Friday, December 9, 2011

The Avoidable Catastrophe

European Union leaders concluded their latest summit, with their usual small solutions to enormous problems.  Here is a link to their release, detailing their new agreement.  They have decided to offer up more funds for member state bond market stabilization and redoubling their efforts at austerity, which has only exacerbated this problem thus far (including a ridiculous tax on countries that go over the 3% rule).  They still have Italy contributing 17% and Spain 11% of the EFSF funds, which sounds ridiculous given the fact that they are currently mired in severe deficits and Italy is already paying high interest rates to service its debt.  The only good thing to come out of this summit was that nobody has left the Euro (yet).

During the summit, fears and rumors led to multinational corporations reportedly moving their money from countries rumoured to be exiting the Euro to presumed safe countries.  That also probably compounded the bank runs problem in Greece.

Despite markets being up Friday, these problems will likely continue as none of the them have really been solved.  This means that none of the uncertainties that have created deflationary conditions in southern Europe will go away, and the economic conditions will continue to deteriorate.

European leaders signing the Treaty of Rome in 1957

Speculation of this variety does not help, but for countries that could be forced out or leave the Euro, this could amount to an economic catastrophe.  Their country will likely be almost immediately bankrupt unless Eurozone countries agree to continue bailout loans, or a bailout fund through the IMF.  It is hard to imagine that their currency will have any reputation as a store of value.  Their central banks will have little in the way of credibility to create monetary policy.  This will leave these countries in something like a liquidity trap because any monetary policy they try to employ will have little effect.  Deflation will be immediate and substantial, and it will be difficult to turn that around towards inflation or GDP growth.

A liquidity trap is defined as the point that monetary policy is no longer effective because bonds and money are perfect substitutes.  This situation is slightly different, because there will likely be so little demand for bonds, coupled with little central bank credibility that they will not be able to hold down interest rates to stimulate the economy in a meaningful way.  This means that monetary policy will be an ineffective tool to stimulate the economy.  Similarly, these countries will likely not have full sales of their bond offerings, and will have to cut government expenses even more significantly.  GDP will almost assuredly nosedive.  This should be classified as something worse than a liquidity trap because it will be a situation where neither monetary nor fiscal stimulus will be possible.

IS-LM in a Liquidity Trap (Krugman)

What would be left of the Eurozone will not be spared from a significant contraction.  Mark Cliffe of ING speculates that the new currencies would plunge.  His white paper speculates on a full break up of the Euro, but similar movements would be felt from select countries exits.  Similarly, northern European countries will inevitably feel the effects of the severe economic contractions of southern European countries in the form of contractions of their own.  These contractions could last a year in the case of northern Europe and years of severe contraction for southern economies.

The only possible heroes are the European leaders, but it looks as though they are still not truly believing in their own shared destiny.  The main villain can easily be viewed as the European Central Bank (ECB).  Their strong currency position has strained the growth of southern European countries, and even this Spring, they raised rates because of inflation fears.  Thursday, they cut rates, but at a paltry .25%; when Greece, Spain and Italy were literally having capital streaming out of their banks, economy, and even geography.  Much of this agreement seems to be stressing an increased ECB role, but hard to imagine them doing what is necessary to help southern economic conditions.  They will be acting as the operating agent of the EFSF and ESM funds to purchase sovereign debt.  Hopefully they will be more active in that pursuit, than they have in monetary policies.


I would argue that there is still time and opportunity to avoid this recession.  I think the best solution is to pool credit risk.  An agency such as the European Stability Mechanism or the European Financial Stabilization Mechanism or another more robust agency could purchase all the debt of all member nations, and in turn issue Euro bonds.  The Eurozone, in total, has a debt to GDP ratio of 85%, which is below the United States and within an acceptable range.  The Euro as a currency has and would continue to have significant transaction demand, and the ECB would continue to have legitimacy and credibility for creating monetary policy.

Creating a true fiscal union (as opposed to the current proposal which merely acts as an enforcement agency of the 3% rule) would also be important to insure that this does not become a repeated problem, and (of course) to pay down the Eurobonds, and pool more government expenses.  These two solutions (Eurobonds and fiscal union) might cause Eurozone nations to rethink whether they actually want to remain in the currency.  It is hard to imagine EU members that have not adopted the Euro join this arrangement which would leave countries like the U.K. and Sweden out.  For that reason, I think secondary treaties such as a greater European community (but explicitly non-EU) would be important for keeping important commercial and economic ties, while being excluded from a federal system and unified currency and bonds.

It does not look like enough European leaders are interested in this arrangement.  I think we are still staring at a difficult situation in Europe that hasn't really been solved.  If conditions continue to deteriorate, European leaders will be forced to hold another summit, and who knows how much longer bond markets are going to tolerate these half-steps.  They're barely tolerating it now!

If countries leave the Euro, France and Germany will instead likely be somewhat forced to bail out banks that will be overexposed to southern European debt or too weak to withstand this recession (Commerzbank, which is trading at an awfully low price of € 1.37 might be the first) or face a more severe recession of their own.  Southern Europe will be have negative economic growth for years.  It should be considered a failure of leadership that Europe was not able to find a way towards this solution over the past year and a half.

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