Euro in 2011

What to expect for te euro zone next year?

In Wolfgang Münchau article ( you can get an excellent perspective of the possible eventuality for the European Money.

Summing up, what we have is that the survival of the euro will mean a lot of misery.  Why? because the best condition of financing sovereign debt will be  quite impoverishing. That is because interest rate would be higher than NGDP growth which will crowd out resources to create jobs. If interest rate of the debt is higher than NGDP growth, th ratio Debt/NGDP is susceptible of exploding.

So how many time we must expect a trend of misery, high unnemployment, and low life level to save the euro?

I´d like to point out some Münchau´s paragraph:

1) The eurozone survived 2010. My prediction is that it will survive in 2011. The question is, in what condition?

2) Most of the countries in the periphery suffer from a competitiveness problem – which is what makes this crisis so toxic. If you reform your labour markets and deflate your wages to become more competitive, inflation falls, and so may house prices. The real value of your debt explodes and you might end up insolvent. Combined debt and competitiveness problems are very hard to resolve without devaluation or inflation. It is not a matter of discipline. Infinite discipline could still make you insolvent.

3) The European financial stability facility (EFSF) is lending money to Ireland at an interest rate of about 6 per cent, which is higher than the country’s nominal growth rate is likely to be for many years. While the loan solves Ireland’s funding problems, it actually exacerbates the country’s underlying solvency problem. The Irish situation reminds me of one of these loan shark advertisements: “Need money fast? No questions asked.”

4) Spain should be solvent, but of course there always exists an interest rate/growth rate combination at which the solvency assumption breaks down. With 10-year yields no higher than 5.5 per cent, the approximate current level, I would expect Spain to go through a severe and long recession, possibly with further asset price falls. Productivity will probably remain low and unemployment high for the foreseeable future. But the country should remain solvent – miserable but solvent. If interest rates were to rise to over 6 or 7 per cent, perceptions of Spanish solvency may change.

5) All existing bondholders will be protected until 2013. All government bonds issued from 2013 onwards will have collective action clauses. This means that if a government cannot service the debt, it can agree a haircut with a majority of investors – with legal force for all investors, including those who disagree with the majority vote. Looking at it from a risk-management perspective, this means that the entire default risk of the eurozone periphery will be concentrated on post-2013 bond issues. No one in their right mind would buy such junk bonds.

6) The way the new crisis mechanism is constructed ensures that the market for European periphery bonds is going to remain thin. What is now being conceived as a new crisis mechanism may end up as the eurozone’s principal funding agency if no one else will provide the funds. It would issue its own bonds – eurozone bonds – underwritten by the few remaining triple A-rated sovereigns, most importantly Germany and France. It is hard to see how such a construction could be sustainable. Should there ever be a default, Berlin and Paris would have to pay up – or default themselves.

This year, Europe’s political leaders pledged to do “whatever it takes” to save the euro. They never answered the question of what that meant. My central prediction for 2011 and beyond is that we will find out.


Commodity prices

Is the monetary expansion of the FED rising the prices of commodities?

As Krugman says, and the graph shows, it is the huge growth in emerging economy which determines the prices of commodities. So, it is not the US´ internal demand the cause of the increase in commodities prices.

On the other hand, it is convenient to remember that, in the long run, commodity prices tend to decline in relation to industrial prices, as you can see in the graph courtesy of

More on velocity (II)

Velocity of circulation of money, as we have seen, is the residual of the identity MV = NGDP.


NGDP is a variable known late  and with quite uncertainty. M is not easy to define, we have several definition of it.

So, for the central bank it is not very practical to fix its objectives in this variable term.

The Velocity can be stable in normal times, but  fluctuate very much in a crisis. Fortunately, We count with some indirect variable to know if velocity (reversal of demand for) of  money –  has been affected by a shock. The most practical indicator is the short-term  interest rate in the interbank market and its spread in relation with the official rate. This one is the interest rate at which the FED promise to lend funds to one day to all banks that need it. Normally, the spreads with other interest rate are stable and quite low. In a crisis, this spreads tend to rise and are an efficient indicator of stress in the interbank market because the uncertainty rise.  This movement  is equal to a fall in velocity. For example, in 2008, before and after the fall of Lehman Brothers, this spreads reach historical level.

Attached, a  detail graph of this spread. We can see  the very high level of the spread since the beginning of the crisis and its record around late 2008:

So, we can say that the Velocity of money fall dramatically with the crisis, and the centre of the collapse was in the banking system. bur we cannot see directly the velocity, if is not through other variable connected with it. In the 1929´s crisis, they was the run to deposit the most direct signal of increasing demand for holding, and the fall in velocity. Today, deposits are 100% guaranteed, so there is no run.

More on velocity (I)

There is some confusion around the noisy debate about Bernanke QE and its justification. I remember the problem was the same many years ago. The reason, the ambiguity of the concept of velocity of circulation of Money.

Velocity is defined as the GDP (nominal) /quantity of money. It is the reverse of Demand for money. When people, for some reason desire to hold more cash, some monetary aggregate is retired from the circulation: The velocity lows. But demand for money and its reversal velocity are unobservable.  We can observe  a some quantity of money (M1, M2, Monetary base…) and the NGDP, and some we can obtain a proxy of velocity: NGDP/M2, for example.

But that  doesn´t  say any thing practical, because is a circular argument. V can be lowering because good (a more efficiency in the bank system) or bad (a contraction of NGDP) reason. In spite of this, about all  economist  are debating now on this subject.

Friedman used to affirm that the change in velocity are rare in normal times, so Monetary Policy should be to maintain M2 growing at a constant rate, 5% for example. But when V falls suddenly, FED should act to compensate this by augmenting monetary base, injecting more money in the system to compensate the supposed increase in money demand.

All that is more or less reasonable, but the problem is that V is a sort o redundant variable. V can fall because NGDP is growing or M2 is contracting. Or both.

In the figure, we can see the variations of M2 been cuasi reflected by theses of V.  So, the main determinant of V is M2. decrease in V is saying M2 is increasing.  ¿Is not that a sign o inflationary risk?

I think so. So, the Movement to down in V are meaning a risk for NGDP if (¿only if?) M2 is falling. That is, NGDP is falling faster than M2.

Velocity and Bernanke

The pain task of the FED, in Milton Friedman´s opinion (, is to watch the velocity of money to counter balance its ups and downs to maintain stable the nominal GDP.

In the figure, we can see the velocity of M2 (GDP/M2) and monetary base, the only variable controllable by the FED. In opinion of Friedman, Greenspan had got a good performance, since the inflation was subdued and the MB balanced quite well the autonomous velocity ups & downs.

Now, some have serious doubt about if Bernanke´s QE (1&2) have been sufficient to reestablish the GDP trend – in spite of the huge ballooned MB…

True, the velocity is now at its lower historical level. The MB increase has not been translated totally to M2 because of the bank deposits in the FED. In any case, GDP Is now growing, and the inflation is low but positive. In fact, velocity is beginning to surge last months…

Is Bernanke acting too much prudently? Well, it is clear that he is been prudent, buy until now the critics of both side (Tea Party & democrats), seem to me precipitous. As Adam P point out:

“The only puzzle is why nobody can just accept that the data say the Fed has simply been doing a truly incredibly good job?  And if you can accept that then clearly you should not expect QE to be inflationary at all, you should believe that the fed know what it’s doing and is just responding to an increase in money demand.”


I remember that by october 2008, I was quite disappointed with Bernanke´s passivity. He is not Greenspan -I used to say. It is possible that the FED was wrong with so much cautious, but I remember that then, Greenspan was unanimously accused as the cause for the crisis. So, I can imagine the reason for Bernanke being quite prudent in his words. Simply, he could not announce that he would follow an inflationist policy at cero interest rate and Ilimited quantitative easing.

It is not easy. In 1933, only FDR was able to cut the Gordian knot of deciding a very risk politics, never used: reflating economy, restablishing price level of some years before. I think that Bernanke has been quite prudent because his margin is not so ample. In any case, I agree with Advent in that too many people were thinking in the priority of saving the banks, anda that a FEd with an unique objective on the NGDP, had not got a good result.

(comment to

should we learn anything from Iceland?

Iceland suffered a financial crisis unprecedented -taking account of the small size of the country. During 2004-2007, capital input was such that their external debt reached 600% of its GDP. For that reason alone it’s worth looking at his moren rapid recovery than other similar countries. The bursting of the rush in 2007 was inflated public debt, 30% of GDP to 125%. In 2009, GDP fell by 7%. And now comes the important
Despite these figures, says the IMF in this report, the recession was less severe than in other countries. The key, I quote, has been the recovery of exports, for which key has been to devalue the Icelandic krona (as always happens in the IMF bailout program) from 80 c / € to 160 c / €. That is, a devaluation of 100%. A devaluation helps to recover lost competitiveness, but if no action is taken, it could lead to inflation. In fact inflation happens , says the report, but was quickly contained. But not quite, because the NGDP has grown since 2007, a 23% (maybe not so bad a little inflation).
Naturally, you can think what you want, but it is hard to deny that this was a key pair to reduce the external deficit to the point of going to steer net debt to more tolerable levels.
There are other measures, of course. Measures that are painful, if it comes to deleveraging  so enormous volume of debt .
Some say that Iceland is fortunate to be as small as it is so easy to rescue for others. Yes?see Ireland, what good has come out.
Iceland has been given the opportunity to grow. Compared with countries of similar smallness in the zone, which have not devalued, Krugman offers this comparison charts: Both real GDP and
employment have performed much better in Iceland than in Estonia and Latvia.Now we want to put an example to Latvia, to hold Ireland what to expect, it’s a long road to poverty.
As Krugman says:
Now it’s true the Baltic Countries That Have Been
Able to Maintain Their fixed exchange rates. And this is crucial Because ….?
If someone can answer why it is crucial to hold the nominal value of one currency, say so.
Hint: There is a theory that a country too small has  no possibility of monetary autonomy: no point having a floating exchange rate because there is no defense face a monetary external shocks. Well, um, well, well, no. Whose is this absurd theory that I do not remember now …
Facts, facts, facts, facts.
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