The European Troika’s Rescue Plan Will Fail

(cross posted from EconoMonitor)

Yet another rescue plan for the EMU is making its way through central Europe—raising the total funding available to the equivalent of $600 billion. Germany agreed to raise its contribution to the fund by more than $100 billion equivalent. However, Slovakia has vetoed the rescue and all eyes are now turned to a forthcoming October 23 summit.

In any event, some rescue package is assured because the center of Europe wants to save its banks—that hold billions of euros of troubled government debt.
No one is foolish enough to believe that will be enough. The latest casualty is Dexia Group, a Belgian-French behemoth that specializes in sovereign debt. It had already been bailed out once, and now needs another bail-out. Rest assured that Dexia is just today’s domino—the other big European banks will fail, too. This is not a Greek problem. It is not an Irish problem. It is not a Portuguese problem. It is not a Spanish problem. It is not an Italian problem.

It is an EMU problem and Band-Aids will never suffice.

The problem with the set-up of the EMU was the separation of nations from their currencies—as I have long argued, along with Charles Goodhart, Warren Mosler, and Wynne Godley. (Go here for a relatively recent piece.) And as I said a few weeks ago, it was a system designed to fail. With no central government that issues currency it has no way to use fiscal policy on a large enough scale to counter the business cycle, let alone to deal with a financial crisis on the scale we’ve seen since 2007.

And with the gathering storm, the individual members of the EMU will be swamped as their financial institutions are forced to realize losses.

Even if the member states were not busy pointing fingers and squabbling over profligate spending by neighbors, the current arrangements prohibit any effective response to crisis. When markets decide to attack one member, it quickly finds itself in a vicious debt trap, with interest rates rising that blow a hole in the budget. At most, other members can put together a debt package—lending at slightly more generous terms.

But what highly indebted members need is debt relief and economic growth, not more debt. With austerity demanded in order to get the proffered loans, growth turns negative, increasing budget deficits and leading to more desperate borrowing.

So either way, the indebted country gets into the debt trap: if it borrows from markets, interest rates rise; if it borrows from the EMU (or the IMF) its growth falls and tax revenue plummets.

Damned if you do, damned if you don’t.

So one solution for a troubled country is to leave the EMU and return to a sovereign currency issued by the government—ie, the drachma for Greece, the lira for Italy, and so on. The transition would be disruptive, with near-term costs. But the benefit would be to create domestic fiscal and policy space to deal with the crisis. Default on euro-denominated debt would be necessary. Retaliation by the EU is possible. However, this is preferred to the “Teutonic vs Latin” two currency scheme that some have recommended—which would simply tie, say, Greece to another external currency. It would have no more fiscal or monetary policy space than it now has, albeit with a currency that would be devalued relative to the euro.

If dissolution is not chosen, then the only real solution is to reformulate the EMU. Many critics of the EMU have long blamed the ECB for sluggish growth, especially on the periphery. The argument is that it kept interest rates too high for full employment to be achieved. I have always thought that was wrong—not because lower interest rates are undesirable, but because even with the best-run central bank, the real problem in the set-up was fiscal policy constraints. Indeed, in a paper several years ago, Claudio Sardoni and I demonstrated that the ECB’s policy was not significantly tighter than the Fed’s—but US economic performance was consistently better. (Read it here.)

The difference was fiscal policy—with Washington commanding a budget that was more than 20% of GDP, and usually running a budget deficit of several percent of GDP. By contrast, the EU Parliament’s budget was less than 1% of GDP. While individual nations tried to fill the gap with deficits by their own governments, these created the problems we see today—as the chickens came home to roost, so to speak.

The problem was that as deficits and debt rose, markets reacted by increasing interest rates—recognizing that unlike a sovereign country like the US, Japan, or the UK, the EMU members were users of an external currency. As I argued previously, they were more like a US state. On one hand, they could run much bigger deficits than US states (all but two of which are constrained by constitutions to balance their budgets)—in part due to the expectation that if things went bad, the ECB would probably help their state central banks. But on the other, US states have Washington to provide fiscal relief—something EMU members did not have. At best, they could borrow euros—from European institutions or from the IMF. But borrowing would just increase interest rates—bringing on the vicious debt trap. To some extent America avoids this as markets force balanced budgets on states and Washington eases the pain with fiscal transfers. As a result a larger percent of EMU national deficits went to interest payments which may not be the best stimulus as much leaks out to foreign holders of the debt.

Once the EMU weakness is understood, it is not hard to see the solutions. These range from ramping up fiscal policy space of the EU parliament—say, increasing its budget to 15% of GDP with a capacity to issue debt. Whether the spending decisions should be centralized is a political matter—funds could simply be transferred to individual states on a per capita basis.

It can also be done by the ECB: change the rules so that the ECB can buy, say, an amount equal to a maximum of 6% of Euroland GDP each year in the form of government debt issued by EMU members. As buyer it can set the interest rate—it might be best to mandate that at the ECB’s overnight interest rate target or some mark-up above the target. Again, the allocation would be on a percapita basis across the members. Note that this is similar to the blue bond, red bond proposal I discussed a couple of weeks ago. Individual members could continue to also issue bonds to markets, so they could exceed the debt issue that is bought by the ECB—much as US states do issue bonds.

One can conceive of variations on this theme, such as creation of some EMU-wide funding authority backed by the ECB that issues debt to buy government debt from individual nations—again, along the lines of the blue bond proposal. What is essential, however, is that the backing comes from the center—the ECB or the EU stands behind the debt. That will keep interest rates low, removing “market discipline” and vicious debt cycles due to exploding interest rates. With lending spread across nations on some formula (ie percapita) every member should get the same interest rate.

All of these are technically simple and economically sound proposals. They are politically difficult. The longer the EU waits, the more difficult they become. Crises only increase the forces of disunion or dissolution, increasing the likelihood of eventual divorce and increasing hostility. That in turn forestalls a real solution, which makes the possibility of a Great Depression “2.0”—a combination of a downturn plus Fisher debt deflation dynamics–ever more probable.

I won’t repeat here my argument that US banks are also toast—hit by the gathering storm of the bursting of the commodities and equities bubbles, the continuing decline of US real estate, and the tidal wave of law suits and settlements against all the fraud committed by the banksters.

All that means that “money manager capitalism” is doomed. We only need to decide on the endgame we prefer.