Counterparties: Man with power to do something about the Euro crisis urges others to do something about the Euro crisis
Time to Press the Big Red Button...

The Three Issues in the European Crisis

There are three issues in today's European crisis. They should be dealt with separately and independently, for they are different problems amenable to different kinds of solutions. Instead, they are mashed together. And that is the major reason that the crisis is intractable.

The first issue is that Northern European bankers and investors loaned Greek politicians money when the Greek politicians did not have a mandate to raise taxes to pay that money back. The bankers and investors were betting on rapid growth that would produce a sufficient fiscal dividend that Greek taxpayers would not notice. Failing that, they were betting on being bailed out by somebody. It was a risky growth-or-moral-hazard play. It has gone wrong. The bankers and investors cannot collect on the "growth" portion. If they want to collect on the "moral hazard" portion, they should apply to the ECB and the German government. This issue seems to me to have very little to do with Greece: it should be settled in Northern Europe.

The second issue is how Greece is going to balance its government expenditures and government revenues going forward, for nobody--or at least nobody sane--will lend the Greek government more money for a long time to come. This, it seems to me, is an issue for the Greek political system and the Greek political system alone: it should be settled by the Greeks.

The third issue is how is Greece as a country is--and the other countries of southern Europe that also received enormous capital inflows that pushed up their nominal wage and price levels are--going to balance its exports and imports going forward without suffering a decade-long depression. The Friedmanite monetarist solution would be to let the foreign exchange market do the job: abandon the euro, and let the drachma find the level at which imports balance exports. The alternative is structural adjustment--an increase in the level of nominal wages in euros in Northern Europe and increased efficiencies and stable nominal wages in euros in Greece and Italy and Spain and Portugal and Ireland. This structural adjustment strategy preserves the euro, but it calls for adjustment on both sides: structural reform in Greece, etc, and also higher inflation in Germany.

Northern Europe wants to restore confidence in the stability of the euro. Greece and the rest of the European periphery wants to avoid a decade-long depression. There is a deal that can be struck here that gets both what they need and want, but only if both sides of the deal focus on what their real fundamental interests are. And only if both sides recognize that structural adjustment has to take place in both surplus and deficit countries.

UPDATE: And Paul Krugman drops the hammer: It ain't happening! Run for your lives!

The Breakeven Point (Wonkish But Terrifying): A number of us have been saying for some time that the euro crisis is, at its root, a balance of payments problem. During the careless years, capital flooded from the core to the periphery, leading to big trade deficits and overvalued real exchange rates; now, all that needs to be reversed. Yet “internal devaluation” via deflation in southern Europe is basically impossible; if this is going to have any chance of working, we need a real devaluation in Spain mainly via German inflation rather than Spanish deflation. 4 percent German inflation plus zero in Spain might work; 2 and minus 2 can’t. And this in turn means that overall eurozone inflation must be sufficiently high. That’s a necessary but not sufficient condition for salvation…. One indicator I like to look at is the German “breakeven”…. I’ve been arguing for a long time that it really needs to be above 2 for there to be real hope.

So what’s happening? Oh, boy! I’m not sure this really means that investors expect only 0.7 percent inflation over the next 5 years; it’s probably also reflecting a collapse of liquidity, which drives down prices in the relatively thin markets for index bonds (which happened after Lehman too). But that’s just another kind of disaster. This chart shows a euro on the verge of imploding. If the ECB can’t change this perception very, very soon — and I think it really is up to them — this goose is cooked.