Circling the Drain: Can the Euro Be Saved, Or Is It Doomed? A Freakonomics Quorum
Photo: Images_of_MoneyOn Jan. 1, 1999, the euro was launched in electronic form. A few years later, amidst much fanfare, 12 European countries began replacing beloved national currencies with the euro, and the currency rapidly became the tender of choice across Europe. Wim Duisenberg, the then-president of the European Central Bank applauded the new currency: “By using the euro notes and coins we give a clear signal of the confidence and hope we have in tomorrow’s Europe.”
Almost ten years later, things look a little different. The financial crisis that has brought much of the developed world to its knees looks poised to bring down Europe’s single currency as well. The cover of this week‘s Economist reads “Is this really the end?” Inside, the magazine offers the following observation:
The chances of the euro zone being smashed apart have risen alarmingly, thanks to financial panic, a rapidly weakening economic outlook and pigheaded brinkmanship. The odds of a safe landing are dwindling fast.
The magazine goes on to warn that a breakup would not be pretty:
A euro break-up would cause a global bust worse even than the one in 2008-09. The world’s most financially integrated region would be ripped apart by defaults, bank failures and the imposition of capital controls (see article). The euro zone could shatter into different pieces, or a large block in the north and a fragmented south. Amid the recriminations and broken treaties after the failure of the European Union’s biggest economic project, wild currency swings between those in the core and those in the periphery would almost certainly bring the single market to a shuddering halt. The survival of the EU itself would be in doubt.
Elsewhere, the Financial Times reports (gated) that businesses are “preparing contingency plans for a possible break-up of the eurozone.”
The situation appears a bit brighter today, with news that the world’s central banks are coordinating to provide liquidity to Europe’s embattled banks. The fundamental question of whether the euro will survive remains, however. And so we’ve decided it’s high time for a Freakonomics quorum on the future of the euro. We asked a bunch of very smart economists the following questions:
In light of the recent European debt crisis, what do you think will happen to the euro? In your opinion, what should happen to the euro?
Below, you’ll find their answers, all written prior to Wednesday’s central bank action, it should be noted. They run the gamut from “The euro will die a bloody death that damages Europe and the world,” to the more measured “[I]t is unlikely that the euro will come apart.” All in all, we think it’s as comprehensive a read as you’ll find on the euro crisis. And, as always, thanks to everyone for participating.
Christian Leuz is the Joseph Sondheimer Professor of International Economics, Finance and Accounting at the University of Chicago Booth School of Business and a Co-Director of the Initiative on Global Markets.
It is, of course, hard to predict what will happen to the euro. Nobody knows. The current volatility in the financial markets indicates that investors are very uncertain as to the outcome, resulting in large swings. With that caveat in mind, my view is that the most likely outcome is that the euro will survive. It might end up being a much weaker currency if the ECB is forced to print money in response to a deepening debt and banking crisis. But given the tremendous “political capital” vested in the euro, it is unlikely that the euro will come apart. Even in Germany, the euro still has a lot of political and popular support. The same is true for the German membership in the European Union for obvious historical reasons.
If the euro zone breaks apart, it can occur only at the top, i.e., only the strongest countries can afford to leave the euro and create a new currency. The reason is that an exit by Greece or Italy, for instance, would lead to an immediate devaluation of that country’s new currency against the euro. While this helps to restore competitiveness, all liabilities are denominated in euros. Thus, the exiting country (and its banks) would likely default, which would shut the country out of the capital markets for some time to come. But if that country is now no longer part of the euro zone, there would be very little political and economic incentive for the remaining euro zone countries to help out.
Exit at the top, however, could be “sold” as the natural next step in the integration process of the EU and could be properly planned, i.e., the date of the exit and the currency rate for the transition could be announced well ahead of time. While the current push by Germany and France for stronger integration among EU countries preserves this option, the more likely outcome is that euro zone countries increase the firepower of the European Financial Stability Facility and at the same time use the ECB to stabilize the situation (e.g., with larger bond purchases).
As for the question of whether there should even be a euro, I think the answer is again yes. There are many good reasons to have a joint currency in the EU. My view is that the EU largely exists for political reasons. In this regard, a joint currency was a natural next step in the European integration process, and the euro was agreed to for political reasons. Many have argued that this step came too early and that the construction was flawed. Probably true. However, I am convinced that if the EU had adhered to its principles and responded differently to the Greek crisis, the soundness of the currency union would not be in question today. The Greek crisis was an opportunity to draw a line in the sand and to demonstrate the no-bail-out principle, largely because the Greek problems were special and the country is small. In the beginning, the crisis had very little to do with the euro, and it was a cardinal mistake to connect it to the currency. Instead, it was a sovereign-debt crisis combined with too much leverage in the banking system. A Greek default (or restructuring) with ample liquidity for the banking system, including a (forced) recapitalization of systemically important and over-extended banks would have been the proper response.
As this opportunity was missed, the crisis is now connected to the euro for two reasons. First, it is euro zone members that have been first in line to support peripheral countries like Greece or Ireland. However, it is not clear that this demarcation is the right one. The UK has probably as much to lose from an Irish default as the rest of the EU. Second, the ECB had to step in repeatedly, largely because the poli
tical process was too slow and the EU’s response inadequate to calm the situation. This created another connection to the euro.Given this situation, the question is now whether it still makes sense to have the euro. Here, my take is a pragmatic one. If the ultimate political goal is to have a tightly integrated European Union, it still makes sense to have a joint currency going forward. However, given the recent experience showing that governments are unwilling or unable to commit to the no-bail-out principle, a survival of the euro necessitates a stronger fiscal integration, more oversight and, most importantly, more “automatic” responses that are based in law and not subject to political discretion. It also entails a long overdue recapitalization of the banking system.
Roger Craine is an emeritus professor of economics at the University of California, Berkeley.
Will the Euro Survive?
In a word no. The euro will die a bloody death that damages Europe and the world. The only question is when. I don’t expect the euro to last another year.
The grim reality that the Union has no credible plan to hold the euro together is beginning to sink in. Bond speculators, like lions after a herd of water buffalos, have picked off the weakest, like so.
Now the jackals are arguing over whether a 50 percent loss on Greek sovereign bonds is a default. Some banks fear a Greek default because they hold Greek bonds and a default would force them to recognize the loss. And the writers of credit default swaps that insure bondholders against loss from default don’t want a default because they would have to make good on their contracts. Of course, the owners of credit default swaps want their insurance to cover the 50 percent loss.
Greece is a weak, small country on the periphery. It shouldn’t, and can’t, cause the euro to collapse. But the herd has panicked and scattered. Now the loins can kill the isolated strong, and the hyenas and jackals will devour the remains. That’s how the euro dies. And the process is well underway.
The leaders of the water buffalo herd (Germany and other northern European countries) still refuse to recognize that virtuous austerity can’t solve the problem. Investors and speculators rightly suspect that Italy, Spain and maybe even France are vulnerable even though their fundamentals are strong. Investors want to reduce their exposure to European debt. The Vanguard Money Market Fund decided not to roll over a short term loan—of $1.6 billion—to a French bank because they feared that the bank holds too much European sovereign debt. Sophisticated residents in the euro zone are shifting their bank deposits to safe havens—like Switzerland and the U.S.–because they know that when the collapse occurs, the governments will freeze deposits to stop bank runs. And speculators betting on the collapse feed the fire. This already has set off a vicious cycle where bond rates rise and the carrying cost on an inherently solvent country’s debts rises to where they in fact are insolvent. The spread between Italian and German ten year government bonds rates is 5.5 percent, and it is 4.5 percent for Spain. And on Nov. 21, the German Treasury auction was under-subscribed. Investors fear European debt.
Maybe if the bulls—read Germany–had acted courageously six months ago they could have driven off the predators. But they didn’t. Now it is too late. European governments cannot credibly guarantee any large economy’s debt (read Italy or Spain). The feeble attempt at a Eurobond Bailout fund—which the Europeans hoped would be largely financed by foreign investors—is a failure, and a joke. The European Central Bank (ECB) now is the only hope. It has the one resource—the ability to print money—to credibly stop the run on the euro. But they have steadfastly maintained that their job is price stability and that they will not support the price of a member nation’s sovereign debt. So even if rationality suddenly invades the ECB—what must the ECB do? They must convince the predators and the world that now they are serious. Not a chance.
Elias Papaioannou is an assistant professor of economics at Dartmouth College.
What do you think will happen to the Euro?
Economists are bad forecasters; and making a reasonable guess about the future of the euro nowadays is even harder, as incoherent and inconsistent policies by European policy makers have created confusion and added uncertainty. In any case, this is my guess of what we will see in the near term.
The recurring tale
It is not bad to make mistakes, as long as you realize them and change routes. Yet there is no indication that European policy makers have learned from their mistakes. So over the next months (perhaps year), I think that we will continue observing the following sad tale. European politicians will keep talking about bold reforms; but at the same time their actions will be minimal; markets in turn will become increasingly anxious, and contagion will continue spreading, hitting gradually the countries and banks of the European core. Then at an EU Heads of State Summit (alongside some anti-market anti-globalization rhetoric), EU leaders will announce a bold package that aims to resolve the crisis overnight! But, as always, the specifics of the plan will be intentionally left out; markets will soon realize the deficiencies and, after a brief drop in the cost of borrowing, bond yields will continue climbing; the ECB therefore will step in and more aggressively implement their bond purchase program; but soon some statement from some German (or Dutch) official will jeopardize ECB actions. Then (relatively) bad news on the implementation of the adjustment program will arrive from Athens, Lisbon, Madrid, Dublin or Rome (Paris???), and there will be a massive sell-off with investors running for treasuries, bunds and the like. Then we will start over again.
ECB
Given the inconsistent policies and the constant back-and-forth (especially regarding the funding and operations of the European Financial Stability Mechanism), the resolution of the crisis — at least in the short term — lies at the European Central Bank. If economic rationality is to prevail (as we teach in the classroom), then the ECB will take an aggressive role, intervening massively in the markets to restore confidence in the European financial system. Most economists believe that the inflationary effects of a massive quantitative easing program of the ECB will be minimal. While moral hazard issues have clearly got to be taken onboard, the ECB will sooner or later step in. Given the interference of politicians and the opposing statements of German officials, the ECB’s move will have to be bold, decisive and large. I expect that the ECB will coordinate with the other major central banks (the Federal Reserve and the Bank of England), in a similar way to their joint actions in the end of 2008, when Lehman Brothers collapsed.
In your opinion, what should happen to the Euro?
The collapse of the euro will trigger what Barry Eichengreen has eloquently coined as the “mother of all financial crises.” While impossible to quantify and forecast, the costs to the European and the world economy will be unprecedented. Equally important, the political costs for Europe will be immense, as the successful (so far) process of European economic, social and political integration will be reversed. The credibility of both EU-wide institutions and national governments will suffer a massive blow, and it will take a lot of tim
e to get repaired. The stakes could not be higher. As such, a mega, multi-dimensional, coherent plan is urgently needed. This step will require bold short-term action and painful medium-run reforms. It also entails some non-actions.Non-actions
Shhhhhh. Whenever European policy makers talk, yields on government debt in the vulnerable countries go up, and stock prices around the world decline. The markets (and in recent months, also the European people) put almost zero weight on the contradictory, inconsistent, and in many instances senseless statements of EU politicians. The EU leaders can offer much help, if they stop their nonsense rhetoric and start working on implementing the much-needed structural reforms.
Do Not Open the Discussion of Modifying the EU Treaty Now. In recent months, some European politicians have pushed for a new EU Treaty in 2012. While clearly the rules of the game need to change and institutional reform is needed, opening the discussion when the crisis is underway is wrong. It will increase uncertainty; moreover, it will amplify tensions among euro-area countries; and perhaps most importantly, ratifying the new treaty is going to be far from straightforward, as the crisis has hit a significant portion of the electorate, and politicians have so far failed to tackle the ongoing recession. If the ratification of the previous treaty took much time and effort (remember the French referendum), the ratification of a new treaty touching the core of economic integration will be polemic.
Coherent Actions. Europe should move from its current talk-talk-talk approach to implementing coherent policies. What is worse than a bad politician is an indecisive politician. And so far we have seen many incoherent policies at the EU level. Over the past two years, European policy makers have jeopardized their own actions. For example, after numerous discussions EU leaders decided last year to establish the European Financial Stability Facility (EFSF) and arm it with almost half a trillion euros, but still the EFSF has not been operational. The bank stress tests have also been a joke; sorry, a repeated joke!
Restore ECB independence and credibility. The ECB’s independence has been seriously questioned. Consequently, the ECB has suffered a huge loss in its credibility. The European policy makers (from all countries, yes including Germany) should let the ECB perform its role without interfering. If the ECB’s Governing Council believes, for example, that extending the Securities Market Program and the refinancing operations is needed, then they should go ahead with these policies. The treaties for the establishment of the single currency do not say that Germany — or any other country — has a veto over monetary policy. My argument is not that there are no dangers of massively expanding the money supply or monetizing the deficits of the fiscally irresponsible countries; but that the monetary authorities alone should evaluate the pros and cons and then implement decisively the policies.
Bank Recapitalization. When the IMF Director openly raised the issue of the need to recapitalize European banks, EU policy markers dismissed the idea, arguing that banks in Europe are well-capitalized. But reality bites; and soon afterwards, European politicians changed course, also acknowledging the need for bank recapitalization. Yet so far they have not delivered. Even worse, since the bank stress tests were quite mild (to be polite…) we still do not know the exact amount of capital injections that European banks need. The European agencies should quickly proceed with the recapitalization of the banking system, perhaps using the EFSF funds (which, though clearly inadequate for bailing out Italy or Spain, seem sufficient for a bank recapitalization).
Medium-run Policies
Even a decisive involvement of the ECB in the secondary bond market and a quick bank recapitalization plan will not solve the structural problems in the crisis-hit countries and the euro area. Policies at both the national- and the EU-level are needed. Specifically:
Adjustment programs
1) The EU should modify its current “a single one-size plan fits all” approach. While there are some common elements, the roots of the economic downturn are quite different in Spain, Italy, Ireland, Portugal, and Greece. In Greece, the huge debt and the ballooning deficits are symptoms of an institutional breakdown and a weak state that is unable to collect taxes, provide basic public goods and safeguard the rule of law. In contrast, in Spain or in Ireland the problems are mostly in the private sector and the exposure of the local banking system to real estate. Common fixes will not work. The policy geeks in Frankfurt, Brussels and D.C. need to realize this and modify the current adjustment programs so as to tackle the idiosyncratic problems of each country.
2) Likewise, the current myopic focus of the adjustment programs on fiscal measures needs to change. Clearly countries like Greece and Portugal need to start running balanced budgets and steadily move to primary surpluses. Yet fiscal prudence is not a panacea. Greece, for example, needs an institutional bailout plan (see here) so as to rebuild tax collection mechanisms, enhance the judicial process, and improve state bureaucracy.
Jobs, Jobs, Jobs. European politicians keep quarrelling about the role of the markets and the rating agencies, the ECB, the EFSF, banks’ stress tests, the ESM; yet there is no discussion and, most importantly, no policies trying to assist those suffering from the crisis. Yet public support is vanishing both in crisis-hit countries and the countries of the core. Unemployment in Spain exceeds 20 percent. And Greece will most likely follow root (as unemployment has increased over the past two years from around 10 percent to more than 17 percent). Youth unemployment is about 50 percent in both countries. When one browses over the adjustment plans, it is hard to find even a page with policies to tackle the massive economic and social costs of the rising unemployment. This has to change. Sooner rather than later…The EU Commission, for example, could increase the funds of the Social Cohesion Funds to the crisis-hit countries, so as to increase temporarily unemployment benefits or cover part of non-wage labor costs (social security contributions) to incentivize firms to recruit. But most importantly, the focus of leaders should be on promoting growth agendas.
Within Euro Area Imbalances. In the longer-run, EU policy makers need to design and implement policies that will account for the huge current account and competitiveness imbalances that have marked the euro area even before the 2007/2008 crisis. Perhaps the Stability and Growth Pact could be modified so as to target also “soft” indicators of competitiveness; moreover, the EU budget could increase so the Commission would be in a position to implement some form (of medium-scaled) fiscal transfers.
Anil Kashyap is the Edward Eagle Brown Professor of Economics and Finance at the University of Chicago Booth School of Business, a co-director of the Initiative on Global Markets, and a previous Freakonomics contributor.
In light of the recent European debt crisis, what do you think will happen to the euro?
There are two inter-related but different problems that are plaguing Europe. Greece will never be able to fully repay its debts. (Reasonable people can disagree on what happens in Portugal and Ireland, but Greece is definitely broke.) Many large European banks, including some important ones in France and Germany, would suffer losses when that default happens. For a long time, the problem was one of finding money to stop a run on the banks when the inevitable default occurred. This was a solvable problem because the losses involved were modest (when one looked at the total size of Europe compared to Greece).
But given the dithering over finding that money, investors began to question whether the European governments’ unwillingness to pay to backstop the banks reflected deeper problems with the governments’ own finances. Especially in Italy, where there have been high levels of debt and very little growth for years, investors became nervous about continuing to lend to the Italian government. Italy seemed unable to get its affairs in order. Although Spain started in a much better position than Italy, it too is looking at years of low growth and mounting levels of debt.
The sovereign funding problems are much harder to solve. Spain and Italy have hundreds of billions of euros of debt to roll over in the coming years. They too will go broke if they have to refinance at the current interest rates. A bankruptcy by Spain or Italy would take down the entire banking system of Europe. Recently, no one wants to fund these governments.
So there are now three ways that the crisis ends. Most simply, the ECB starts buying the sovereign debt and thereby relieves the funding pressure. If Italy and Spain use the time to restructure their economies to create growth, the currency union can be saved. The ECB solution likely involves much higher inflation than we have seen since the launch of the euro. If the restructuring does not occur, then there will be a lot of inflation.
A second alternative is to relieve the funding pressure by having the strong countries (most importantly Germany) agree to help cover the debt repayment for Italy and Spain. This kind of guarantee would crush Germany’s own credit rating, but it would likely bring down funding costs for Italy and Spain. Once again, if they put their fiscal houses in order, the bailout by Germany could work. But as with the ECB solution, if the Italians and Spaniards do not cut their spending, reform their economies to make them more competitive, and raise tax collections, the Germans could be on the hook for a very big guarantee.
The third option is an exit by the strong countries because they don’t want to give the guarantees or take the inflation risk. A break-up will be very messy, but they might bumble into this as the only choice if they keep drawing lines in the sand that are subsequently crossed.
In your opinion what should happen to the euro?
The politicians ought to come clean to the voters about these three choices. They should call snap elections in Germany and France and let the people decide which option they prefer. The elites in Europe created the euro without really consulting the people. They ought to let the people decide its fate now.
Charles Wyplosz is professor of international economics at the Graduate Institute in Geneva and the director of the International Center for Money and Banking Studies.
The stakes are getting sharper by the day. Extraordinarily inept management of the debt crisis over the last two years by both governments and the ECB now threatens the very existence of the common currency. The problem is not really economic, as there is a simple solution: the ECB can act as lender of last resort and provide a partial guarantee to euro zone government debts. Once this is done, some countries can negotiate haircuts with their creditors, and the crisis will be done with even if the after-effects are long and painful.
This solution is being held out by a dogmatic vision of German policymakers. They remember that the monetary financing of their deficits in the 1920s led to hyperinflation and, quite understandably, they do not want that to happen to the euro zone. They fail to distinguish between a one-off intervention on the existing stock of debts and an unlimited financing of ongoing deficits. German policymakers also mix up an emergency intervention and the long run moral hazard problem that the bailouts have created. In fact, they consider that a harsh punishment of countries that have displayed a lack of fiscal discipline is necessary to deal with moral hazard.
This strategy will not work. Imposing a tough fiscal contraction on a country already in recession only deepens the recession and makes it impossible to reduce the budget deficit. The most likely evolution is a worsening economic situation throughout the euro zone – and beyond – which will pull more countries into a crisis situation. With a debt of about 80 percent of GDP and weak banks, Germany itself stands to be sucked in. At some point, the ECB will probably act as lender of last resort, but the costs will be enormous. Several governments will have to default on their debts, and the size of defaults will be bigger the later comes the intervention. This, in turn, will lead many banks to fail, which will require more lending in last resort from the ECB. The deeper the restructuring of the banking system, the worse and longer lasting will the recession be.
Can the euro zone break up? This would be an economic nonsense. First, a country may well default and remain in the euro zone. Second, contrary to the accepted wisdom, there are no serious competitiveness problems within the monetary union. Germany converted its marks into euros at an overvalued exchange rate; since then it has recovered equilibrium. Conversely, Greece started with anundervalued conversion rate and has also returned to equilibrium. Of course, a devaluation helps when the government and banks default, but leaving a monetary union is not a mundane event. It would leave millions of private contracts in limbo, and it would lead to massive wealth transfers.
The risks to the euro are political. Public opinion starts rebelling against policy mistakes that hurt citizens without any improvement in the debt situation. They are told that sacrifices are needed to remain in the euro zone. They may conclude that leaving the euro zone will make their lot better. The referendum-that-was-not-to be in Greece is an early signal of things to come.
Richard Cooper is the Maurits C. Boas Professor of International Economics at Harvard University and a former chairman of the Federal Reserve Bank of Boston.
After a decade of relatively benign existence, Europe’s 17-country euro area has finally come under the kind of serious strain that was foreseen by some economists many years ago. It was precipitated by the revelation in late 2009 that Greece’s budget deficit was very much larger than previously reported and that Greece needed assistance in continuing to finance it. Europeans represented that they could solve this European problem without outside help and then dithered for three months before sending Greece to the International Monetary Fund for a corrective program with financial assistance, to which Europe would contribute.
If this had been done earlier, there was at least some possibility that Greece’s problem could have been isolated. But the months of irresolution served as a wake-up call to financial markets that all might not be well in the eurozone, and doubts gradually spread about Ireland, Portugal, Spain, Italyand even Belgium and France – despite significant differences among these countries in fiscal policy, outstanding public debt and internati
onal payments. By late 2011, euro-denominated bond spreads over ten-year German bonds, which had been negligible until late 2007, had risen to 155 basis points for France, 290 for Belgium, 466 for Spain, 480 for Italy, 650 for Ireland, 945 for Portugal, and an extraordinary 2550 (25.5 percentage points) for Greece, thus raising greatly, but differentially, the cost of new borrowing, both to finance continuing deficits and to roll over maturing debt.By then Greece, Ireland and Portugal had official sources of funding and did not need to pay these rates in the marketplace. But other countries did and were judged to have requirements so large that they could not plausibly be met by official lending, except from the European Central Bank (ECB). Italy’s public debt, for instance, was six times that of Greece.
Most of the focus of official and public attention has been on budgets and outstanding sovereign debt. But this crisis exposed an even more serious problem, which should have been evident earlier: some euro zone countries, again especially Greece at over 9 percent of GDP in 2011, were running large current account deficits, meaning that they were importing much more than they were exporting and had to borrow abroad to cover the difference. There is nothing wrong with this in principle – drawing in foreign saving permits larger investment than could take place based on domestic saving alone. In Spain, however, foreign saving was largely financing an unsustainable construction boom; and in Greece (and to a lesser extent Portugal and Italy), it was largely financing public consumption, which was not being covered by adequate tax collections. The counterpart surpluses were largely within the euro zone itself, especially in Germany and the Netherlands.
Loss of competitiveness in many countries has been rectified by depreciating the currency, resulting in a decline in wages and other local costs when measured in foreign currency. That course is not available for the countries of the euro zone, since they do not have their own currencies. Thus, it would seem that apart from cutting public expenditures to reduce public borrowing requirements (they seem unwilling to pay taxes), Greeks need to cut wages and rents to improve competitiveness, and/or emigrate and send remittances home to families. If outsiders are unwilling to lend, this adjustment is like that required under the gold standard, but without gold.
Leaving the euro zone, possibly desirable in principle, cannot in practice be done. Liquid assets will leave the country in anticipation, and liabilities in euros will lead to widespread bankruptcy, thus producing the severe austerity it was hoped to avoid. Greece faces a bleak decade under all circumstances. But what can be done to mitigate it and make it politically tolerable? I suggest the following courses of action:
Greece and Portugal could simulate a currency devaluation for trade by imposing a special tariff on all imports, matched by a corresponding subsidy to all exports. This course would not be permitted within the European Union. But they could increase their valued-added taxes, which would be levied on imports and rebated on exports. With the increased revenues they could provide an employment subsidy to firms, thus approximating a currency depreciation by lowering effective wages. By stimulating net exports, this would mitigate the austerity which Greece and Portugal must inevitably undertake.
To bring borrowing costs for Spain and Italy within manageability, Europe could adopt the scheme proposed by George Soros, whereby the ECB would purchase sufficient bonds to hold market rates below, say, five percent; and the ECB would be guaranteed against potential losses on such purchases by the European Financial Stability Fund (EFSF), which at 250 billion euros is not large enough to persuasively purchase enough Spanish and Italian bonds on its own. Just the promise of such purchases should be sufficient to stabilize the markets, obviating the need for heavy exposure. Neither Spain nor Italy would be relieved of improving their public finances; but the new governments in both countries could do so in a measured way, without constantly being worried about short-term market reactions, which would distract them from the longer term adjustments required.
These actions would be made much more effective in a buoyant economic environment, which Europe, verging on recession, does not enjoy at the moment. Germany needs to back more stimulative fiscal and monetary policies, the latter by the ECB. Germans seem to have low tolerance for both, even though they strongly (though inconsistently) welcome economic stimulus coming from the export sector. But in the environment it is helping to create, one in which all its euro zone neighbors pursue austerity measures, Germany will also slip into recession, with or without a financial crisis.
Over the longer term, and in the context of an effective EU mechanism for assuring fiscal discipline (which emphatically does not mean balanced budgets at all times), Europe should create true Eurobonds, guaranteed by all euro zone members but served by each country originating the bond.
Contrary to the initial European claim that Greece was a European problem to be solved by Europeans, financial turbulence in the euro zone has become an issue of global concern, capable of destabilizing global financial markets and even driving the world into another recession. For this reason the G20, led by the U.S., China, Japan and Britain, should stand ready to provide financial support if it proves to be necessary, i.e. if Germany remains obstinately doctrinaire and fails to act in the interests of Europe, and indeed in its own long-run interest.
Randall S. Kroszner is the Norman R. Bobins Professor of Economics at the Booth School of Business of the University of Chicago, and a former governor of the Federal Reserve System.
Lessons from the 1780s and 2008 for Europe Today
The experiment of monetary union without fiscal union is at a crossroads. As the “failed” bund auction from last week illustrates, markets are now realizing that the Germans simply cannot – and certainly will not – take on the debt of all of the rest of the euro zone and their banks. Funding conditions for the European banks are at least as bad as during the heights of the crisis in the fall of 2008. Deposits are flowing out of banks in the weaker euro zone countries. Banks even in the strongest euro zone countries are finding it increasingly difficult and costly to obtain short term finance in the markets.
Bold and decisive action is necessary to prevent the collapse of the euro and the euro zone. A few lessons can be learned from the U.S. playbook from the dark days of 2008 as well as from the dark days of the early U.S. republic in the 1780s.
After the Revolutionary War, the U.S. confronted challenges similar to those facing the euro zone today: What is the extent of fiscal integration that is consistent with monetary union? The initial answer was a loose confederation of fiscally independent states under the Articles of Confederation. The Continental Congress had the right to issue paper money (“Continentals”) but not the power to tax. The states could tax but not issue money. The states refused requests to share their tax revenues with the Continental Congress, so the Congress turned to issuing Continentals in increasing quantities, leading to hyperinflation. This is the origin of the phrase “Not worth a Continental.”
From the beginning, Alexander Hamilton argued that a stronger central government with the power to tax and issue debt was necessary for the economic success of the United States. In 1789, Hamilton and his fellow Federalists triumphed with the ratification of the U.S. Constitution, replacing the Articles of Confederation.
< p>At the EU summit next week, Europe will be facing parallel issues. Will there be changes in governance that would lead to greater fiscal integration and monitoring in the euro zone? How will the balance of power change between the individual member states and the EU itself? Is there a possibility of a centralized EU obligation like a “Eurobond”? Will a Hamilton of Europe emerge? Without resolving the key governance and fiscal issues, it will be difficult for the long-term stability and sustainability of the euro to be determined.
In the short run, indecision and incremental steps in the euro zone are generating market turmoil and driving up to unsustainable levels the borrowing rates of countries like Italy. This reminds me of the drama surrounding the passage of what is now known as the TARP legislation in the U.S. in the fall of 2008. The initial vote on that legislation failed and the Dow Jones Industrial Average plummeted by more than 700 points that day. That market turmoil helped convince some legislators who had opposed the original legislation to support a lightly amended version of the legislation days later. Unfortunately, Europe seems to be caught in a seemingly endless cycle of policy makers responding only when there are sharp adverse market movements, but then not taking the decisive actions necessary to calm the markets, leading to adverse market reactions, etc.
In contrast, after the passage of TARP, risk spreads came down significantly as the funds were used to inject capital into the banks and to support an FDIC program to provide temporary guarantees for certain debt instruments. TARP funds were also used to capitalize a Term Asset-Backed Securities Lending Facility (TALF) in which the Federal Reserve provided financing to leverage up the TARP funds.
The European Financial Stability Facility (ESFS) has the potential to act in the same way as the TARP, but it hasn’t. Proposed more than a year ago, discussions continue on what should be its appropriate size, how it might be used for bank recapitalization, what types of guarantees it might offer, and how it might be leveraged. To be effective, the ESFS needs to have greater firepower and a clear mandate to act immediately and concretely in these key areas.
In all of this, it is crucial that the ECB be able to maintain its independence and credibility. The ECB can provide liquidity support to the banking and financial system, both through short-term and longer-term lending, much as the Federal Reserve did during the crisis. Encouraging European banks to obtain dollar funding through the Fed-ECB swap line arrangement would also reduce liquidity pressures that could spill over to U.S. institutions. Simply having the ECB buy the debt of troubled member states, however, will not solve the fundamental fiscal and governance problems that are necessary to sustain the Euro. Otherwise, we run the risk of “Not worth a Euro” replacing “Not worth a Continental.”
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