Saving the EurozonePosted: October 26, 2011
Martin Wolf’s latest column strongly encourages Mario Draghi, the incoming president of the European Central Bank, to do the unpopular but correct things in Europe to save it (and the world) from another severe crisis (are we out of the last one?). He makes a compelling case, as always, but after seeing events in the Eurozone unfold over the past 2 years, I feel incredibly doubtful that European policymakers will be up to the task. The hope is that the pending situation will become so terrible and the pressure to take the drastic and correct action so immense, that they will finally act in the last hour. That this is the last real hope for success is staggering. One feels the bureaucrats, the elite and the elected failing miserably in their jobs for no good reason except adherence to some old orthodoxy that has clearly been proven wrong over the past years.
What bothers me the most is that the EFSF seems inadequate, and no fine-tuning (half a trillion here, half a trillion there) seems likely to really solve the problem. Why? The main source of the money will likely come from Germany and France. And France’s ability to contribute to the fund without bringing itself into the coterie of countries needing a bailout seems like a realistic question many are asking right now. So while in theory a 2 trillion-dollar fund would take care of the countries in need, the fact that it is backed by countries who may potentially find themselves in need is not likely to convince the private sector. I find it highly unlikely that Germany will then choose to bail out the rest of the Eurozone (or that it could if it wanted to).
What really needs to be done, as Wolf points out, is for the ECB to step in. Months ago when Spanish and Italian yields were rising, they stepped in and started to purchase the sovereign debt. The results were perplexing: yields fell (good), and many central bankers and policy makers in the area called foul (huh?). It is difficult to gauge just how serious these people are in their willingness to take the Eurozone to the brink in this made-up morality play.
I have found myself thinking about what the ECB can do. Martin Wolf covers this, but I wanted to explore it further. It strikes me as similar to a situation (slightly unrelated but telling) in which the Switzerland National Bank intervened with the necessary force and solved its problems. Several months ago, as a result of a general flight to quality, the Swiss Franc had appreciated to levels that seemed dangerously high (difficult for manufacturers/exporters, and increasing deflationary pressures as imports fall in prices). The Swiss National Bank then committed to cap the value, stating that it “is prepared to buy foreign currency in unlimited quantities.”
The bank announced a policy and committed itself to it. And the results were incredible. They said they wouldn’t allow the value to fall below 1.20 Euros / Swiss Franc on September 6. See the results:
The idea with the ECB buying government bonds in this situation has to be considered similar in some respects. The ECB doesn’t need to announce a specific yield for Spanish and Italian bonds, nor should they. But there are clearly yields which make default much more likely (6, 7 percent) vs. rates that allow the governments to borrow (3-4 percent). Some sweet spot like a spread over German bonds seems like a good idea. But what’s more important is that the ECB commit to doing whatever it takes. This is difficult for many of the elite to accept, yet it is the right course of path. Moreover, if it is a real and credible commitment, this will directly effect expectations of government bond yields. Buying government bonds in Spain and Italy will suddenly seem safer when you have the central bank stepping in to make sure the rates don’t go into certain territories, and the risk of default effectively falls. The ECB would then commence purchasing bonds until its objectives were achieved, and then be ready again to step in lest anyone doubt its commitment. This is how you save the Euro.
Martin Wolf points out that austerity now does not help. It has not helped in Greece nor anywhere else in this depressed world economy. As Richard Koo aptly points out in his books on balance-sheet recessions, for the government to cut spending while households and corporations are doing the same is economic suicide. In the Eurozone, we have a monetary union where there is, as of right now, no exchange rate mechanism and no central banking mechanism to prevent a catastrophe. The ECB has to step in. The EFSF will not be up for the task.
Martin Wolf answers the three main objections, but I will summarize them briefly.
- The Central Bank may lose money: Who cares, and they probably won’t lose much if they make a real commitment to doing what needs to be done, and if they lose some money, who cares, as otherwise the Eurozone will be doomed and many more people will be losing much more money.
- It may exacerbate moral hazard: The Euro is on the verge of collapse, and the main countries under threat right now are Spain and Italy, which under normal circumstances with their own currencies, would have no trouble getting the necessary funding and making credible commitments to policies that would stabilize and lower debt/GDP in the long-term. But again, at this point, who cares about moral hazard at a time like this?
- It may stoke inflation: Good/Who cares. When the problem is an asymmetry in competitiveness in the Eurozone countries, and there are severe debt overhang problems, more inflation is good. And again, who cares when the Euro is on the verge of collapse if the inflation rates is 4-5% rather than 2%?
The answer is “Who cares?” to every single concern. This is the situation we find ourselves in. The solution seems simple but unpopular given the intransigence of the Very Serious People (a Krugman term).