Monday, January 16, 2012

S&P’s Diagnosis

Here it is, in a nutshell, as summarized by  The Economist:

“According to S&P, EU leaders have misdiagnosed the euro-zone crisis. They have focused too much on tackling the increase in governments’ budget deficits, which is only part of the problem. As a result, they did not pay enough attention to the deeper causes of the crisis: the divergence in competitiveness between the euro-zone’s core of strong economies and its struggling “periphery” as well as the huge cross-border debts that stem from this gap. Reforms based solely on fiscal austerity could easily become self-defeating, notes S&P.”

They are perfectly right of course, and of course also fiscal austerity has already proved to be self-defeating (in Greece for instance). But the reason for this misdiagnosis of European leaders is that the fundamental problems of the euro-zone so well described by the rating agency are inherent to the very existence of a single currency, forced upon very dissimilar economies. 

The financial mechanism resulting from the euro is by nature destabilizing: a single interest rate boosts activity and bubbles in countries that have an above average inflation rate, while it further depresses activity in those that have an under average inflation rate (probably resulting from under average activity level). The divergence is built in and cumulative.

Moreover, a single interest rate and structurally fixed (or suppressed) exchange rates boost capital flows from higher income countries towards lower income economies, the “huge cross-border debts” problem signaled above.

Realizing that leads inevitably to a disturbing diagnosis: the source of the problem is the euro itself, and thus what is required is a policy of euro exit. The governments concerned are not ready yet, politically, to face such a reality. A deeper crisis is needed before they do. 

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