A monetary history of the euro area

Christopher Marsh, 5 Feb 2018

Chris Marsh begins his talk by looking at the US Great Depression in order to draw parallels to the economic crisis in Europe. The Depression began with a massive movement of capital from independent, country banks, to large, central, city banks. This mass movement was sparked by the inability of banks to provide cash to all those who wished to withdraw. The panic of insufficient currency created an unfavorable balance of payments as loss of money supply in country areas encouraged debt holders to liquidate debt held and to cease to invest in these areas. It is not hard to see that this behavior is self-reinforcing; this is just the sort of economic behavior that monetary policy was created to prevent.

The EU saw a similar decrease in currency levels during 2010. Marsh focusses on Latvia and Greece to tell the story of the crisis. Prior to the crisis Latvian banks had borrowed heavily from abroad and lent domestically, so when the crisis hit it saw a great contraction in its currency supply. Domestic demand and real GDP fell sharply in 2009, prompting the IMF to step in. The IMF decreased reserve requirements in order to allow Latvia to begin to pay off debt.
This lowering of capital requirements meant that there were suddenly excess reserves of Latvian currency. The overflow in currency reserves then triggered implementation of a clause in the IMF’s program which meant it would have to reevaluate its handling of Latvia. This created uncertainty for the future of Latvian currency, prompting the Nordic banks to bet against it. Nordic expectations became reality, and the bets against the currency led to its severe devaluation. In retrospect, had Nordic banks been forced to keep credit lines open, the result would have been more favorable. This hindsight observation begs the question of what the IMF’s place is in today’s financial market: should it follow market trends or attempt to create them?

It is well known that Greece entered the economic crisis with large amounts of government debt. The vast majority of this debt was owned by non-residents, meaning that the Greek government was particularly powerless to determine how this debt was handled. It was clear to the IMF and the EU that in order to pay off this debt Greece could not simply adjust its domestic policy, but would need to generate flows of foreign exchange. This is a catch-22 as the more it became necessary for Greece to increase production, the less available capital there was to do so.

Furthermore, the European economy’s exposure to the Greek debt meant a decrease in demand from the very economies to which Greece ought to be exporting. Along with other factors, this exposure led many experts to believe that Greece had no chance of paying off its debt even if it followed the plan imposed by the IMF. Though there may be no clear solution to these problems, it is at the very least evident that the current view of the machinations of the European economy and the policies which this view produces are insufficient to manage the interdependent nature of the modern global economy.

by Solomon La Piana