Monday, November 07, 2011

End of the euro, Monday edition (on the wonky side)

Paul Krguman is on a roll this morning with arguments and links. You can access his columns and blog posts via his Twitter page without being blocked by the New York Times' non-subscribers limit.

In Wishful Thinking And The Road To Eurogeddon 11/07/2011, he provides information and links for his evaluation of the terrible record of the EU in dealing with the eurozone debt crisis: "The result is a eurozone headed for recession, and one in which a breakup of the euro itself is looking ever more possible."

No one can easily what the effects of a euro breakup will be. Largely because neither the public nor the regulators know the extent to which European banks directly vulnerable to eurozone sovereign defaults are interlinked with other banks, including American ones, through derivatives like credit default swaps (CFS). We've already seen one major bankruptcy of an American firm, Jon Corzine's MF Global, as a result of bad bets on eurozone debt combined with reckless levels of leverage. The Obama Administration publicly calls the threat of new European recession - which would take place in the midst of the longer depression period we're experiencing - a danger to the US economy.

Krugman points to an analysis by Gavyn Davies, The eurozone decouples from the world Financial Times 11/06/2011, who offers this gloomy observation:

A less optimistic way of summarising recent news is to say that Europe has now decoupled from the rest of the world. It is already in recession, which may prove to be a deep one, and the debt crisis is arguably getting worse, not better.
His analysis veers into wonkier territory than the average news article, specifically having to do with the current account balances among countries within the eurozone, a separate matter from the current account balance of the eurozone taken as a whole.

The common currency unites the economies of the participants in particular ways that go beyond free trade arrangements. Skipping some of the wonky pieces of the argument, Davies argues that for the austerity policies of the EU to work, the result would have to be capital transfers occurring between the wealthier eurozone countries and the periphery countries like Greece and Spain:

Viewed in this light, it is clear that there needs to be a capital account transfer each year amounting to about 5 per cent of German GDP from the core to the periphery. Without that, the euro will break up. Until 2008, this transfer happened voluntarily, by private sector flows, mainly in the form of bank purchases of higher yielding sovereign bonds in the peripheries, and to a lesser extent via asset purchases (notably housing in Spain). Since 2008, these private flows have dried up, and in fact reversed, so the public sector has had to step in. It has done so in the form of direct sovereign loans, and more importantly by international transfers which have been heavily disguised within the balance sheet of the ECB. Although disguised, these transfers are very real.
Under current approaches, this would have to happen by severe reductions in prices and salaries, both public and private, in the periphery countries. And while that may look benignly neutral on an economist's chart, the actual economic result would be (and already is!) a devastating economic blow to those countries and their people. As Davies writes:

The eurozone’s proposed solution to this problem – budget contraction plus economic reform in the debtor nations, with no change in policy in the creditor nations – is very familiar to students of balance of payments crises in fixed exchange rate systems such as the Gold Standard or the Bretton Woods system in the past. It is not impossible for these solutions to work, but they are very contractionary for economic activity, and very frequently they fail. When they fail, they lead to devaluations by the debtor economies, normally because the required degree of contraction proves politically impossible to undertake. That is where Greece probably finds itself today. Others may be in the same position before too long.
Krugman also points to this New York Times article about the self-delusion that is destroying the euro and perhaps the EU, as well: Landon Thomas Jr. and Stephen Castle, The Denials That Trapped Greece 11/05/2011. As they report, an internal International Monetary Fund (IMF) report in 2009 showed what everyone now knows, "that Greece could no longer pay its bills and needed to cut its debt drastically."

If leaders had agreed earlier to ease Greece’s debt burden and moved faster to protect countries like Italy and Spain — as U.S. officials had been urging since early 2010 — the worst might be behind Europe today, experts say.

Today, Greece’s problems have worsened so much that they threaten to rip apart the euro and the decade-old 17- country monetary union created within the European Union to manage the prized common currency. An endless series of crisis meetings has pushed Athens into imposing an increasingly strict program of austerity on the Greek public in return for the promise of two major bailouts from more credit-worthy European countries, along with the crucial support of the I.M.F. and the European Central Bank.
They cite the chief economist of Citigroup saying that the writedown on Greek debt may need to be as high as 80%, the first time I've seen that kind of estimate.

"It was quite obvious, by the spring of 2010, that Greek debt could not be paid off," said Richard Portes, a European economics professor at London Business School. "But in good faith, policy makers felt that Greece could grow out of its debt problem. They were wrong."
It was pure Herbert Hoover fantasy economics for EU leaders to assume, on the one hand, that Greece could grow its way out of its debt problem, but on the other hand insist that Greece pursue austerity economics that would and did have the effects of damaging economic growth.

There was also no shortage of denial in Greece itself:

In February 2010, Yanis Varoufakis, a political economist with ties to Mr. Papandreou’s party, suggested publicly that Greece default. He was attacked by the Greek Finance Ministry for spreading what officials there viewed as treasonous notions.

He kept making his arguments, but a year later, after a debate on Greek public television with a government official, Mr. Varoufakis’s once-frequent invitations to speak on Greek state television started to dry up.

"On one of my last appearances," Mr. Varoufakis recalled, ‘‘my television interviewer said to me, ‘Please stop using the word default — it is getting me in lots of trouble.’" ...

By the spring [of 2011], the realization in Greece that it would need another bailout was pushing Mr. Papandreou to consider all options — even the extreme step of leaving the euro, according to one banker who talked with him at the time. But the subject of reducing Greece’s debt, which was on course to swell to more than 180 percent of the annual Greek economic output, was still taboo.
And the current inadequate plan for private banks take a 50% haircut on their holdings of Greek debt depends on voluntary acceptance by the banks, each of which will be wheeling and dealing frantically through their lobbyists to get the best individual deal for themselves:

While the deal reached in late October will require bondholders to accept deeper losses, Europe, Greece and Mr. Dallara continue to insist that the transaction will be voluntary. As a result, there will be no need to activate Greek credit-default swaps, which would add to the complexity and cost. But in the eyes of many debt experts, this is simply another form of denial.

"You have to have a coercive element to make it work," said Mitu Gulati, a sovereign debt expert at Duke University Law School. "To not accept that means you are living in Alice in Wonderland."
Fixing the problem of the euro in a constructive way would have required vision and leadership skills that Nicolas Sarkozy and Angela Merkel very clearly do not have.

But the eurozone debt crisis has represented and astonishing failure of leadership on virtually all sides: debtors and creditors, conservatives and social democrats, bankers and politicians.

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