Tuesday, December 7, 2010

Parsing Ireland, Germany, and the Euro

. Tuesday, December 7, 2010

Here's how Tyler Cowen sees it:

My model here is simple. The Germans fear that if Ireland pulls the plug on the bailout deal, some of the other PBIIGS will meet immediate financial crises, and that spills over onto both German lending banks and Germany as the country holding the eurozone together. Ireland feels that if it pulls the plug on the bailout deal, the Germans don't lend enough support and a) they lose what's left of their banking system, and b) their next government bond auction goes very, very badly.

Here's the most recent news:

Despite rising pressure for new measures to draw a line under the debt crisis, Germany moved Monday to close off debate on an increase to a 750 billion euro bailout fund, or the more radical step of issuing common euro-zone bonds. ...

European diplomats say privately that there has been a debate in recent days on whether to increase the fund to make it clear that a big economy like Spain could be defended, if needed. But many believe that the public mood in Germany makes such a move politically impossible for Mrs. Merkel, unless it was presented as a last-ditch effort to save the euro itself.

“It is a last-resort mechanism,” said a European official who was not authorized to speak publicly. “We still have enough money for Portugal, if needed, and Spain is not drowning. There is also the question of whether this would send the right signal to the market. It might be misinterpreted as suggesting that there was more to come.”

Right now the domestic political equilibrium in Germany seems to be "We like regional integration but not being the PIIGS' sugardaddy. Greece was one thing, but Ireland, Portugal, Spain, and Italy are quite another. We can go back to the mark without too much problem. We'll have to bail out our banks, but that's cheaper than bailing out all of the PIIGS. If the PIIGS won't commit to austerity in order to make our banks whole, then we're not footing the bill. It's insane and immoral that we should be forced to pay for bad governance in the Euro's periphery." This is a reasonable and even right perspective.

The political equilibrium in Ireland seems to be "It is insane and immoral that we should be forced to pay off the bad bets of foreign bankers while they are made whole. Our government made a huge mistake in guaranteeing those foreign bets, thinking that a strong guarantee would never actually be called, but now it is being called and we're not paying. Any Irish government that wishes to pay will be removed from power immediately. We'd rather be Iceland than the alternative." This is also a reasonable and right perspective.

I have less information about attitudes in Portugal, Spain, and Italy, but if I were a citizen of one of those countries I'd be very hesitant to engage in austerity before it is clear what the outcome will be in other countries. If the Euro is going to break up or contract, why go through the pain? Just wait, then default and/or devalue.

Everybody in this equation -- Germany and the PIIGS -- have strong incentives to defect even if cooperation would yield a better outcome. And it's not even clear that it would. Those who gain the most from the Euro while contributing the least -- Belgium, Luxembourg, France, etc. -- are the ones pushing the hardest for cooperation.

I don't think it is very accurate to describe things this way (from the article):

Germany, once the driving force behind European integration, now has to placate public opinion, which is openly hostile to measures that could require Germany to pick up more of the tab for weaker economies.

This was always a concern, hence Maastricht. Now that it's clear that Maastricht is meaningless, German fears have been fully realized. As far as Germany is concerned, they've already donated billions of euros plus sacrificed the integrity of their central bank to peripheral economies that may or may not ever get their house in order. There is now discussion about moving to a fiscal union. Germany rightly recognizes that continued bailouts is a de facto fiscal union already. They don't want that. Why would they?

Germany isn't interested in sharing its credit rating either, and no wonder. Who in their right mind would co-sign for the PIIGS right now?

Mrs. Merkel has rejected a separate call from Luxembourg and Italy to create a common euro-zone bond. Such a move would not be permitted under the European Union’s governing treaty, she said. Creating the legal possibility to issue euro-zone bonds, German officials suggest, would require a substantial rewriting of the European Union treaty, something most countries would be unwilling to do because it could require referendums in several countries where it lacked enough support.

The question is now: how much is the Euro worth to Germany? How much is it worth to the PIIGS? Will Germany continue to add hundreds of billions of euros to the tab? Will the PIIGS enact and enforce the sort of austerity that Germany will need to see to keep the price down? Is there any way to ensure that this won't be a recurring feature of the monetary union?

Here's what will happen when one or several countries leave the union. Here's Barry Eichengreen going off. Here's a post asking IPE scholars to step up to the plate. Here's a very good discussion of the economics and politics of the situation, including a reference to Beth Simmons' book on the politics of adjustment during the interwar gold standard years, and this quote from Kindleberger:

[W]hether deflation and unemployment would saddle a major share of the load on the working class, as contrasted with the rentier. ... Keynes observed in 1922 that the choice between inflation and deflation comes down to the agonizing outcome of a struggle among interest groups.

I would note that during the interwar years not all of Europe were democracies; nevertheless, everyone left the gold standard eventually. The working classes have certainly gained bargaining power since then.

At this point, I think the IMF needs to prepare to lend currency to the PIIGS following a break-up of the Euro. That might not happen, but they need to be ready for it if it does, and those countries will need access to foreign exchange. The IMF needs to have a program of organized devaluation + writedowns ready in that case.

Many in the U.S. are quick to point out the lessons from Europe regarding debt. They should also note the lessons regarding currency. An inflexible currency leads to all kinds of other problems, including the ability to manage debt. This should be a warning to all those who want the U.S. to go back to a gold standard now, or to abolish the Fed in favor of a fixed monetary policy.


Emmanuel said...

The euro is an inflexible currency, eh? While I take it that you mean member states cannot change the nominal exchange rate in a currency union, the phrasing is suspect.

Parsing Ireland, Germany, and the Euro
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