So Spain has got the downgrade and now folks have worked themselves into a lather.
The question remains, as it has for the last 18 months: what did you think was going to happen? And the truth is, it's going to happen again.
This is not happening, primarily, because Southern European countries refuse to cut spending. Many of the countries may need to cut spending and regulation but these crises are happening because Southern European countries aren't growing and when you don't grow, your deficit blows up. Recessions do that (Mr. Ryan, take note).
Europe has a banking crisis from under capitalized banks who hold rapidly depreciating assets (in the form of these government bonds) so there is a constant danger of insolvency and runs on them. It's not so different from the US banks in 2008 in that way. But, rather than directly recapitalize the banks a la TARP, the ECB is giving the banks cheap loans to keep themselves running. They are taking the money and calling in every loan they can to reduce their leverage. So it has set the stage for an awful credit crunch which undermines growth.
Europe also has a direct growth crisis/fiscal crisis (depending how you are inclined to describe it).
Southern Europe has had low productivity growth and Northern Europe high productivity growth. Normally, a country getting into trouble like that of Southern Europe would have a devaluation and use exports as their growth strategy. But locked in at the high exchange rate, S. Europe can't do that. Without growth and with the credit contraction from the banks trying to reduce their leverage because of the banking crisis, these countries' deficits are awful and likely to get worse. Even the most savage austerity really isn't going to fix this problem.
We know a lot about how very different economies can be held together in a monetary union. Choose one: 1) The rich guys subsidize the poor guys permanently. 2) A massive exodus of people goes from the poor guys to the rich guys or 3) the poor guys experience massive, extended unemployment and stagnation as they try to grind down everyone's wages and do the equivalent of a devaluation.
Sometimes, as when East Germany joined West Germany at an over-valued exchange rate, they can have all three and have it last for decades.
The problem is, each of them seems impossible but the hard part is coming up with an alternative. Some might add a 4) ECB prints money to monetize the debt and creates inflation but I tend to lump that into the permanent subsidy hypothesis. Regardless, it also seems impossible.
What this means for investors and spectators is the following prediction:
Europe will struggle and find a way to adopt an approach they describe as temporary/one-time/final/emergency that calms the market about Spain. It will involve something vaguely financial market sounding and have some acronym--XLRPTO--but will be some explicit or implicit subsidy--loan guarantees, extra liquidity from the ECB, or anything of that sort would count in the style. It will come with a lecture from the stronger part of Europe about how Spain needs to get their house in order and cut spending and Spain will probably start such a program.
Within three months, the grim iron logic of no growth will blow the deficit up in some other country in Southern Europe--Portugal, Italy, maybe Greece again--and then spreads will rise again and they will do the same dance. Then within three months of recession and no growth, deteriorating finances in another country will lead to another scare and the same thing. Then within three months ...
It will be the most painful version of the permanent subsidy solution that could possible exist. It will hold things together for as long as the rich countries remain willing to foot the bill (or implictly foot the bill in the case of Euro guarantees).
I dread this outcome. I really don't want it to happen. But, please, someone help me understand why the argument is wrong.
The prediction is correct -- because not enough economists are willing to say the pro-Euro folks were wrong at Euro launch. Since so many economists are those who were wrong.
ReplyDeleteAt some point, some country is going to give up austerity, and default, while staying in the Euro zone. And then there will be some new dance.
Until Germany leaves the Euro ... which would allow the non-German ECB to print money. Or maybe the whole Northern Europe will leave the Euro, and go to the eMark. With the S. Europe Euro devaluing and printing.
My own recommendation is for the S. European countries to print Bearer Bonds, 1-yr, 0% interest, used to pay gov't bills -- NOT legal tender yet accepted by the printing gov't as tax payments at 100%. (This idea didn't win the Wolfson prize tho.)
One issue to me that often gets overlooked is the fact that even the rich guys -- Germany -- have done very badly in terms of both GDP growth and with core inflation being below target the past few years, despite the fact that Germany did not have a housing crisis or have to deal with trillions in capital flows from China. They just had to deal with Trichet.
ReplyDeleteSo, if GDP is below target, and inflation is below target, this usually means the central bank should cut interest rates, right? But in Europe, the key short-term rate is still 1%... And that's the lowest they ever got during the crisis.
(Here's a source on Eurozone core inflation, at a 20 year low: http://seekingalpha.com/article/491401-the-eurozone-is-turning-japanese)
People say Europe's problem is that the ECB has a singular mandate, but a separate issue seems to be that they aren't even hitting that mandate... Core inflation is at 1.5%. A third problem is that their inflation target is too low (as is ours).
In a way, it's no too different from our Fed. The economy is clearly not getting better at the pace we need, and so the Fed does nothing.
"We know a lot about how very different economies can be held together in a monetary union."
ReplyDeleteTo what extent might this apply to individual U.S. states, some of which have economies on the same scale as EU member nations? In terms of GDP per capita, the range of productivity among U.S. states seems pretty wide. Delaware's per capita GDP is more than twice Mississippi's.
Would Mississippi benefit from the ability to manipulate its own state-specific currency? (Ignoring the fact this could never, ever actually happen.)
Austan,
ReplyDeleteGiven the deficit and rapidly growing federal debt in the US (much of which is external debt), what do we eventually expect to happen to America?
Sure we can print money like there's no tomorrow (which we've already been doing). But eventually all this comes back to haunt us.
The dream was Europe would function as a single market. But Europe's labor market is not really very liquid. It is not nearly as easy for a Spaniard to go get a job in Germany as it is for a Californian to get a job in DC, Indiana, etc.
ReplyDeleteSo outside of vague notions of labor market reforms and reduced social outlays, is there any answer to this crisis that isn't a de facto implosion of the Eurozone as we know it?
ReplyDeleteI feel like so many politicians and policymakers on both sides of the Atlantic refuse to see the obvious: that the EU as currently structured is not sustainable as long as monetary union does NOT equate with fiscal union.
Am I wrong Austan?
Will. I'm not Austan. But the US does not have fiscal union either. Granted almost all the state constitutions have "balanced budget" requirements. But that can mean a variety of things. States are in very different fiscal shape.
ReplyDelete"Fiscal union" is not a bad idea, it just doesn't really solve the problem materially.
Spaniards don't all speak German. And while they all speak English pretty well as their transactional language, they're almost all more fluent in their native language than in English. So putting aside labor rigidities, there is no "European" labor market. That is a core problem that makes the Euro an immense challenge (and probably ultimately doomed to fail - in its current form).
That's a great point John. The European labor market is deceivingly more complicated than just reforming visas and regulations.
ReplyDeleteDespite strides being made in terms of cultural integration, a Greek will have a much harder time finding work in Germany and Belgium than someone who is native.
One of the countries will drop out, as long as it's a minor economy like Greece, the pain will bring the remaining countries together in the United States of Europe. It will be painful and messy for a decade or more. It will take the US that long to heal our own gutted middle class.
ReplyDelete