Thursday, March 28, 2013

Scylla and Charybdis: Arguing for the second best.


I honestly have to admit that I never was, and I hope I will never be, a supporter of the EMU dissolution, or of the exit of any member-state from the Euro. I have previously expressed myself as far as Cyexit is concerned and I am not intending to reconsider my views. When Krugman wrote that the only solution left for Cyprus given the current circumstances is quiting Euro I started thinking about debt dynamics, currency in circulation, destabilization, spillovers, etc. A couple of hours later Krugman described Cyrpus being between Scylla and Charybdis and as a matter of fact Cyprus is indeed between the two monsters of Greek Mythology. The main argument is that by cutting a deal with troika austerity measures- the one and only panacea- will be implemented, Cypriot economy will dip into recession and thus debt will become explosive. Correct! Absolutely correct! I believe that everyone who has at least some non-neoclassical logic left would agree.

Below, I have embedded some charts which you may take a look before we go on (feel free to use the drop-down menu in the second one).

Annual growth rate of Cypriot GDP in constant 2005 prices
0.01=1%


If you checked the central government debt (% of GDP) you surely noticed that in case of Cyprus the figure was 56.4% in 2009 and approximately 77% in 2011 (CYSTAT), which is totally viable and does not need any austerity measures at all. Nonetheless, if we add some 55%, i.e. €10bn to 17.98bn of 2011 GDP (current prices), the existing one we get some 132% debt-to-GDP and this calls for austerity measures out of the blue. Imagine that some day while you are  carelessly walking along the beach and suddenly someone comes over, tells you you need to guarantee the finances of your family, he loads you with more debt equal to 55% of your income and then he comes again to "guide" you through the paths of fiscal soundness... I am beginning to think that the Europeans we have some austerity fetish, that there are some psychic traumas lying deep into our abyss of instincts probably a legacy from previous generations. I really see no other reason why we would force someone to divert from the so called fiscal soundness and then force him into austerity in order to restore the fiscal soundness from which we took him out! Complicated, eh?

I honestly believe that some day- and that day is not long away; hopefully before it is too late- European leaders will overcome this neoclassical (?) austerity psychosis and will then focus on providing some adequate boost.

If you checked the other charts from the drop-down menu as well as the first graph you must have noticed that Cyprus has been doing really well over the past decade, and in certain cases much better that the Euro area in total, the US, Greece and another candidate member; Poland. Debt declined even during the 2007-2008 turmoil without persistent nor large recession, savings immediately started to rise after the credit-crunch, high-tech exports and total exports are also higher than these of the two giants EMU and USA- relative to their size- and Cyprus seems to have been recovering from the 2008 crash in a relatively sufficient pace. Given that, Cyprus seems strong and if they quit euro we have reasons to believe that even after a quite long period of continuous devaluations, mildly negative growth and default they will eventually recover.

However, no one predict what will happen to a country after quiting the EMU and, besides, no one can tell how such an abandonment may escalate around the globe triggering more forceful consequences.

In other words, uncertainty is rife throughout the entire conversation of a member withdrawal from the EMU and hence we cannot decide which of the two monsters is the most manageable.

Both the withdrawal and the deal with the troika appear to be two possible second best solutions. By definition, either of these two options can serve as better than the second best one (they cannot be better that the second worse, either). So, what would be best?

Maybe financing the regulatory capital needs via European Stability Mechanism (yes! ESM is not an urban legend... ESM really exists!). How? I can think of a way, surely not the only one. Cypriot banks proceed to a public offering in order to raise funds equal to their regulatory needs and the amount of shares not absorbed by the public will be bought by the ESM. If you are inflation-phobic (being inflation-phobic it is not a bad thing at all, provided you can keep this phobia under control) ESM can request  credit provision restrains in order to limit the monetary expansion. And that it a costless- one of many- solution.