Euro Crisis Update (Lazy Block-Quote Edition) II

...the re-updatening.

Here's that block-quote:

The IMF usually has maximal bargaining power at a country’s moment of crisis – it typically cares far less about whether the country makes it through than the country itself does, and hence can extract harsh conditions in return for aid.2 But – as we have seen with the Greek crisis – EU member states are far less able to simulate indifference when one of their own is in real trouble, both because member states are clubby, involved in iterated bargains etc, and because any real crisis is likely to be highly contagious (especially within the eurozone). In other words, the bargaining power of other EU member states (and of any purported EMF) is quite limited. If Greece really starts going down the tubes, Germany faces the unpalatable choice of either helping out or abandoning the system that it, more than any other member state, created. In short – any EMF, unlike the IMF, needs (a) to concentrate on preventing countries getting into trouble rather than dealing with them when they are already in trouble, and (b) deal with the fact that any country in trouble likely has significant clout in the architecture overseeing it.

From my sense of the EU integration process, and of the rough bargaining strengths of the actors involved, I imagine that any final bargain will emphasize forward-looking measures, which are intended to forestall problems before they arise. Unhappily for Bundesbank disciplinarians, these are likely to rely more on carrots than sticks – it is clear from previous experience with the Growth and Stability Pact that threats of harsh punishment are not sufficient to produce virtue if these threats are not credible. We can expect moderate levels of fiscal transfers (likely ratcheting up over time), aimed at helping ease the pain of adjustment, together with admonishments (and withdrawal of goodies) for those who fail to live up to their promises...So yes – the Greek crisis is plausibly a very significant step indeed in EU integration (whether for good or bad, I am not going to speculate, since even if I am right, it would depend heavily on the detail) (CrookedTimber).

In my first big post on this topic, I speculated that because the current arrangement in Europe is so unsustainable both economically or politically (Greece being the case in point), the system could only fall one of two ways: Europe will unravel or it will converge, but the middle ground can't hold any longer.

But I think I may have been wrong. For reasons relating to policy inertia, confidence in financial markets, politics, and the sheer limits of logistical implimentation, it seems like integration is a bit of a one-way street. It would be very difficult for any one actor in Europe to begin disentangling itself from the rest of the continental system, let alone to disentangle that system itself. At this point, it seems like things can only roll one way.

Euro Crisis Update (Lazy Block-quote Edition)

First, Simon Johnson:

Some financial market participants cling to the hope that the stronger eurozone countries, particularly Germany, will soon help out the weaker countries in a generous manner. But this view completely misreads the situation.

The German authorities are happy to have the euro depreciate this far, and probably would not mind if it moves another 10-20 percent. They are convinced that they must – in fact, should – export their way back to acceptable growth levels.

Competitive depreciation is of course a no-no in international policy circles. But if your dissolute neighbors – with whom you happen to share a credit union – threaten to implode their debt rollovers, and markets react negatively, how can you be held responsible?
[...]
The euro depreciates, the dollar strengthens, and our path to recovery starts to run more uphill.

And if these European troubles start to be reflected in difficulties for leading global banks over the next few days or weeks, the negative impact will be much greater.

Then, Yves Smith:

We do have a factor here that could get the reluctant Europeans, meaning the Germans in particular, to act, namely, that Eurobanks are still wobbly and are not doubt exposed directly and indirectly to a European sovereign debt crisis. There is no way to avoid rescue operations of some sort, it’s merely a matter of picking which poison. Do they want to face the ugly bailout of countries they see as profligate, or wait till it morphs into a crisis and have to put their banks on emergency life support? The problem is the latter is politically more palatable, even though ultimately more destructive, since a lot of collateral damage will occur in the wave that hits the banks.

And just for the sake of reiteration, lastly, Paul Krugman:

Spain is an object lesson in the problems of having monetary union without fiscal and labor market integration. First, there was a huge boom in Spain, largely driven by a housing bubble — and financed by capital outflows from Germany. This boom pulled up Spanish wages. Then the bubble burst, leaving Spanish labor overpriced relative to Germany and France, and precipitating a surge in unemployment. It also led to large Spanish budget deficits, mainly because of collapsing revenue but also due to efforts to limit the rise in unemployment.

If Spain had its own currency, this would be a good time to devalue; but it doesn’t.

On the other hand, if Spain were like Florida, its problems wouldn’t be as severe. The budget deficit wouldn’t be as large, because social insurance payments would be coming from Brussels, just as Social Security and Medicare come from Washington. And there would be a safety valve for unemployment, as many workers would migrate to regions with better prospects. (Wages wouldn’t have gone up as much in the first place, because of in-migration).

The point is that this has nothing to do with a spendthrift government; what’s happening to Spain reflects the inherent problems with the euro, which now more than ever looks like a monetary union too far.

My Big Fat Greek Debt Crisis

Evidently it took last week's €8 billion bond sale to alert bond and currency traders world-wide that, now that you mention it, with its massive debt and deficit to GDP ratios and its rapidly deteriorating economy, Greece might not be the primest of borrowers. Greek government and corporate bond yields have been steadily climbing this week and even the euro itself is beginning to feel the panic. In the meantime, having run to China for an emergency loan, only to be denied, it looks increasingly likely that the birthplace of European civilization will soon be structurally adjusting itself back into the good graces and deep pockets of its less swarthy neighbors up north like the best of the third world.

Whether or not the Greek government receives a string-laden emergency loan from the the richer Eurozone countries or, less likely, the I.M.F., the lack of a coherent response from within the E.U. is disturbing in its own right. This is particularly relevant given the respective economic profiles of countries like Spain, Portugal, Ireland, and to a certain extent, Latvia and Estonia, all of which look disturbingly similar to Greece. That is, encasing the creamy, rich center of Europe, we have a host of economies with highly indebted governments, declining incomes, and an unhealthy dependency on foreign creditors. These countries are also either operating on the euro, or currencies pegged to it.

"If fears of contagion become widespread, risk-averse investors could start to gun for even the larger or 'stronger' euro zone economies and their debt," said Geoffrey Yu, a currency strategist at UBS.

"Spain, Italy, Austria and Belgium -- together accounting for more than 35 percent of the euro zone economy versus just over 6 percent for Greece, Portugal and Ireland combined -- may then be next in the firing line," he added. (AP)

As significant and potentially awful as the immediate situation is, what I find to be the most interesting element of this story is how the development and eventual resolution of this crisis reveal and potentially address the structural and logical failings of the E.M.U. system.

Does it really make sense, for example, for an economic powerhouse like Germany to share a monetary policy and currency with a much more fragile economy like Greece's? As Yves Smith points out, Germany might see the logic in to the relationship during the boom where it can trade its way into a massive surplus upon a currency cheapened by its union members. Likewise, I suspect countries such as Greece spent the better half of the last decade enjoying their ability to borrow on better terms than would otherwise be available to them (all the better to fuel a financial or a real estate bubble). But in a downturn, say, like the one we're in, such an arrangement might suddenly seem a lot less attractive for both partners.

Paul Krugman wrote the following for a lecture he is about to give to the Allied Social Science Association. It's on the slightly different issue of currency crises, but I think this excerpt is still applicable:

Suppose that the underlying problem is a level of prices and wages that makes your production uncompetitive – typically the consequence of an earlier period of excessive capital inflows. Then what must happen, sooner or later, is a decline in prices and wages relative to those in your trading partners – a real depreciation. This can happen through nominal currency depreciation – but this has the unpleasant consequence that the real value of foreign currency debt will rise, creating a deleveraging crisis.

Unfortunately, the alternative is worse. Real depreciation without nominal depreciation must take place through deflation. And this means that the real value of all debt, not just foreign- currency debt, rises. So the deleveraging crisis will be even worse if you don’t depreciate. (Krugman)

That is, in the case of a pegged and overvalued currency, the inevitable readjustment during a debt (or broader economic) crisis can come in two flavors: a downward adjustment of the currency, the "external price" of all goods and services (which will be terrible for domestic borrowers using foreign cash and consumers of foreign goods) or a downward adjustment of all "internal" prices and wages, (which will be terrible for everyone). Of course, Greece does not have a peg (though the Baltic states do), but in using the euro, it is effectively using an overvalued currency. With the euro then, Greece's hands are tied: it has no ability to conduct monetary policy and currency values are determined by the larger economic aggregate of the Eurozone.

At the heart of the issue is the concept of the "optimal currency area." From its inception, because of the differentials in productivity, in language, in fiscal policies, in fiscal goals, and because of remaining constraints on factor mobility, many criticized the Eurozone for being definitively non-optimal. That is, that the European Union made more political and ideological sense--that the economic logic was missing. As Paul Krugman wrote on his blog last month:

Suppose that some members of the euro zone are hit much harder by a downturn than others, so that they have much higher-than-average unemployment; how will they adjust?

In the United States, such shocks are cushioned by the existence of a federal government: the Social Security and Medicare checks keep being sent to Florida, even after the bubble bursts. And we adjust to a large degree with labor mobility: workers move in large numbers from depressed states to those that are doing better.

Europe lacks both the centralized fiscal system and the high labor mobility. (Yes, some workers move, but not nearly on the US scale). (TCOAL)

However, in my mind, this is not necessarily an argument for the dissolution (or the inevitability of the dissolution of the EMU), but potentially just the opposite. If Athens and Berlin are considered illogical candidates for a mutual currency while rural Alabama and downtown Chicago are, this may very well be due to linguistic and cultural divisions, and it's certainly possible the productivity differential between those two countries is more extreme than that between those of the American example (I really have no idea). But if, as Krugman writes, more than anything else rural Alabama and downtown Chicago are able to share the almighty dollar because a broader political and economic framework exists to support that otherwise unequal pairing, that sounds like a case not for fragmentation, but further economic unification.

In this respect, the Eurozone stands in an illogical half-way house between a multi-currency system and an United States of Europe. Quoting Nouriel Roubini:

"The eurozone could drift, essentially with a bifurcation, with a strong centre and a weaker periphery, and eventually some countries might exit the monetary union," he warned.

For all the focus on Greece, however, he also said that Spain may eventually pose an even bigger threat to the eurozone because it is the region's fourth-largest economy and has higher unemployment and weaker banks. (Independent)

That is certainly a possibility. But it's also possible, though probably less so, that a crisis in Greece (or Spain, or Portugal, or Ireland, or...) will push the richer Eurozone members into taking the first crucial steps towards a comprehensive continental fiscal system. Either way, whether a bailout of Greece establishes an accidental precedent for future transfer payments or drachmas and pesos make a surprise reappearance in Europe, it seems like something will have to give. The maintenance of the status quo--either through a series of one-off bailouts on one hand, or total inactivity on the other, allowing the peripheral economies to wither, hoping the Eurozone will persist in its current state through pure inertia--will only postpone the resolution of Europe's structural inconsistencies until the next crisis.