Tuesday, May 15, 2012

Krugman on the euro: "months, not years"

Paul Krugman is speculating on the shape of the Eurodämmerung, also the title of a chapter in his new book. Here is the new scenario he expects to play out in "months, not years":

1. Greek euro exit, very possibly next month.

2. Huge withdrawals from Spanish and Italian banks, as depositors try to move their money to Germany.

3a. Maybe, just possibly, de facto controls, with banks forbidden to transfer deposits out of country and limits on cash withdrawals.

3b. Alternatively, or maybe in tandem, huge draws on ECB credit to keep the banks from collapsing.

4a. Germany has a choice. Accept huge indirect public claims on Italy and Spain, plus a drastic revision of strategy — basically, to give Spain in particular any hope you need both guarantees on its debt to hold borrowing costs down and a higher eurozone inflation target to make relative price adjustment possible; or:

4b. End of the euro.
Nobody knows exactly what will happen when one country bolts from the euro, of course. The uncertainty is compounded by the lack of national and international transparency on the credit default swaps (CDS) held by banks. These are financial derivatives meant to act as insurance policies on risky loans like, say, Greek or Spanish bonds. When a country defaults - Greece looks like the most likely candidate at the moment, though it could be Portugal or Spain - those CDS start triggering. Depending on how many they are and how well the banks have built up reserves to cover losses, it could have a major effect internationally, and not just within the eurozone or the EU.


Martin Feldstein, who was Chairman of Reagan's the Council of Economic Advisers 1982-84, isn't one of my favorite economists. But he has a worthwhile article speculating on what would happen when the euro ends, "The Failure of the Euro: The Little Currency That Couldn't" Foreign Affairs Jan/Feb 2012. Taking the case of a unilateral Greek exit from the euro, he writes:

Here is how that might work: although Greece cannot create the euros it needs to pay civil servants and make transfer payments, the Greek government could start creating new drachmas and declare that all contracts under Greek law, including salaries and shop prices, are payable in that currency; similarly, all bank deposits and bank loans would be payable in these new drachmas instead of euros.

The value of the new drachma would fall relative to the euro, automatically reducing real wages and increasing Greek competiveness without requiring Greece to go through a long and painful period of high unemployment. Instead, the lower value of the Greek currency would stimulate exports and a shift from imports to domestic goods and services. This would boost Greek GDP growth and employment.

Withdrawing from the eurozone would of course be difficult and potentially painful. The announcement that Greece was leaving the eurozone would have to come as a surprise-otherwise, a bank run would be likely, as Greek depositors would have the time to move their euro-denominated funds to banks outside Greece or to withdraw them and hold euros in cash. Since some flight of deposits from Greek banks is already happening, Athens would have to act before this became a flood of withdrawals.
Other risks he names for such an event are: Greece could be forced to leave the EU; and, there will be legal disputes public and private over whether loans made to Greek institutions in euros can be paid back in drachmas.

But based on faith in austerity economics otherwise, he thinks a Greek euro exit would be a relatively minor event for other euro countries:

Looking ahead, the eurozone is likely to continue with almost all its current members. The challenge now will be to change the economic behavior of those countries. Formal constitutionally mandated balanced-budget rules of the type recently adopted by Germany, Italy, and Spain would, if actually implemented, put each country's national debt on a path to a sustainable level. New policies must avoid current account deficits in the future by limiting the volume of national imports to amounts that can be financed with export earnings and direct foreign investment. Such measures should make it possible to sustain the euro without future crises and without the fiscal transfers that are now creating tensions within Europe.
The idea that anything like the current eurozone can be maintained through the magic of balanced budgets without making the eurozone a genuine transfer union is very unrealistic.

But Feldstein does give a good description of how algebra works against Greece in their current financial trap imposed by Angie and the EU:

To achieve a sustainable path, Greece must start reducing the ratio of its national debt to GDP.This will be virtually impossible as long as Greece's real GDPis declining. Basic budget arithmetic implies that even if Greece's real GDPstarts growing at two percent (up from the current seven percent real rate of decline) and inflation is at the ECB target of two percent, the deficit must still not exceed six percent of GDPif the debt ratio is to stop increasing. Since the interest alone on the debt is now about six percent of GDP,the rest of the Greek budget must be brought into balance from its current three percent deficit.

Cutting the interest bill in half and simultaneously balancing the rest of the budget would reduce the ratio only very slowly, from 150 percent now to 145 percent after a year, even if no payments to bank depositors and other creditors were required. It is not clear that financial markets will wait while Greece walks along this fiscal tightrope to a sustainable debt ratio well below 100 percent.
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