MacroScope

The reality of  ‘political economy’  is something that irritates many economists – the ”purists”, if you like. The political element is impossible to model;  it often flies in the face of  textbook economics;  and democratic decision-making and backroom horse trading can be notoriously difficult to predict and painfully slow.  And political economy is all pervasive in 2010 – Barack Obama’s proposals to rein in the banks is rooted in public outrage; reading China’s monetary and currency policies is like Kremlinology; capital curbs being introduced in Brazil and elsewhere aim to prevent market overshoot; and British budgetary policies are becoming the political football ahead of this spring’s UK election. The list is long, the outcomes uncertain, the market risk high.

But nowhere is this more apparent than in well-worn arguments over the validity and future of Europe’s single currency — the new milennium’s posterchild for political economy.

For many, the euro simply should never have happened –  it thumbed a nose at the belief that all things good come from free financial markets; it removed monetary safety valves for member countries out of sync with their bigger neighbours and put the cart before the horse with monetary union ahead of fiscal policy integration. But the sheer political determination to finish the European’s single market project, stop beggar-thy-neighbour currency devaluations and face down erratic currency trading meant the  currency was born and has thrived for 11 years.

Now the budgetary and bond market upheaval currently afflicting euro member Greece and stalking  Portugal, Ireland, Spain and Italy has reawakened the whole debate. “Will the euro survive?” seems a legitimate question once again.

Apart from financial analysts, Paul Krugman seems to have made his peace with the euro’s existence but he still reckons it was a bad idea. Eric Maskin thinks financial markets are right to question the future of the single currency. And much is being made once again of Milton Friedman – high priest of 20th century monetarism – having reportedly said in 1998 that the euro would not survive the zone’s first serious economic downturn.

As rare as it is to get any two economists to agree, the chances are even slimmer of hearing three Nobel economics laureates concur.

And so it was that each of the award winning economists — Eric Maskin (2007), Michael Spence (2001) and Robert Merton(1997) — all had their own take on the legacy of three years of financial and economic crises when they spoke to a conference organised by Pioneer Investments  in London last week.

 To be fair, they broadly coagulated around the inevitability of greater regulation of banking and finance and also on the enormity of China’s now imposing position in world economic affairs.

Juergen Stark , Germany’s ECB executive board member, is well known as a true believer in tight fiscal discipline, so his reported comments in Italy’s Il Sole 24 Ore about not bailing Greece out of its financial difficulties are not out of character. But the market reaction must have at least given pause for thought to EU leaders wondering how far to go in coddling their wayward child.

Within moments of Stark’s reported musings that markets were “deluding themselves” if they thought member states would “put their hands in their wallets to save Greece”, hitting the foreign exchange rooms, the euro was on a tumble.  It hit a low of $1.4285 from a day’s high of $1.4371 – which doesn’t sound like a lot, but is, especially over a very short period of time.

It is true that it recovered very quickly and that other EU notables have hinted that EU member states will indeed bail out Greece if needed (they are unwilling to say so explicitly for fear of taking too much pressure of the Greek government and the Greek public). And it is not really up to the ECB anyway.

Wolfgang Munchau, co-founder and president of Eurointelligence, has raised an uncomfortable prospect for investors in Greece. In a Financial Times column today, the long-time Europe commentator argues that Brussels may not be willing to bail Greece out if it were to default on its debt à la all-but sovereign Dubai World is about to.

The EU’s authorities, rightly or wrongly, are more afraid of the moral hazard of a bail-out than the possible spillover effect of a hypothetical Greek default to other eurozone countries. If faced with a choice between preserving the integrity of the stability pact and the integrity of Greece, they are currently minded to choose the former.

Munchau reckons that outright default is unlikely, but wonders whether the current spread between Greek and benchmark German bonds really reflects the risk that investors are taking.  It is currently around 178 basis points after recovering from a blow out on Dubai worries last week.

The European Central Bank’s President, Jean-Claude Trichet, has torpedoed a request for a new 30 euro banknote, backing up the rejection with ice-cold historical and mathematical reasoning.

European Parliament member and former Irish deputy finance minister Jim Higgins had asked Sharon Bowles, chairwoman of the parliament’s Committee on Economic and Monetary Affairs, whether a 30 euro note could be introduced.

She passed the question on to Trichet, but instead of dismissing the question out of hand, the ECB boss answered the question with a typically analytical approach.

The Venice backdrop may have warranted some high Italian Opera but financial markets appeared to be humming to the sound of Irish crooner Ronan Keating during the European Central Bank’s latest monthly news conference.

Keating sang the chart-topping hit with the line “You say it best when you say nothing at all” in 1999, the year the ECB was established.

 FX and bond markets appeared to concur as ECB President Jean-Claude Trichet and his Italian colleague Mario Draghi gave their latest assessment on the state of the euro zone economy on Thursday, after the central bank kept interest rates at their current all-time low of 1 percent.

The strains on various outlying European economies have triggered talk about a break up of the euro zone (usually swiftly followed by denials that any such thing could happen). Now comes an interesting report from the London-based Centre for European Reform, looking at what would happen practically if a country were to leave the currency union. For an insight, the think tank turned to Jan Mathes, a former Slovak National Bank board member who was around when Czechoslovakia split.

As most euro zone countries don’t have a stock of national currencies in reserve, a leaver would have to create one, he says. But this takes ages. Coins alone require months and bank notes these days have to be high-tech to be secure. A leaving country could still use euros for a while but with a national stamp on (as happened with the old Czechoslovak crown). But it would be easy to remove a stamp and the underlying currency would be a euro — too tempting.

The biggest problem, or course, would be in keeping a new currency above water, which would be difficult because it was leaving the euro zone because of bad fundamentals in the first place. So IMF-style reforms would be needed. “But the same reforms, if introduced early, would also reduce the chances of a country dropping out of the euro in the first place,” Tomas Valasek, author of the CER note, writes.

All the G7 countries outside the euro zone now have interest rates of 1 percent or less, prompting some grumbling in various financial quarters that the European Central Bank is being particularly stubborn in keeping its rates at 2 percent.

Now comes an interesting take on this from JPMorgan Asset Management which suggests the gap may have more to do with egg on the face than monetary policy. 

“There is a school of thought,” it writes in a new note “that the ECB has been in a state of denial ever since it decided to raise rates last July.  An organisational behaviourist would observe a desire to preserve ‘face’ in the deliberate way by which the central bank has reversed its previous tightening stance.”

The periphery economies of the euro zone are suddenly in the spotlight.  Credit rating agency Standard & Poor’s has cut its outlook on Ireland’s sovereign debt to negative. It worries that fiscal measures to recapitalise banks and boost the economy might not improve competitiveness, diversity and growth — all making it harder to manage debt.

Next came Greece. S&P basically put the country on watch with a negative bias. The global financial crisis has increased the risk of a difficult and long-lasting struggle to keep the Greek economy on track, it said.

All this is a long, long way from the unravelling of the euro zone — it just got a new member, Slovakia, after all. But the subject has been raised. Gary Dugan, chief investment officer of Merrill Lynch’s wealth management arm, told a group of reporters in London recently that he expected political calls to quit the currency to be heard in some member countries as the global recession bites. He added that it wouldn’t happen, but that the talk could weaken the euro.

Merrill Lynch's monthly poll of fund managers around the world has a bit of a surprise in the small print. More investors now reckon the Japanese yen is overvalued than see it as undervalued. This is the first time this has been the case since Merrill began asking the question, said by staff to be about eight years ago.

It clearly reflects a 13 percent dive in dollar/yen this year and a 24 percent plunge in euro/yen. But does the new view of value suggest that the unwinding of the carry trade is over? Another question from the Merrill poll shows hedge fund deleveraging levelling off.