27 September 2011

Is this the Beginning of the End for the Euro?

The first time I wrote about the economic crisis in Europe and the Greek debt issue I suggested that the most logical scenario for them is to default and get out of the Eurozone. With the new drachma they could devalue at will, I said, and they could increase their exports and get a large portion of the budget vacationers who are nowadays leery of traveling to North Africa and Egypt. Since staying within Euro was conditional upon accepting crippling austerity measures which makes the repayment of their massive debt impossible, I thought this was the sanest choice.

I even offered the relatively recent examples of Argentina and Russia, both of whom found rapid prosperity after defaulting. Yet they suffered mightily while vacillating towards that decision.

Fast forward two months, yesterday, Stergios Skaperdas, a professor of economics at the University of California at Irvine wrote this:
The demands go well beyond those prescribed by conventional economics. They will deepen the depression and make full debt repayment even less likely than it now is. Therefore, the clear, strong nudge is for Greece to default as soon as practicable. (...) 
Since Greek banks will become insolvent, they will have to be nationalised and preparations will need to be made for that. The insurance and pension funds will need to be bailed out, too. For both banks and funds to be bailed out, the country will need its own currency. Therefore, exit from the eurozone would follow. 
Professor Skaperdas believes that Greece's exit from the Euro is necessary because without its own currency the country could never recover:
"There is little doubt among economists that the easiest mechanism for a country to gain competitiveness is to have its currency depreciate. Hence, Greece having its own currency is the easiest path to gaining international competitiveness. Cars and iPhones will become more expensive but food might actually become cheaper and employment will pick up within a few months after the introduction of the new drachma. By contrast, unemployment and deprivation with no end in sight are the predictable results of following the troika's policies."
Moreover, he feels that, with and without Greece in it, the future of the Euro is rather bleak (and therefore it is best for Greece to leave now):
For the countries of the eurozone it has become apparent that there are only two clear options: political integration or breakup. Anything else is politically or economically unsustainable. Since there is no appetite for political integration, exit from the eurozone can be expected later anyway, when it could be even less advantageous for Greece.

What he means by that cryptic duality of integration or breakup is that the current crisis showed that it is impossible to have a common currency without substantially integrating other fiscal tools as well. That means that all major economic and budgetary decisions will have to be made at the European level. And as he rightly points out, that is essentially a political integration.

The alternative he says is breakup.

The problem is that it might already be too late for that dilemma to represent a viable decision point. For that, we need to listen to another professor, this one a Nobel Laureate. Krugman looks at the bond market breakevens ("the difference in interest rates between regular bonds and inflation-protected bonds of the same maturity, which give a measure of inflation expectations") and from the German breakevens he concludes that:
The market seems to expect price stability for Germany — an inflation rate of 1 percent or so over the next 5 years. And that has a clear message: it’s signaling catastrophe for the euro. 
Why? I tried to lay this out a while ago.A reasonable estimate would be that Spain and other peripherals need to reduce their price levels relative to Germany by around 20 percent. If Germany had 4 percent inflation, they could do that over 5 years with stable prices in the periphery — which would imply an overall eurozone inflation rate of something like 3 percent.
But if Germany is going to have only 1 percent inflation, we’re talking about massive deflation in the periphery, which is both hard (probably impossible) as a macroeconomic proposition, and would greatly magnify the debt burden. This is a recipe for failure, and collapse.
In other words, if you try to manage this crisis with monetary tools, there is no way you can accommodate both the over-heating economies and the weaker economies that are contracting as we speak. The former needs deflationary measures (reducing the money supply, less government spending, higher interest rates etc)  while the latter needs inflationary measures (increasing the money supply, expansionary government spending and low interest rates). The ECB acts with a deflationary focus, which means the peripheral economies will eventually collapse.

This is very relevant because if Krugman's calculations are in the ballpark it means that more than half of the European economies will have to reduce their prices by 20 percent. That is not economically sustainable for any government.

So, I agree with Professor Skaperdas' verdict. If you are going to do it, do it now. And as I said two months ago, there is no other way out of this.

Making an impassioned plea to German business leaders will not help in any way.

Or floating a rescue plan that includes a 50 percent haircut will only lead to a temporary bump but will not solve the underlying problem. The problem is structural and there is no way to manage German economy and Greek economy with the same set of tools.

Something will have to give.

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