Euro in Crisis

I've been making the argument for a long time--at least seven years in print, and in private before that--that the eurozone looks about as stable as the Unabomber.  Especially when you have a fiat currency, you need to think about what makes an optimal currency zone--the largest unit that can easily share a unit of money. The euro countries are not an optimal currency zone: their economies do not move in sync, and they are not fully integrated.  That means that at any given time, monetary policy will be too loose for some countries, too tight for the others--Italy was in recession even as Ireland was overheating.

That's not necessarily fatal--the United States isn't an optimal currency zone either, since the state economies have their own local business cycles which can be quite different from the country as a whole.  But over the centuries, the US has evolved a number of ways to mitigate these stresses.  We have strong central banking regulation (maybe you think it isn't strong enough, but it still plays a powerful co-ordinating role across the various states).  Our labor force is extremely mobile compared to Europe--we move around even more than Europeans do within their own country, much less between countries--so when jobs get scarce, people pick up and move, relieving some of the unemployment that results when tight national monetary meets sinking local economies.  The general flexibility of our labor market also helps reduce unemployment.  And our national system of unemployment insurance, welfare and health benefits moves money from booming states to busting ones.

Europe has fitfully tried to replicate these institutions, but the barriers are higher.  People don't like to move across borders, languages, and cultures, especially when doing so means you also have to change social insurance programs, health systems, and laws.  Perhaps more importantly, Europe has much more powerful state governments, and a much weaker central regime, to contend with than the US ever had, even in the 19th century.  Those governments aren't always willing to give up power to Brussels, and even when they are the negotiations take years, and the required compromises often render the new regime toothless or worse.  The restrictions on budget deficits, for example,had been largely gutted by the middle of the last decade because none of the major players wanted to commit to them.

All this was known five years ago.  But the fiscal crisis has revealed even more gaps than expected.  The euro essentially integrated banking systems without integrating bank regulations, and now Germany is in a position where it has to bail out the periphery in order to save its own banking system.  But there is no mechanism, and worse, no political will, to really do what is required.  German voters resent paying for the excesses of Greek politicians and Irish bankers, while Irish voters are revolted by the prospect of paying much higher taxes, and receiving fewer services in order to bail out German deposit-takers.  And the Greeks are, well, near revolt.

In today's Financial Times, Martin Wolf finally says what I've been thinking: "the eurozone, as designed, has failed."  As the PIIGS teeter on the brink of insolvency, the central banks are financing their banks--and the governments--by accepting discounted public debt as collateral.  And because of the interlinkages between creditor-nation and debtor-nation banks, practically speaking, the Bundesbank is now guaranteeing all that debt.  Cosigning a loan for someone with shaky credit is a very risky activity; there's not much evidence that it works better at the international level.  The picture Wolf paints is pretty dire:

Prof Sinn makes three other points. First, this backdoor way of financing debtor countries cannot continue for very long. By shifting so much of the eurozone's money creation towards indirect finance of deficit countries, the system has had to withdraw credit from commercial banks in creditor countries. Within two years, he states, the latter will have negative credit positions with their national central banks - in other words, be owed money by them. For this reason, these operations will then have to cease. Second, the only way to stop them, without a crisis, is for solvent governments to take over what are, in essence, fiscal operations. Yet, third, when one adds the sums owed by national central banks to the debts of national governments, totals are now frighteningly high (see chart). The only way out is to return to a situation in which the private sector finances both the banks and the governments. But this will take many years, if it can be done with today's huge debt levels at all.

Debt restructuring looks inevitable. Yet it is also easy to see why it would be a nightmare, particularly if, as Mr Bini Smaghi insists, the ECB would refuse to lend against the debt of defaulting states. In the absence of ECB support, banks would collapse. Governments would surely have to freeze bank accounts and redenominate debt in a new currency. A run from the public and private debts of every other fragile country would ensue. That would drive these countries towards a similar catastrophe. The eurozone would then unravel. The alternative would be a politically explosive operation to recycle fleeing outflows via public sector inflows.

He says that Europe has two choices: tighter integration, or partial dissolution.  I agree, but I just don't see how the former can work.  The Irish and the Germans and the Portuguese and the Greeks do not identify with "Europe" the way 1930s Americans identified with "America"; neither group is going to readily sacrifice its own self-interest for the others.  The elites have gotten around this so far by leaning heavily on unaccountable institutions like the central banks, but as Wolf shows, this cannot last forever. 

Unless their economies rapidly start to mend, continuing in the euro will be economic suicide for the PIIGS once the backdoor subsidies stop.  In this week's column, Robert Samuelson notes just how dire things are "Already, unemployment is 14.1% in Greece, 14.7% in Ireland, 11.1% in Portugal and 20.7% in Spain. What are the limits of austerity? Steep spending cuts and tax increases do curb budget deficits; but they also create deep recessions, lowering tax revenues and offsetting some of the deficit improvement."  Add on top of this the drawbacks of an expensive currency and a tight monetary policy for a troubled economy, and they'd have to be crazy to stay.

Maybe they are crazy--now.  But clinging to a failed monetary peg causes problems that can drag on for years.  Look at Argentina in the 1990s, or the entire developed world during the Great Depression: the longer a country clung to the gold standard, the longer and deeper the economic suffering.

I think the chances of the euro zone surviving intact are now less than 50%.  They're not 0%.  But they do seem to be shrinking every day.