the firm, including the relationship between management and the board(s),  the remuneration package of the manager, the market for corporate control in which the firm operates, and the nature of the managerial market place.  The case that there is too little risk taking in the UK economy, relative to the expected rewards on offer, has not been made effectively by anyone.

There may be too little risk capital available for launching new firms or new ventures by existing firms.  Capital gains taxation, however, is a very inefficient instrument (both from the point of view of its ability to correct the distortion that is targeted and from the point of view of the revenue effects for the tax authorities) to address the problem of the inadequate availability of external finance.  Capital gains taxation means taxing capital gains on the existing stock of capital assets.  Reductions in capital gains taxes benefit owners of existing capital assets.  Expectations of future low capital gains tax rates will have a favourable effect on investment today, but lower capital gains taxes today only increase the returns to investment decisions already made.

If governments want to boost investment, the revenue-efficient way is to work at the margin of new investment, say through a marginal investment subsidy, or through an investment tax credit, accelerated depreciation of new investment etc.  If governments want to encourage the availability of external finance for new firms and, more generally, for those enterprises whose access to external finance is inefficiently constrained, lower capital gains taxes (which come at the end of the investment process) are a singularly ineffective means to achieve this.  Measures to encourage venture capital funds that can pool the risk of many (hopefully imperfectly correlated) investment projects are one.  So are measures to strengthen the rights of external financiers vis-a-vis the owner-entrepreneurs. 

Encouraging small business
After the incredible lobbying power of the agricultural sector in advanced industrial countries, the cult of the small business is, to me, the second most incomprehensible feature of the industrial political-economic landscape.   Small businesses are ‘the seed-corn of economic growth’, ‘the backbone of the economy’, ‘the engine of growth’, the ‘well-spring of innovation and dynamism’, the ‘life-blood of the nation’.  Perhaps.  To me, the key feature of small businesses is that they are small.  And small is small.  Other things being equal, I would rather have a lot of medium-sized businesses, and much rather a lot of large businesses than a lot of small businesses.

Most small businesses stay small.  A lot die quite soon following their birth.  A few grow and become medium-sized businesses.  Very few grow and become large businesses.  Then, every 30 years or so, there is a Microsoft or Google. 

Are small businesses discouraged from growing and becoming medium-sized or large by capital gains taxes?  Most small businesses probably want to stay small.  I have a very small business, with two shareholders, two directors and two employees - my wife and myself.  I definitely neither expect nor want the business to grow significantly.  It does what I intended it to do.  I don’t expect to retire on the capital gains I will make from selling the business.  Most small businesses I am familiar with fall into that category.

There is a chronic tendency to romanticise and dramatise the role of the small business and the solitary entrepreneur.  Let’s face it, business is mostly boring; very little of it is glamorous, creatively challenging or intellectually exciting.  It’s mostly hard work - grinding and grafting.  Rather like farming or paid employment, in fact.  There is a small chance that an entrepreneur will be quite a bit worse than the wage slave, and an even smaller change that (s)he will make a staggering fortune and end up creating a lot of jobs for other people.  There is no clear evidence that, in the field of small business, the private risks are significantly greater than the social risks or the private returns much lower than the social returns.

Again, if there is a problem facing small businesses, it relates not to the taxation of capital gains, but to the cost and availability of external finance.  Much of this is due to the fact that new businesses have no track record on which to base a request for a bank loan or an injection of equity from a venture capital fund.  That problem should be tackled right at the point where the distortion arises. Subsidising small loans to small businesses that have never received a loan before, might help.  So would the possibility of postponing for a number of years the payment of business-related taxes by start-ups, while ensuring that in present discounted value terms, all taxes get paid in due course. But the selection criterion would be not size, but being new.

Granting small businesses special privileges (such as the rumoured proposal for a £100.000 tax-free allowance for capital gains from the sale of a business on retirement) is putrid pandering to the lobbyists from the UK small business community.  It is a waste of public money and unfair to those retirees who have only non-business assets to sell.  To belabour the obvious: assets are assets; the identity of the owner, whether they are business assets, personal assets, assets held in the investment portfolio of  an insurance company, or state-owned assets is irrelevant.  And small is small.  Not inherently good. Certainly not better than medium-sized or large.  And most definitely not obviously deserving of capital gaints tax breaks. 

I hope the current Chancellor will be able to see off his predecessor in this matter.  If we are ever going to get an income tax structure in the UK that is transparent and understandable, let alone simple, the original reforms proposed by Alistair Darling are a good place to start.    

On 11 October 2007, I gave a presentation for the Bank of England’s Graduate Induction Programme, titled: “MPC Past Present and Future: the good, the bad and the ugly”. A pdf version of the Powerpoint presentation I gave is available here.

Labels: Economics, Financial Markets, Monetary Policy, Politics

Two announcements have been made during the past couple of days about official support for Northern Rock – one relating to the asset side of its balance sheet and one relating to the liability side. As regards its assets, Northern Rock is now being provided with additional facilities enabling it to borrow through the Bank of England on a secured basis against all of its assets, rather than just against prime mortgage collateral as was the case up to this announcement. As regards its liabilities, the government’s guarantee of its deposits has now been extended to included new deposits.

The asset-side measure makes good sense and brings the Bank of England’s lender of last resort policy closer to what I have advocated for a while. The liability-side measure is likely to compound the earlier mistake.

By accepting the bulk of Northern Rock’s assets as collateral for borrowing from the Bank of England through the Liquidity Support Facility that was purpose-built for the Northern Rock bail-out, the Bank of England is getting close to turning the Liquidity Support Facility into something approximating the Federal Reserve System’s (primary) discount window. The Bank of England’s own discount window, its Standing lending facility, is a pale and anaemic shadow of the Fed’s discount window, because it only accepts extremely high-grade and already utterly liquid securities as collateral. All the Bank of England does at its Standing lending facility is maturity transformation. It exchanges long maturity (duration) liquid assets for very short maturity (duration) liquid assets. It does therefore not provide liquidity in any meaningful sense.

The Fed can, provided it decides that exceptional circumstances prevail, accept at its discount window as collateral absolutely anything it deems fit. When the (private) Bank of New York (back in the 70s I believe) needed to access the discount window of the New York Fed overnight because of some technical glitch (I think they had to borrow $23 bn), they offered as collateral the entire bank, including the building and the furniture.

If an asset can be valued, it should, properly valued and subject to the appropriate haircut, be acceptable as collateral at the discount window. The central bank should insist on sufficient ‘over-collateralisation’ (in addition to the penalty rate it charges for discount window borrowing) to make sure that the tax payer can expect to benefit from the transaction. If the Bank of England had operated a similar sensible policy at its discount window in August and September 2007, there would have been no need to create the Liquidity Support Facility the Bank dreamt up for Northern Rock. The Fed’s (primary) discount window does everything the Liquidity Support Facility does, and it does so ‘on demand’ and on a scale limited only by the available collateral. It also lends at up to 1 month maturity, unlike the Bank of England’s Standing lending facility, which only lends overnight. Of course, the Fed then went and rather spoilt it, by reducing the spread of its discount rate over its policy rate (the Federal Funds target rate) from 100 basis points to 50 basis points; this is pure pandering to the profits of those institutions that are already able and willing to borrow at the discount window; it would have made more sense to raise the discount rate spread over the policy rate by 50bps (to 150 basis points) to underline the Fed’s commitment to a Bagehotian lender of last resort model: lend freely (against collateral that would be good during normal times, but may have become illiquid during turbulent market conditions) but at a penalty rate. While I am happy about the actions of the Bank vis-à-vis the asset side of Northern Rock’s balance sheet, I am appalled at the Chancellor’s decision to extend the deposit guarantee at Northern Rock to new deposits. This encourages Northern Rock to try to attract new deposits using above-market deposits rates, as long as these are below the penalty rate charged on borrowing from the Liquidity Support Facility. What is especially outrageous about both the old and the new guarantee is that it covers not only retail deposits, but also wholesale deposits and most unsecured lending to Northern Rock.[1]

Why should the unsecured wholesale creditors of Northern Rock get any protection at all? There is no social justice (widows and orphans) argument to support this intervention, nor an efficiency argument – the wholesale creditors to Northern Rock should be expected to be able to pay the cost of verifying its financial viability. No public purpose is served by subsidising, through ex-post insurance, the ‘rate whores’ that are likely to make up the bulk of the wholesale creditors of Northern Rock. Municipalities, charities and professional and institutional investors that were happy to pocket the slightly above-market interest rates offered by Northern Rock should not be able to dump the default risk (whose anticipation/perception was the reason for the higher rates) on the tax payer.

In its statement introducing the deposit guarantee, the Treasury said “Since it would otherwise be unfair to other banks and building societies, the arrangements would not cover any new accounts set up after 19 September, other than re-opened accounts as set out above.” Apparently, it now is no longer unfair or it does not matter that it is unfair. The Treasury statement says that Northern Rock will pay a fair price for the guarantee.[2] We shall see. No doubt a small army of mathematically gifted Treasury civil servants are busy pricing the contingent claim represented by the deposit guarantee for Northern Rock. If the customary lack of openness and transparency of the Treasury prevail, we will never get the information to judge whether Northern Rock paid a fair price for the guarantees extended by the state to its creditors.

Labels: Economics, Financial Markets, Monetary Policy, Politics

I know this is too long. However, the case for the Baltic countries to be admitted forthwith to the Eurozone is overwhelming; and the obtuseness of the ECB and the European Commission - not to mention their disdainful arrogance towards these countries - is so staggering, that I hope some of you may read this to the end.

While for the four countries under consideration the key criteria for EMU membership are the inflation criterion and the exchange rate criterion, I shall briefly summarise all nominal convergence criteria.

1. The Maastricht convergence criteria

The convergence criteria for EMU membership (the so-called Maastricht criteria) are as follows:

The fiscal criteria

The fiscal requirement for EMU membership is that at the time of the examination the Member State is not the subject of a Council decision under Article 104(6) of the Treaty that an excessive deficit exists. An excessive deficit exists if either the deficit criterion or the debt criterion are not satisfied:

(1) the deficit criterion: the ratio of the general government financial deficit to GDP cannot exceed the reference value of 3 percent unless either the ratio has declined substantially and continuously and reached a level that comes close to the reference value; or, alternatively, – the excess over the reference value is only exceptional and temporary and the ratio remains close to the reference value;

(2) the debt criterion: the ratio of the stock of gross general government debt to GDP cannot exceed the reference value of 60 percent of annual GDP unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace.

The interest rate criterion

For a period of one year before the examination, a Member State has had an average nominal long-term interest rate that does not exceed by more than 2 percentage points that of, at most, the three best performing Member States in terms of price stability.

The exchange rate criterion

The Member State must observe the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System (15 percent on either side of a central rate defined with respect to the euro), without severe tensions for at least two years before the examination, without devaluing its currency’s bilateral central rate against the currency of any other Member State on its own initiative.

The inflation criterion

As it was the inflation criterion that has kept Estonia[1] and Lithuania out of the EMU, it is worthwhile to spell it out in detail, and specifically to bring out where the Treaty and the Protocol speak and where the ECB and the Commission are themselves making up criteria, reference values and benchmarks.

The Treaty and Protocol requirements

Article 121 (1), first indent, of the Treaty requires:

“the achievement of a high degree of price stability; this will be apparent from a rate of inflation which is close to that of, at most, the three best performing Member States in terms of price stability”.

Article 1 of the Protocol on the convergence criteria referred to in Article 121 of the Treaty stipulates that:

“the criterion on price stability referred to in the first indent of Article 121 (1) of this Treaty shall mean that a Member State has a price performance that is sustainable and an average rate of inflation, observed over a period of one year before the examination, that does not exceed by more than 1½ percentage points that of, at most, the three best performing Member States in terms of price stability. Inflation shall be measured by means of the consumer price index on a comparable basis, taking into account differences in national definitions.”

The ECB’s and European Commission’s interpretation and operationalisation of the inflation criterion in the Treaty and Protocol

As stated in the Treaty and Protocol, the inflation criterion is non-operational, as it does not explain what is meant by “… the three best performing Members States in terms of price stability”.

It would seem, however, that this ought not to pose a problem, because the ECB, the European institution whose mandate it is to maintain price stability, has, not surprisingly, developed an operational, numerical definition of what is meant by price stability in the euro area. On its website, the ECB states: “The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.”[2] It elaborates on this elsewhere on its website as follows:

“While the Treaty clearly establishes the maintenance of price stability as the primary objective of the ECB, it does not give a precise definition of what is meant by price stability.

Quantitative definition of price stability

The ECB’s Governing Council has defined price stability as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. Price stability is to be maintained over the medium term”.

The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term.”[3]

This would seem to carry the logical implication that the three best performing Member States in terms of price stability would be the three Member States whose inflation rates would be closest to but below 2%. The inflation threshold that a Member State wishing to join EMU should not exceed, would therefore be given by 1½ percent plus the average rate of inflation of the three Member States with inflation rates closest to but below 2 percent

Strangely, however, the operational definition of price stability that the ECB uses for itself (that is, for the existing members of the euro area) is not the operational definition the ECB and the Commission impose on Member States wishing to join the EMU. That rate is defined as follows in the ECB’s 2007 Convergence report (ECB (2007)) (similar statements can be found in all earlier Convergence Reports by the ECB and the Commission, e.g. European Monetary Institute (1996; 1998), European Central Bank (2000; 2002; 2004; 2006a,b), European Commission (1998; 2000; 2002; 2004; 2006a,b,c; 2007a,b)).

“…the notion of “at most, the three best performing Member States in terms of price stability”, which is used for the definition of the reference value, has been applied by taking the unweighted arithmetic average of the rate of inflation of the following three EU countries with the lowest inflation rates: Finland (1.3%), Poland (1.5%) and Sweden (1.6%). As a result, the average rate is 1.5% and, adding 1½ percentage points, the reference value is 3.0%.”

To calculate ‘the notion of “at most, the three best performing Member States in terms of price stability”’, the ECB and the Commission therefore take the average of the three lowest (but non-negative) inflation rates among all EU members – those already full members of the EMU, those who are actively trying to meet the EMU membership criteria, and those who are not actively pursuing EMU membership. Not actively pursuing full EMU membership could be legally the case for the two countries with an opt-out, the UK and Denmark. In practice, any country not wishing to join but not in possession of an opt-out, can always choose not to meet one of the criteria for membership. Sweden does this with respect to the exchange rate criterion.

2. ECB and Commission: better consistently wrong than inconsistent but right?

It is clear that it makes no sense to have one concept of price stability for existing Eurozone members (inflation below but close to two percent over the medium term) and a completely different, and in practice much more restrictive, price stability concept for would-be new members (the average of the three lowest inflation rates among all EU Member States, as long as these inflation rates are not negative). Why set a higher standard for candidate members than for existing members?

A further unfortunate feature of the Maastricht inflation criterion, as interpreted by the Commission and the ECB (the Treaty and protocol are rather vague) is that its benchmark is based on the 3 lowest (non-negative) inflation rates among all EU members, (25 at the time of Lithuania’s and Estonia’s unsuccessful first attempts to join the EMU), and not just on the inflation performance of the Eurozone members (12 in number when Lithuania was formally turned down, currently 13 and soon 15, with Cyprus and Malta joining on January 1, 2008). When Lithuania failed the test, two of the three lowest inflation rates used in the calculation of the inflation benchmark were for countries that are in the EU but not in EMU – Poland and Sweden. The inflation rates of countries in the EU but not in the EMU are no more relevant for whether a candidate country should be admitted to the EMU, than would be the inflation rates of countries in Sub-Saharan Africa.

Once can see how and why, historically, these now inane (indeed insane) criteria were put together. What the authors of the Treaty and Protocol were thinking of was the creation ab initio of EMU through the joining in monetary union of a significant number of countries. They wanted not just a monetary union with a common rate of inflation among member states, but one with a common and low rate of inflation. All EU members were expected to be striving actively for EMU membership, so best-performing was naturally measured with respect to the complete set of EU members.

That was then. We now have a functioning EMU with a low EMU-wide rate of inflation. Common sense now calls for the same definition of price stability to be used for candidate members as for the existing EMU members. Actually, as there is only one monetary policy for the entire EMU, even the inflation rates of the individual EMU Member States is irrelevant for the construction of an inflation benchmark. Both the economics and the politics of a monetary union dictate that the benchmark be based on the inflation performance of just the EMU area as a whole.

When one points out to the ECB and the Commission that their inflation criterion and numerical benchmarks make no sense, all they say in reply is, that this is how it was done in the past. Because the ECB and Commission got it wrong before, they are honour-bound to repeat the mistake again today and tomorrow. To do otherwise would violate equity vis-à-vis those who managed to pass the (wrong) tests in the past. The fact that until Lithuania was rejected for membership and Estonia was strongly discouraged from pressing its application, no application for EMU membership had ever been rejected rather undermines the ‘fairness vis-à-vis earlier applicants argument.

For reasons understood only by themselves, the ECB and Commission therefore continue to make these nonsensical demands, even if the Treaty and Protocol do not require it. The Commission and the ECB don’t mind doing things that are illogical, costly and potentially destructive, as long as there is a precedent for it. They would rather be consistently wrong than inconsistent but right.

3. Dirty politics: why is the inflation criterion the only one for which the ECB’s and Commission’s interpretation is rigidly enforced?

In the case of Lithuania and Estonia, the ECB and the Commission have chosen to stick rigidly to their interpretation and quantitative implementation of the inflation criterion, even though this made no economic sense. Strangely enough, the Commission and the ECB have, in the past, forgiven or waved through many clear violations of numerical criteria stated explicitly in the Treaty and the Protocol, rather than just dreamed up by the Commission or the ECB.

To me this suggests either that the ECB’s and Commission’s decision processes as regards the Maastricht criteria being met are deeply political – indeed a dirty game - or that a monumental mistake was made when Lithuania was blackballed and Estonia was pressured into postponing its application for EMU membership.

Forgiving failures to meet the exchange rate criterion

Italy and Finland did not meet the exchange rate criterion for EMU membership.[4] While they had spent 2 years in the exchange-rate mechanism of the European Monetary System when they joined the EMU, they had not observed the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System without severe tensions for at least two years before the examination - as was the requirement of the Treaty. The Commission judged that, by the time of the examination, the currency, despite not having been in the ERM for two years, had displayed sufficient stability for two years. This is a triumph of good sense over the letter of the law and the exact wording of the Treaty and Protocol. Why could this good sense not be called upon when the inflation criterion was being evaluated for Lithuania and Estonia?

Forgiving failures to meet the fiscal criteria

Both Italy and Belgium had debt-to-GDP ratios well above 100 percent when they were admitted to the EMU. While Belgium has consistently reduced its debt ratio since then, Italy’s debt-to-GDP ratio even today is above 100 percent. Allowing it into the EMU violated both the spirit and the letter of the Treaty and Protocol.

Germany did not meet the debt criterion for EMU membership at the time of the examination and should not have been admitted. In 1998 its debt-to-GDP ratio was 60.9 percent and in 1999 it was 61.2 percent. So it was above 60 percent and rising! Despite some attempts to get serious about its public debt, even in 2006 the German debt to GDP ratio still was 67.9 percent.

The most extreme example of a country not meeting the Maastricht fiscal criteria and yet becoming an EMU member is Greece. Greece did not, by any stretch of the imagination, meet the debt criterion for EMU membership. In addition, the Greek authorities fiddled the data for the calculation of the general government deficit. Until this cheating was discovered, it appeared Greece had met the deficit criterion (general government deficit less than 3 percent of GDP), as is clear from Table 2.3 below (Table 2.3 and Table 2.5, including the Table numbers, are taken from the Convergence Report 2000 of the ECB). The convergence programme for Greece when it was admitted to EMU is included as Table 2.5 below, as a reminder of just how out of touch with reality the ECB and European Commission were when they admitted Greece into the EMU.

When the statistical cheating was discovered and the deficit data were revised upwards, it was clear that both on the deficit and the debt criterion, Greece would have failed to qualify for EMU membership starting January 2001. The debt ratios remain above 100 percent of annual GDP even today.

Rather than suspending Greece’s membership in the EMU after the discovery of the irregularities in its qualification for admission, and requiring it to qualify again (which would have required at least a two-year transition period) Greece was allowed to continue as a full member without any sanctions. The integrity of the vetting process for the Maastricht criteria was further compromised through this. The message is clear: “do anything necessary to formally meet the criteria at the time”. Cheat if necessary. If you are found out after you are allowed in as a member, nothing will happen to you.”

Recently, the Greek government has discovered that there is a second way of lowering a ratio that is uncomfortably high: if reducing the numerator is not practicable, then increasing the denominator may be an option. Eurostat are currently reviewing the merits of the Greek statistical authorities’ request for a significant increase in measured GDP, reflecting, according to the Greek authorities, the informal sector and other unrecorded economic activity.

4. The problem: the inflation criterion for countries with a fixed exchange rate with the euro

Countries that have a fixed exchange rate with the euro face special problems meeting the inflation criterion for EMU membership. The inflation criterion makes no sense from an economic perspective for countries wishing to join an already existing monetary union when that monetary union has a price stability objective, operationally expressed as a target for inflation in the medium term. The first-best solution would be for all countries wishing to join the EMU and meeting the fiscal, interest rate and exchange rate criteria to be allowed to do so. This is the only solution that makes sense. However, politics and logic are not often encountered in the same space.

Candidate EMU members on a fixed exchange rate with the euro have to deal with the problem that their efficient, optimal rate of equilibrium inflation may well be higher than the existing EMU average. That is because of the Balassa-Samuelson effect. When transition countries with a lower level of productivity and per capita income than the existing EMU average succeed in converging gradually but effectively to the higher levels of productivity and per capita income of the EMU, productivity in the traded goods sectors typically catches up faster than productivity in the non-traded good sectors. The result is that transition countries achieving successful real convergence will experience an appreciation of their real exchange rates. With a fixed nominal exchange rate, real appreciation means higher inflation in the candidate EMU members than in the EMU.

What are the solutions?

One solution would be to abandon the fixed exchange rate regime (the currency board), float the currency and allow it to appreciate in nominal terms for at least a year to get inflation down to the benchmark level. Once that has been achieved, the exchange rate gets locked in irrevocably. I hope that not even the ECB and the Commission recommend such an extraordinary policy sequence. You have the closest thing to a common currency (a currency board); you have to abandon this currency board to float the exchange rate for a year or longer to meet the inflation criterion; if you succeed you get rewarded by going back to where you started from. This would be insane.

Another solution is to create a reduction in the output gap of sufficient depth and duration to bring down the inflation rate to the level of the inflation benchmark. Fiscal policy or credit controls could be used to reduce the domestic output gap and lower inflation. Unless the economy is overheating (that is, unless in addition to the Balassa-Samuelson inflation premium there is also a cyclical inflation premium), contracting demand would mean deliberately creating a recession: a pointless sacrifice of output and employment. It should be rejected.

5. A partial solution: make the euro joint legal tender with the national currency

One way for an EU member wishing to become a full EMU member to give visible expression to its desire for and commitment to eventual full EMU participation, is for it declare the euro to be joint legal tender for all transactions under the country’s jurisdiction, on the same terms as the national currency. This would also allow the country to achieve effectively all of the benefits of full monetary union, with the exception of (1) a share in the ECB’s seigniorage (profits), (2) access to the ECB/ESCB as lender of last resort, and (3) a seat on the ECB Governing Council (further development and discussion of this proposal can be found in Bratkowski and Rostowski (2002), Schoors (2002), Buiter and Grafe (2002), Buiter (2005) and Buiter and Sibert (2006a,b)).

Legal tender, also called forced tender, is payment that, by law, cannot be refused in settlement of a debt denominated in the same currency. Currently, in Estonia, only the Estonian kroon is legal tender. This is clear from the Currency Law of the Republic of Estonia, some key clauses of which are reproduced below in Box 1.[5] An important part of legal tender status is that taxes and fines payable to the state can be paid in legal tender, and that indeed the state can require this.

Box 1

Extracts from the Currency Law of the Republic of Estonia

Clause 3. Legal tender

The sole legal tender in the Republic of Estonia is Estonian kroon. The legal persons and single individuals located in the Republic of Estonia have no right to use any other legal tender except Estonian kroon in the accountancy between them.

Clause 4. Obligation to accept the legal tender of the Republic of Estonia without restrictions

Eesti Pank, as well as all other banks and credit institutions of the Republic of Estonia are obliged to accept the legal tender of the Republic of Estonia without restrictions. Other legal persons are obliged to accept valid coins up to the amount of 20 Estonian kroons at a time, but banknotes without any restrictions.

Clause 5. Exchangeability of Estonian kroon with other currencies

The exchangeability of Estonian kroon with other currencies will be determined by law. The conditions and procedure of exchanging Eesti kroon into foreign currencies will be determined by Eesti Pank.

Clause 7¹ Refusal to accept legal tender

(1) Refusal to accept legal tender upon sale of or payment for goods or services is punishable by a fine of up to 200 fine units.

(2) The same act, if committed by a legal person, is punishable by a fine of up to 30,000 kroons.

Legally, all that is required to make the Estonian Kroon and the euro joint legal tender in Estonia, is the rewriting the Currency Law of the Republic of Estonia along the lines suggested in Box 2.

Box 2

Proposal for a revised

CURRENCY LAW OF THE REPUBLIC OF ESTONIA

Clause 1. Monetary unit

The monetary units of the Republic of Estonia are the Estonian kroon, which is divided into one hundred cents, and the euro, which is divided into one hundred cents. The cash of the Republic of Estonia is in circulation in the form of banknotes and coins.

Clause 2. Issuing Estonian kroon

The sole right to issue and to remove from circulation the Estonian kroon belongs to Eesti Pank. Eesti Pank determines the denominations of the banknotes and coins as well as their design.

Clause 3. Legal tender

The sole legal tender in the Republic of Estonia are the Estonian kroon and the euro. The legal persons and single individuals located in the Republic of Estonia have no right to use any other legal tender except the Estonian kroon or the euro in the accountancy between them.

Clause 4. Obligation to accept the legal tender of the Republic of Estonia without restrictions

Eesti Pank, as well as all other banks and credit institutions of the Republic of Estonia are obliged to accept the legal tender of the Republic of Estonia without restrictions. Other legal persons are obliged to accept valid coins up to the amount of 20 Estonian kroons at a time or up to the amount of 1.28 euros at a time, but banknotes without any restrictions.

Clause 5. Exchangeability of Estonian kroon with other currencies

The exchangeability of Estonian kroon with other currencies will be determined by law. The conditions and procedure of exchanging Eesti kroon into foreign currencies will be determined by Eesti Pank.

Clause 6. Damaged and spoilt currency

Damaged and spoilt banknotes and coins of the Republic of Estonia will be received and replaced by Eesti Pank and banks authorized by it, in condition that at least half of the banknote is preserved and the serial number is fully legible; on a coin, at least the denomination and time of minting must be legible.

Other legal persons are not obliged to accept damaged and spoilt banknotes and coins.

Clause 7 Refusal to accept legal tender

(1) Refusal to accept legal tender upon sale of or payment for goods or services is punishable by a fine of up to 200 fine units.

(2) The same act, if committed by a legal person, is punishable by a fine of up to 30,000 kroons or 1,917.35 euros.

(3) The provisions of the General Part of the Penal Code (RT I 2001, 61, 364) and of the Code of Misdemeanour Procedure (RT I 2002, 50, 313) apply to the misdemeanours provided for in this section.

(4) Extra-judicial proceedings concerning the misdemeanours provided for in this section shall be conducted by: 1) the Consumer Protection Board; 2) police prefecture.

In principle, a variety of monetary and exchange rate regimes are consistent with having the euro as a parallel currency and joint legal tender. This includes managed and freely floating exchange rate regimes. A fixed exchange rate regime with the euro, and especially a currency board is, however, the natural vehicle for the euro as joint legal tender. It is also a natural waiting room for the eventual full EMU membership.19

Some further refinements

The exchange rate of the Estonian kroon and the euro is 15.64664 Estonian krooni for one euro. That is not a very convenient number. It would make sense to have a currency reform that creates a new Estonian kroon (perhaps called the Estonian eurokroon, or eurokroon for short, whose value is 15.64664 old Estonian krooni. One new Estonian eurokroon would therefore equal one euro - nice and simple.

It would also make sense to make the coins and currency notes of the new Estonian eurokroon sufficiently similar in shape, weight and appearance (without, however, risking accusations of counterfeiting!) that all new vending machines and other electro-mechanical, digital and optical instruments that handle coins and notes can use both euros and eurokrooni interchangeably.

Formally, the exchange rate regime would remain a currency board. In the strict version of a currency board, the entire domestic base money stock (coin and currency and banks’ balances with the central bank) must be backed by international reserves (euros in practice). It would therefore make sense, since there is no opportunity cost involved in replacing domestic coin and currency with euros, to gradually reduce the issuance of krooni coin and currency. Effective complete euroisation of cash could take place without the formal abolition of the domestic currency. The eurokroon would continue to exist, as a numeraire, means of payment/medium of exchange, store of value and legal tender alongside the euro, but you just would not see very many of them.

By encouraging de facto euroisation, that is, the increased use of the euro as the unit of account in contracts (including financial contracts and instruments) and for pricing, as the medium of exchange/means of payment and as store of value, the risk associated with the status of being almost-but-not-quite in the EMU would be much reduced. Exchange rate risk (as regards the exchange rate of the domestic currency vis-à-vis the euro) would cease to be a concern as fewer and fewer contracts and financial instruments are denominated in domestic currency. To avoid giving ammunition to the forces of darkness in Brussels and Frankfurt, however, it is essential that establishing the euro as joint legal tender is not formally and legally the unilateral adoption of the euro as the only legal tender, and the abolition of the domestic currency.

6. The euro as joint legal tender is not unilateral euroisation and is consistent with the provisions and requirements of the Treaty and Protocol for full EMU membership

According to the letter of the Treaty, unilateral euroisation, is not compatible with the Maastricht criteria if it involves the unilateral abolition of the national currency. The argument is that, once the national currency has been abolished, there no longer is any way for the Council of Ministers to determine the irrevocably fixed conversion rate at which the candidate EMU member’s currency eventually joins EMU. The candidate EMU member would have been able to determine its irrevocably fixed euro conversion rate unilaterally. That would be a bridge too far. The ECB and the Commission will have to cross that bridge if and when Montenegro, which has the euro as its sole legal tender today, prior to EU membership, joins the EU and the EMU, but it is too early to speculate about how that conundrum will be resolved.

In addition to Montenegro, the euro plays a key role in the domestic monetary arrangements of a number of small European countries, none of which are formally members of the EU. The euro is legal tender in Monaco, San Marino and Vatican City, which are licensed to issue and use the euro. Like Montenegro, Andorra has the euro as legal tender but is not licensed to issue any euro coins or notes. The same holds for the sub-national entity Kosovo.

There are also some obvious parallels with the pre-Euro Belgium-Luxembourg Economic Union (1922-2002); from 1944, the Belgian franck was joint legal tender in Luxembourg with the Luxembourg franc, and the Luxembourg franc was joint legal tender in Belgium with the Belgian franc (although you would not have thought so, if you tried to pay with Luxembourg francs in Brussels!)

The ECB’s position on the issue is the following “Any unilateral adoption of the single currency by means of “euroisation” outside the Treaty framework would run counter to the economic reasoning underlying Economic and Monetary Union, which foresees the eventual adoption of the euro as the end-point of a structured convergence process within a multilateral framework. Unilateral “euroisation” cannot therefore be a way of circumventing the stages foreseen by the Treaty for the adoption of the euro” (European Central Bank (2003)).

This argument is correct only if unilateral euroisation means the unilateral abolition of the domestic currency and its replacement by the euro. Having the euro as a parallel currency and joint legal tender without abolishing the domestic currency, and leaving the Council of Ministers the opportunity to determined the eventual irrevocably fixed conversion rate between the domestic currency and the euro, is quite consistent with the Treaty and Protocol.[6] There is no circumventing of the stages foreseen by the Treaty for the adoption of the euro. The structured convergence process is not encumbered or undermined in any way.

7. What the euro as joint legal tender does not achieve

Adopting the euro as joint legal tender does not achieve three things:

1. A seat on the Governing Council of the ECB;
2. A share of the seigniorage (profits) of the ECB;
3. Access to ECB/ESCB resources by domestic banks for lender of last resort operations.

These continuing lacunae are, of course, the same ones experienced by the would-be euro area members under their current currency board arrangements. They are ‘deficiencies’ only when compared to a situation of full membership in the EMU. Since there is no reason why adopting the euro as joint legal tender would delay full membership in the EMU, the opportunity cost of doing so is really zero.

8. Safety in numbers

The ECB and the European Commission are unlikely to welcome with open arms the adoption of the euro as joint legal tender. It is my view that there is not much they can do about it. Still, there is safety in numbers. If, say, all four currency board countries in the EU, Estonia, Latvia, Lithuania and Bulgaria, were to take the identical action simultaneously, the odds on even token attempts to interfere with this decision by Brussels or Frankfurt would be negligible.

I also believe that while the official response may be frosty, at best, there is a lot of sympathy for the Baltic countries and a lot of covert support for their ambition to adopt the euro as soon as possible. It is quite likely that the failure of Lithuania and Estonia to become full members in 2007 was just the result of a big error of judgement in Brussels.

I share the view of many observers that those in charge of the EMU convergence assessment in Brussels believed that Lithuania and Estonia would be willing to cheat to achieve membership. The candidate EMU members could have done this by fiddling with VAT or other indirect taxes and by messing with utility tariffs – that’s what Slovenia did, after all, and Slovenia was rewarded for it with EMU membership. They could even have followed the Greek example and simply have doctored the price data. Finally, the great and the good in Brussels and the national capitals probably did not believe it possible that the ECB would produce quite the eruption of self-righteousness and stupidity that it did by denying Lithuania EMU membership when its inflation rate exceeded the benchmark rate by barely one tenth of one percent. There may be a lot of sympathy in Brussels and in many of the EU capitals , and even some surreptitious support for the adoption of the euro as joint legal tender by the currency board countries of Central Europe and the Baltics.

The very creation of EMU was a triumph of political will over technocratic timidity. Distinguished economists (quite a few of them, like Martin Feldstein, from the USA) said it could never happen, and if it happened it would collapse in short order. Perhaps history will repeat itself. Ultimately it is the politicians in the Council of Ministers rather than the technocrats in Frankfurt and Brussels who determine whether a country will be allowed to join the EMU (the ECB and the Commission have only an advisory function). It is therefore possible that a country that starts of by adopting the euro as joint legal tender, may end up with full euroization, not through unilateral euroisation but through consensual euroisation with the blessing of the Council of Ministers. But it is time to press on with joint legal tender regardless.

Conclusion

The frightening financial turmoil of the past few months has provide a stark reminder of the truth that small open economies with unrestricted financial capital mobility have only one sensible monetary option: to join the nearest big currency area/monetary union. This is true not just in Europe. New Zealand is a model of monetary and fiscal rectitude and of deep structural reform. Yet it is a rudderless plaything of the international capital markets. It cannot control its exchange rate. It has to do incredible things to its monetary policy interest rate to keep any kind of control over domestic inflation. It is not surprising that monetary union with Australia is being talked about in responsible policy circles as an option.

For Estonia and the other currency board countries, the earliest possible full membership of EMU is the dominant policy option. To minimize the risk of monetary and financial instability in the period until full membership is achieved, adoption of the euro as joint legal tender is a sensible transitional option. It will not delay the EMU membership process, but it will make the transition less hazardous.

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Schoors, Koen (2002), “Should the Central and Eastern European Accession Countries Adopt the Euro before or after Accession?” Economics of Planning, Springer, vol. 35(1), pages 47-77.

Labels: Economics, European Union, Financial Markets, Monetary Policy, Politics

Joint blog by Willem H. Buiter and Anne C. Sibert

Charts Source: Bank of England

Source: European Central Bank

Source: Federal Reserve Board

Labels: Economics, Financial Markets, Monetary Policy, Politics