Saturday, September 17, 2011

Possible Outcomes for the Euro

The Financial Times presents a very clear and pedagogical explanation of the consequences of a Greek default, leading to a possible euro exit and potential euro break up,  here including an interactive map describing the mechanism and the succession of events.

The emphasis is put on the “nightmare” that this scenario would represent for
Greek and other European citizens. As such, however, the presentation is unbalanced, first because it neglects to point the responsibility of the euro in leading our economies into this dead end, and second because the high cost of the alternative before us, i.e. higher taxes everywhere in Europe, leading to a deep depression and reduced levels of living for many years to come, is not mentioned at all.

As noted by Paul Krugman today in his blog, “The Conscience of a Liberal” (September 17):

 “It’s astonishing how many European officials and unofficial wise men insist, with a great air of wisdom, that the euro crisis was caused by failure to enforce the stability pact — that is, limits on deficits and debt. How hard is it to look at the data and discover that Ireland and Spain appeared to be fiscal paragons on the eve of the crisis, with budget surpluses and low debt? Yet another triumph of the Very Serious narrative over easily checked facts.”
Indeed, the euro crisis is the result of a chronic overvaluation of the euro with respect to the inflation rates of several member countries, that destroyed their competitiveness and led to a negative cost of funds (the ECB borrowing rate minus the current inflation rate) in many countries, and, logically, to excess borrowing by the private sector and also by governments when the 2008-2009 crisis left them in need of a fiscal stabilization policy, absent any possibility of using the usual loosening of monetary and exchange rate policy to fight the downturn.
This is again the case today. The best policy would be one of substantial depreciation of the euro that appeared likely a few days ago, when its dollar value fell from 1,45 to 1,36, raising the hope that it would fall further to more reasonable values of about 1,1, or even better 0,9.  But this was not to be and it returned towards 1,4 or 1,5.

The second shortcoming of the Financial Times article and of the governments’ official position is in the neglect of the consequences that “saving Greece and the euro” will exert on the economy. The defense of an overvalued euro will continue to depress the European economies (with the possible exception of Germany) while increasing taxes to subsidize Greece and other southern countries (by further transfers to their governments and banks), and simultaneously limiting money creation by the ECB, will make a deep recession more likely.

The real choice then is between disruption now (default and possibly early euro exit) and a durable depression and disruption tomorrow. Politicians having, like the rest of us, a preference for present wealth over future one, and thus for future losses over present ones, it is not difficult to forecast what alternative is most likely.

Given the recent policy choices of the largest governments within the zone, my guess is that they will try to consolidate the euro now by all means, “whatever the cost”, as they repeatedly pledged, that is, by increasing taxes at home and transfers to bankrupt governments, and dampening an already fledging growth to avoid the immediate turmoil and political costs of Greece’s and others’ bankruptcy. They again further the “kick the can” process for a few weeks or months, and by reducing temporarily the risk of an euro exit or break up in the near future they maintaining a high price of the single currency in the markets, and, in the process, lead their countries towards a depression in order to avoid the complete destruction of their political capital and the loss of the coming elections. 

Trying to avoid economic turmoil and political losses they’ll get both economic depression and political turmoil.

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