Options for Europe

This problem is not fixing itself.

Bob Barbera and Jonathan Wright
offer this assessment of the situation in Europe:

Up until a few weeks ago, all European officials declared at all moments that there were no conditions
that could lead to a nation leaving the euro. Suddenly that was no longer true. Contagion fears– if
Greece can be thrown out, why not Spain and Italy– quickly appeared. This produced a quick
calculation. If my money is in a bank in a nation at risk, I might go to bed with 10,000 euros and wake up
with 10,000 pesetas. In other words, my deposit was guaranteed, but the currency value of the deposit was
not. The simple remedy? Open an account in Germany. Wire transfer the money. Conduct business, still
in euros, but from an institution that might convert your euros to deutschmarks. And in growing numbers,
first businesses and then individuals have been making just this kind of transfer….

Central bank data makes it clear that as of April, a bank run was in
full force in Greece and that a bank ‘trot’ was taking hold in Spain and Italy. Target2 statistics reveal that
Spain and Italy borrowings from the ECB had mushroomed from roughly 150 billion euros to close to
300 billion euros, over the first four months of 2012. Germany, in mirror image, registered loans to the
ECB of nearly 700 billion euros. May data is unavailable, but almost certainly witnessed a material
acceleration of flows.

Source: Institute of Empirical Economic Research, Universitat Osnabruck.

Barbera and Wright

What compels Germany to send money to the ECB? Follow the flows. The Spaniard moves his money
from Bankia to Deutschebank. Deutschebank, now awash in excess cash, deposits its excess reserves with
the Bundesbank. The Bundesbank, in turn, lends these funds to the ECB. The ECB then lends them to
Spain and Italy and … the result? The bank run, left unchecked, compels the Bundesbank to lend ever
larger amounts to the periphery, via the ECB. Thus, without a vote in Germany, or a proclamation from
Angela Merkel, the German monetary authority becomes the lender of last resort to frayed Greek, Spanish
and Italian banks….

Just as there is a self-fulfilling prophesy in
bank runs, the same applies to sovereign borrowing. As an example, Italy has a primary surplus. If Italy
can borrow at low interest rates, then Italy is solvent, and investors are right to buy Italian bonds at low
yields. But if Italy is forced to pay high interest rates, then the country is insolvent, and investors are
right to charge high rates.

In the case of a run on private banks, it is not the case that self-fulfilling panics cause any fractional reserve financial system to be inherently unstable. I explained why when I was discussing the U.S. financial problems unfolding in 2007:

The way this problem is solved is to have the capital that the bank lends come not just from its depositors but also in part from the owners of the bank. These owners should have invested some of their own money to start the bank and reinvested some of the profits of the bank to allow it to grow. The capital that comes from the owners rather than depositors is known as the bank’s net equity. The idea is that if the bank takes a loss on its investments, that loss comes out of net equity, and there’s still money to pay off all the people who deposited money in the bank.

In the case of sovereign debt denominated in a currency that the government could not itself just print more of, the equivalent of the bank’s net equity serving as a buffer to prevent bank runs is the government’s ability to cut future spending or raise future taxes to halt a run on sovereign debt. If it’s not possible for a government to take those steps when called on, the unstable “bank run” equilibrium becomes a concern. A full-fledged financial panic centered in Europe seems a reasonable thing to be worried about at the moment.

How can a country thrown into that situation get out of it? Restoring budget balance and international competitiveness would usually require big real wage cuts for all domestic workers. Getting those wage cuts in the private sector typically doesn’t happen without a prolonged period of high unemployment, and getting big wage cuts in the public sector typically doesn’t happen, period. The traditional policy option is therefore to try to accomplish the same thing with a big currency depreciation, accompanied by debt restructuring, that is, accompanied by partial default on outstanding debt. One advantage of achieving real wage cuts through currency depreciation is that, although the loss in standard of living is still there, everyone in the economy– workers, lenders, businesses– can at least start to look forward to improvement from here instead of anticipating continued deterioration. Having some basis for forward-looking optimism can be a huge benefit in pulling out of this kind of situation.

The problem at the moment is that it is extremely difficult for a country currently part of the European monetary system to choose that route. As exit from the euro becomes contemplated or forced on one country, creditors fear it may happen elsewhere. And those fears could easily produce a replay of the credit crunch that brought the world economy to its knees in 2008.

I think it is inevitable that Greece and perhaps some other small countries will have to abandon the euro. But a firewall should be drawn around the larger basically solvent countries to avoid an unnecessary and potentially very destructive outcome.

Barbera and Wright

Euro bonds would be one way of resolving this problem. A quicker and easier
way would be for the ECB to commit to buying the sovereign debt of all euro zone countries at a fixed
small spread over corresponding maturity German bonds. The magic of this solution is that the credible
commitment to do so might be enough– the ECB might not even have to buy bonds in size.

The strategy we describe would have a very good chance of resolving the immediate crisis.
Unfortunately, if the past is any guide, European policymakers will prefer a “compromise” of taking a
half-measure, thinking that this brings at least half of the gain. But half measures will do nothing.
Policymakers will have to go back and try again at even greater cost (if they get another shot)….But following a hypothetical Greek exit, we would be in totally
uncharted territory. Europe may well have only one shot at getting this right.

10 thoughts on “Options for Europe

  1. Doc at the Radar Station

    Good post. Things looking bad.. Some sort of “solution” keeps popping up to check the gloom at the last minute. Time is running out though and the relief is shorter each time. Merkel mentioned something about a “two-track” Euro months ago. Perhaps we will see a Greek exit followed by formation of two Euros: One anchored by Germany for the northern states, and the other anchored by France for the Latin bloc.

  2. Bob_in_MA

    It’s hard to see how that “resolves” anything.
    If Greece leaves, they will have a crisis, the drachma will drop 50%, tourists will start coming to take advantage of cheap prices. The money that left as Euros will start coming back as drachmas, and within a year they’ll be issuing drachma bonds.
    Spaniards will look at that and say, why are we putting ourselves through this?
    The only way it will stop with Greece leaving is if Germany leaves too.

  3. ppcm

    Déjà vu
    “The problems are not fixing themselves”, they were not fixed through the last financial therapy either.
    The subprimes were deemed to be the byproducts of the source of growth that is the housing. The housing growth deemed to produce the positive GDP growth differential with export oriented partners countries. The equilibrium between expanding surplus countries and expanding deficit countries, would be maintained through low interest rates. The savings from one country being driven in the current account deficits countries,as long as the positive growth differential would prevail.
    With more than a little help from central banks, financial corporations and all ancillaries functions, that worked.
    Now it is the unwinding time and European bonds risks tranches would be the new panacea. This time, the loop closes itself and the derivatives are going back to the primary functions the sovereign risks. The risk slicing in tranches has been tested and not successfully.
    It deals with countries sovereignty, it deals with moral hazard, it deals with substitution of functions. The politicians have to deal with their structural problems and not to deal in loans recoveries.The task in this perfect world is devoted to the financial operators and the IMF.One may wonder how much leeway,is given to the governments after having trespassed,all the terms and agreement of the European union without their constituents prior consents. A single or two countries in Europe, cannot solely shoulder the sovereign debts at the core or at the periphery. The over hedged financial have the Value At Risks for themselves, and they may have already booked profits on unrealized profits.
    OCC report on derivatives,BIS and
    “ Banks’ Hyper-Hedging Adds to Risk of a Market Meltdown”

  4. Dr. Beate Reszat

    There seems a widespread misunderstanding concerning the nature of the Target2 balances. Target2 is a payment and settlement system where no liquidity is created and accordingly no loans are made or granted. In my view, the main reason for the confusion is the dual role of the ECB as (1) central bank of the euro area and provider of liquidity and (2) Central Counterparty of the RTGS system settling payments in euro. See for further details http://reszatonline.wordpress.com/2012/06/10/target2-qa/

  5. Ricardo

    Keynes would be proud. I have always been amused at his P.T Barnum proposal of inflation to fool workers into taking a pay cut. His assumption, and yours, seems to be that workers are ruthless enough to resist cuts in a sound currency, but stupid enough to ignore a pay cut via inflation, a debased currency. In truth even Keynes had to face the fact that this doesn’t work when the unions demand cost of living adjustments and inflation clauses in wage contracts. Keynes even began to beg the unions not to call for raising wages so his ruse would work.
    If the state is determined to spend more than it produces then white-washing the economic consequences will not solve the problem. Inflation in theory has the potential of lowering real wages, but in practice simply makes things worse. Additionally, there are other consequences from inflation that simply exacerbate the loss of production without solving any of the underlying problems.
    I did appreciate the post of Barbera and Wright, but this is definitely not one of your best posts.

  6. Encuestas Remuneradas

    The politicians have to deal with their structural problems and not to deal in loans recoveries.The task in this perfect world is devoted to the financial operators and the IMF.One may wonder how much leeway,is given to the governments after having trespassed,all the terms and agreement of the European union without their constituents prior consents. A single or two countries in Europe, cannot solely shoulder the sovereign debts at the core or at the periphery. The over hedged financial have the Value At Risks for themselves, and they may have already booked profits on unrealized profits.
    OCC report on derivatives.

  7. don

    And yet the euro continues to climb in the face of more promised “stimulus” in U.S. monetary policy. To me, this effect, the effect on commodity prices and the stock market are about all we will get from more monetary “stimulus.”
    As for the rise in the euro, what are they thinking? Is it a matter of traders in U.S. quasi-banks engaging in the dollar carry trade, thinking they can get out before a collapse? (The temptation is huge – borrow a billion at 0% and loan at 7% with 100-to-one leverage) Or is it the notion that those holding current euros will see dramatic appreciation if the periphery is obliged to exit? That outcome seems less likely, the more we see depositors from the periphery putting their money in German banks. The story Barbera and Wright tell might explain why the ECB is reluctant to make more loans to the periphery, but it also implies the remaining euro stub would be left with dodgy reserve backing, which draws into question the notion that an anticipated future euro appreciation is behind the recent rise in the currency and makes me lean toward the dollar carry trade explanation. Last time, it pushed the euro to over $1.50, which certainly harmed the local economies. To me, this was a stupid thing for the Fed to do, unless they operate under the view that the bad effect would not be recognized, whereas the salutory effect on stock prices would bring them praise (never mind that it did nothing for unemployment). A few things make me think Ben acts more from political than economic considerations, including his cite of outrageous gains from trade in Congressional testimony, and his early statements about the likelihood that the housing collapse would not spread to the economy at large.

  8. Lord

    Most Greek debt is publicly owned while much Spanish and Italian debt is still privately owned and more subject to runs and large enough to be difficult to defend. Look for southern Europe to stay or go as one.

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