As Spain starts looking rocky, Tyler Cowen writes:
In a nutshell, we're watching the most pitched, highest-stakes, most determined battle between politics and finance which has been staged. I am expecting finance to win.
1. What is the true state of the large European banks? In particular, if, they had to write down the principal on the debt of the PIGS by, say, 15 percent, which banks would still be solvent?
2. What does the option for inflating away European debt look like? How would the cost of that inflation be distributed? Can the inflation take place within the context of the euro, or does it require that some countries leave the euro?
3. Does a crisis create an opportunity for governments to make radical changes to the welfare state, or is that still not possible?
4. Suppose that governments have to choose between preserving their banks and preserving high levels of spending on public employees and retirees. Which choice is better for the economy? For political survival?
I don't know the answer to any of them, but of the four, I think the last is the most interesting; Europe cannot let its banks fail, but it also can't divert public pensions to line the pockets of bankers. Yet it may well have to do one or the other. I am also expecting finance to win. Forget whether Germany has the political will to bail out the PIIGS: does either the EU, or the ECB, actually have the means to bail out all five? If Spain topples, that is what it will come to.
This is starting to throw off more echoes of the Great Depression, where you have a sequence of crises, each touched off by the ones that came before, like dominos falling into some diabolic design. Europe and America thought they'd seen the worst of things by the end of 1930, only to be knocked back down even harder by the contagion of the Creditanstalt crisis. In the US, the crisis ultimately triggered a string of bank failures worse than those sparked by the initial stock market crash, and the worst two years of the Great Depression were 1932-3.
I don't want to lean too hard on this, as economic commentators (maybe including me) have started seeing Creditanstalt everywhere--in Dubai
, in Greece
, now in Ireland and maybe Spain. It's entirely possible that we'll eventually muddle through without a second major event. But it's worth remembering that these things take a long time to unfold, and that we are often most vulnerable just when we think we have time for a breather.
Related thoughts: whatever events unfold, a lot of pundits who insist on treating whatever has happened in the last five minutes as if they were the final events of the crisis, are going to look like idiots. If Spain ends up in the same place as Ireland, the virulent arguments over Irish austerity are going to look rather silly in retrospect; if Europe's banking system is badly compromised, the model of economic crisis that centers around American bank regulation and monetary policy will be severely compromised; and so forth. Pundits and regulators should both be playing the long game.