Re: That EMU Stealth Bailout

See Daniel Davies' comments on my original post, plus this from Whelan at IIEA and this from Storbeck. Via Felix Salmon, who also had this to say.

The upshot is that this appears not to be the stealth bailout that I thought it was, although I have to admit that at this point I'm confused on a few points and will need a bit of time to sort through it all. Also, even if this isn't a stealth bailout I think that's probably a shame. The monetary authorities can do much more to help the Europeriphery, while the fiscal authorities are out of political bullets. So I'd rather have some clandestine bailouts than not.

Some Politics of Debt, Default, and the EMU

Tyler Cowen notes that Irish (and Portuguese and I'd add Spanish) are not yet out of the clear, and writes:

The first country which can, with no shame, credibly threaten to leave the eurozone or outright default can blackmail Brussels and Berlin into further aid, due to fear of contagion effects. Some are arguing that Portugal is already assuming that strategic stance.

Let's try to tease this out a little bit. One of the first rules of bargaining theory is that the side with the best outside options has quite a lot of negotiating leverage. Eric Voeten has looked at this dynamic in the context of international institutions, where there is an asymmetric power distribution among the members. Specifically, he looked at the UNSC and found that the presence of strong outside options makes multilateral agreements more likely, so long as there is some incentive not to exercise them. But, and this is key, Voeten argues that "the first condition for multilateral action is the [most powerful state] be willing to act alone or with close allies" (p. 856). In other words, thinking only about how the PIGS have leverage over Berlin is probably not the best way to go about it.

Which most needs a Euro that includes Ireland, Greece, and Portugal: those countries, or Germany? Well, departure from the Euro (and ensuing debt restructuring/default) will massively impair those countries' abilities to engage international credit markets for a long while to come. Michael Tomz has written about the reputational effects of debt defaults, and it's not pretty. Defaults not only adversely affect countries access to foreign credit in the short-run, thus making austerity inevitable, but these effects persist. In other words, possible EMU defaulters have two choices: austerity with devaluation (which reduces real wealth but boosts competitiveness) but no external finance, or austerity without devaluation but with external finance (in the form of ECB/EFSF plus continued access to bond markets in at least some form). The question is which benefit is greater: access to foreign finance that can help smooth out the pain from austerity, or the shock treatment of devaluation. So far the answer appears to be the former.

What about Germany? Now that it's in a currency union it's better to keep it. The EMU is very good for German exporters. If the union splits, and peripheral European economies devalue, Germany's exports become much more expensive for those economies. Additionally, if some of the weaker members left the Euro the currency's value would likely increase against other international currencies. That, too, would bad for German exports. So Germany has incentives for keeping the EMU intact, and thus fulfills one of Voeten's criteria. On the other hand, Germany would do fine under a narrower Eurozone. The value of EMU membership that accrues to Germany is significant, but limited. There is a price tag that is simply too high for it to pay. That should give Germany quite a lot of leverage in Voeten's framework.

This is where Cowen's mention of contagion could come in. I'm not sure what he means by that; it could be Asia1997-style currency contagion across the PIGS, or it could be the fact that German (and French) banks are heavily exposed to PIGS' debt, so a sovereign default could have large knock-on effects for the financial systems at the core of the Eurozone. From Germany's perspective, the latter is much more salient. It increases the costs associated with a break-up in the EMU, and thus provides incentives to keep the union intact. But these costs, too, are not infinite. At some point it might be easier to bail out the financial sector than to bail out Europe's periphery, especially if domestic polities in the PIGs revolt against austerity or demand better terms from the EFSF.

So Cowen's right: the PIGS have some blackmail room, but only until the German and French banking sectors recapitalize. Meanwhile, Berlin has the nuclear option. If it comes to blows, Germany will end up in far better shape than the PIGS. So given what we know about the ways that powerful states use international institutions to help them achieve their goals, the most likely outcome seems to be either that the PIGS pay up, or that there is an intermediate period where the ECB/EFSF provides some funding to the periphery basically as a stalling tactic, buying time for the banks, and then pulls out the rug. The former seems to describe Ireland, the latter may end up being the story of Greece and Portugal.

Has the ECB's Independence Gone Up or Down?

The question in the title refers to the fact that central bank independence usually refers to the isolation from the political process that a central bank has in setting policy. Traditionally, the ECB has been considered to have a lot of independence. But it has also had a very narrow, strict mandate: to promote price stability in the eurozone. It did not have a mandate to promote full employment. It did not regulate the European banking system. It was not a lender of last resort. So the ECB's freedom to pursue the goal of price stability was very high, but pre-crisis its freedom to pursue other goals was very low. Depends on what you mean by independence.

That's all changed over the past few years. The Financial Times' stupid, self-hurting TOS prevent cutting, which means (among other things) that I've been linking to them a lot less frequently than I used to, but this article is worth highlighting. Who would have thought in 2006 that the ECB would be intervening in bond markets to prop up Portugal's debt auction? Portugal says it does not need a bailout, but this is a bailout. It's just a monetary bailout rather than a fiscal bailout. The ECB intervened so the auction wouldn't fail.

At this point the ECB looks like the main thing holding EMU together. And it's able to do it because, unlike national governments, it doesn't have to face an election following a fiscal transfer to the PIGS. It can just intervene when necessary, serving as the "lender of last resort" that it claims not to be. In other words, its scope of authority has been greatly expanded since the crisis began, without (as far as I know) any new statutory authority being given to it.

The ECB is still not pursuing employment-boosting monetary policies, but by buying the debt of needy countries it is in effect subsidizing fiscal policies that could boost employment. The alternative is austerity, either self-imposed or demanded by the EFSF/IMF, which involves major internal contraction. And while the ECB is not regulating banking sectors, it is doing whatever it can to prevent a banking collapse, especially in Spain. If the ECB hadn't overstepped its official mandate back in 2007-8, there is little question that the entire European banking sector would have melted down by now.

So the ECB is now acting more like that Fed than it had pre-crisis. I would consider that an increase in the ECB's independence, because it can act in more ways to promote the economic well-being on Europe. The difference is that the Fed has a political mandate to act the way it does. The ECB does not. By intervening in bond (and other) markets, the ECB is essentially spreading the credit risk of the eurozone's riskiest governments across the entire union. If this were properly understood in Frankfurt it would be deeply unpopular. Perhaps it is; my thumb isn't enough on the pulse of Euro domestic politics to know.

There are political battles on the horizon in the eurozone. It will be interesting to see the fate of the ECB in the coming years. My guess is that Europe's leaders will see that a stronger, more flexible ECB would make fiscal union less necessary; given that, I expect the ECB to retain its new-found authority, and perhaps get some more. We'll have to see.

Parsing Ireland, Germany, and the Euro

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.

The European Crisis Is About European Politics

Wow. Paul Krugman almost had a Eureka! moment:

A number of commenters have pointed out that unemployment has been falling in Germany over the past few months. Um, yes — but not in the eurozone as a whole. And that is what we’re talking about here, aren’t we? Or is European monetary and fiscal policy to be run solely based on how things are going in one country?

Um, that is exactly what we're talking about here, Professor, where "that" refers to "Who controls monetary and fiscal policy in Europe". That's what all of this is about. Up until now, monetary policy was controlled by one country -- Germany -- and fiscal policy was supposed be to restricted by the Maastricht criteria. But since the Euro isn't an optimal currency area and poorer countries in southern Europe didn't control monetary policy, they had to use rely more on fiscal policy to satisfy domestic demands, which left them all in debt and effectively broke Maastricht. This is what all of this is about.

Somehow Krugman still misses it, tho:

The point is that what amounts to a regional development within an ailing European economy doesn’t signify much.

It does when that region is the one that controls monetary policy for the rest of the Europe.

Does Krugman really not know what this is about? What has he been talking about for the past few months?

Parsing the IMF PIGS Package

Mark Copelovitch writes about Spain and the IMF, and how his own research sheds some light on these issues, in a guest post at Menzie Chinn's place:

As the Fund's largest quota contributors, the "G-5" countries (the US, Germany, Japan, UK, and France) exercise de facto control over IMF lending decisions. At the same time, the G-5 countries are also home to the largest private creditors in global markets, including the world's largest commercial banks. Consequently, G-5 bank exposure heavily influences these governments' preferences over IMF lending policies. In particular, I find that IMF loan size and conditionality vary widely based on the intensity and heterogeneity of G-5 governments' domestic financial ties to a particular borrower country. When private lenders throughout the G-5 countries are highly exposed to a borrower country, G-5 governments collectively have intense preferences and are more likely to approve larger IMF loans with relatively limited conditionality. In contrast, when G-5 private creditors' exposure to a country is smaller or more unevenly distributed, G-5 governments' interests are weaker and less cohesive, and the Fund approves smaller loans with more extensive conditionality. ...

So, what are the implications for a future EU/IMF bailout of Spain (or Portugal, or Ireland)? Despite the heated rhetoric by Angela Merkel, Nicolas Sarkozy, and others about the need for the PIGS to put their own house in order by imposing staunch austerity measures, we are quite likely to see even stronger support for Spain (and Ireland), given its importance for the profitability and solvency of French and German banks. Portugal, in contrast, is likely to fare worse than Greece, given its limited importance for the major eurozone (and G-5) banking sectors. At the same time, we are also likely to see tensions within the IMF over the size and terms of any contribution to future PIGS rescue packages, given that American and Japanese views about the importance of eurozone bailouts are colored by their own, less extensive, financial interests in these countries. Ultimately, whether the "core" countries in the EU and the IMF view a rescue package as a "bailout" or a worthy endeavor depends not only on whether the borrower in question has been "profligate," but also on their own domestic financial interests and the vulnerability of their own commercial banks to a potential financial crisis.

We've covered similar themes for quite some time on this blog (see, e.g., here), and the way in which domestic political constraints influence the actions of international institutions has been a major theme in IPE for quite some time. It's good to see it get more play in bigger outlets. It's too bad to see Tyler Cowen refer to it as "public choice" rather than IPE, but hopefully this sort of analysis will catch on with bigger blogs and other media outlets, and the profile of the discipline will be raised a bit.

Copelovitch's soon-to-be-released book expands on these themes, and certainly appears to be worthwhile reading.

Parsing the Euro Bailout

Well. The much-anticipated Euro bailout plan has been revealed, and it's impressive: just short of $1tn, $625bn of which comes from Euro governments, and the rest from the IMF*. Why so large?

Officials are hoping the size of the program — a total of $957 billion — will signal a “shock and awe” commitment that will be viewed in the same vein as the $700 billion package the United States government provided to help its own ailing financial institutions in 2008.

Yes, that's part of it. But the reason why TARP was so big was so that it wouldn't actually have to be. In other words, the U.S. government hoped that by making an enormous commitment to secure illiquid/insolvent institutions that were susceptible to runs, it would prevent those runs from even occurring, thus saving the actual financial commitment in the long run. To some extent this happened, as only about half of TARP's funds were ever disbursed (even after extending loans to non-financial firms, like the auto makers). I'm sure that Euro governments are hoping for the same thing; if the commitment is perceived as being sincere, then part of the follow-through may become unnecessary.

Euro governments aren't the only ones hoping to instill confidence:

Underscoring the urgency of the situation, President Obama spoke to the German chancellor, Angela Merkel, and the French president, Nicolas Sarkozy, on Sunday about the need for decisive action to restore investor confidence. And in a sign of the spreading anxiety, the United States Federal Reserve, along with the European Central Bank and the central banks of Canada, Britain and Switzerland, announced the establishment of instruments known as swap lines. The swaps are intended to ease pressure on European banks and money markets by providing more liquidity. ...

The actions by the United States represented significant concern that the European crisis could spill over and hinder the American recovery.

Why might that be? Well, who owns all the sovereign debt of Greece and the other PIIGS? Already-weakened banks in the U.S. and Europe. U.S. banks are exposed to European banks to the tune of $3.5tn (yes, trillion), and if Greece or any other countries default, those European banks will go under and take U.S. banks with them. Obviously that can't be allowed to happen. The recent ratings downgrades of Greece's debt have already dealt a blow to banks' capital ratios. A default or restructuring would be devastating.

But this new bailout cash has only been pledged, not actually raised, so here's what I'm going to be watching over the coming days:

In a statement after their meeting, the ministers emphasized that the [funds] would expire after three years and that its use would be strictly dependent on “national constitutional requirements.”

The language most likely reflected the reservations of some governments to providing even more money than is available in bailout packages already approved.

Remember that TARP did not pass the House the first go-round. Europe now has to pass several of them in several different countries. There are strong domestic political pressures in some countries (notably Germany and Britain) to not bail out the PIIGS at all, and it might be very difficult to muster enough domestic support to actually procure this huge level of funds. Perhaps more distressing is the fact that Greece could end up defaulting anyway because of domestic politics there. A lot of national polities have to play ball in order for this to work the way it's supposed to work, and I'm not sure whether that will actually happen.

One thing is clear: one way or another, the eurozone will never again be as it was from 1999-2009. The mandate of the ECB is already shifting, the likelihood that one or more countries will leave the monetary union is still somewhat high, and the rise of economic nationalism throughout the zone indicates that there is less camaraderie than previously thought. Something's gotta give.

*Presumably the IMF funds will also be coming from Euro governments, although I'd be interested to see if that's actually the case. How will voters respond if the U.S. is spending $100bn to bail out Europe? Not well, I imagine.

A Little Light Game Theory (Greek Sovereign Debt Edition)

A few days ago I saw Jeffrey Friedman extend his "Basel thesis" -- in which the risk-weighting scheme in the Basel Accords created the incentive structure that led to the subprime financial crisis -- to Greece's debt crisis:

So why did the bursting of the asset bubble in housing cause a banking crisis, freezing interbank lending and then bank lending into the "real" economy?

Because, according to the Basel thesis, Basel I bank-capital regulations, enhanced in 2001 in the United States by the Recourse Rule, encouraged banks worldwide and especially in the United States to leverage into asset-backed securities, including mortgage-backed securities, that were either government guaranteed (by Fan or Fred) or were privately issued but had an AA or AAA rating. How did the Basel rules encourage this? By giving such securities a 20 percent risk weight.

Translation: An AAA-rated mortgage backed security worth $100 required only $2 in bank capital at the 8 percent Basel rate for adequately capitalized banks. $100 x .08 x .20 (the 20 percent risk weight assigned to asset-backed securities by the Recourse Rule) = $2. By contrast, a commercial loan of $100 required $8 of bank capital, because Basel gave such loans a 100 percent risk weight. $100 x 8 percent x 1.00 = $8. Similarly, a $100 whole mortgage retained by the bank required $4 of capital, because the Basel risk weight for unsecuritized mortgages was 50 percent. With these risk weightings, securitized mortgage-backed debt offered significant capital relief.

Today's FT brings the news that "European financial institutions have $235 billion worth of claims on Greek debt, most of which is thought to be in government bonds." Why do they hold so much Greek government debt? Because the only category of bank asset treated more kindly by the Basel rules than asset-backed securities is government debt, which has a zero risk weight. I.e., no bank capital need be used to buy a government bond.

So today I was interested to read that some major banks are fanning the flames engulfing Greece:

Bets by some of the same banks that helped Greece shroud its mounting debts may actually now be pushing the nation closer to the brink of financial ruin. ...

As Greece’s financial condition has worsened, undermining the euro, the role of Goldman Sachs and other major banks in masking the true extent of the country’s problems has drawn criticism from European leaders. But even before that issue became apparent, a little-known company backed by Goldman, JP Morgan Chase and about a dozen other banks had created an index that enabled market players to bet on whether Greece and other European nations would go bust.

Last September, the company, the Markit Group of London, introduced the iTraxx SovX Western Europe index, which is based on such swaps and let traders gamble on Greece shortly before the crisis. Such derivatives have assumed an outsize role in Europe’s debt crisis, as traders focus on their daily gyrations. ...

A result, some traders say, is a vicious circle. As banks and others rush into these swaps, the cost of insuring Greece’s debt rises. Alarmed by that bearish signal, bond investors then shun Greek bonds, making it harder for the country to borrow. That, in turn, adds to the anxiety — and the whole thing starts over again.

How can we square this circle? If Friedman is right, then banks are highly leveraged in the sovereign debt of Greece (and other countries). Basel rules required a 0% right weight for any OECD sovereign debt, but not all sovereign debt paid the same yield. Some states, like Greece, are relatively more risky than others, like the U.S., but they all had the same risk weight. So banks looking for a bigger profit would plow funds into the riskier countries at a higher interest rate because yields were higher.

Why, then, would many of the same banks now do their best to increase the risk of a Greek default? If that happens, and Friedman is correct that many banks are leveraged to the hilt on Greek debt, then they lose a lot of money. They can't be trading on moral hazard, since if they believed that Greece will eventually be bailed out and their debts made whole they wouldn't waste money purchasing insurance (a.k.a. credit default swaps). So what's going on?

One explanation is that a need for hedging has created the equivalent of a bank run in CDS markets, and this is creating a self-fulfilling prophecy. Another is that this represents a classic Prisoner's Dilemma: in aggregate all banks would be better off if none of them bid up the prices of CDS on Greek debt and thus relaxed the credit constraints on Greece, but each individual bank is incentivized to defect and insure themselves against potential default. Banks in competition against each other cannot credibly commit to cooperate, so (Defect, Defect) is a dominant strategy for all banks exposed to Greek debt. This creates a run, which manifests itself in CDS markets, and leads to a sub-optimal outcome for all involved.

If this is the appropriate model, then there would seemingly be a role for outside players to influence the game. Germany, or the ECB, or the IMF, or even the US could step in and provide financing for Greece to roll over their debt, meet counterparty obligations, and loosen the constraints that Greece faces in credit markets. But this simply raises another Prisoner's Dilemma: how could a third party guarantor be sure that Greece will not defect from that agreement and continue in its fiscal profligacy? Again, the dominant strategy seems to be (Defect, Defect) unless Greece can somehow credibly commit to austerity in order to meet its obligations. Unfortunately, it doesn't appear that they can.

Maybe the EMU should play a Grim Trigger strategy: they'll provide financing for Greece in exchange for austerity. If Greece defects, then the EMU boots Greece out of the monetary union and they're on their own. That threat might be significant enough to escape the Prisoner's Dilemma if it's perceived as being credible.

Or maybe not. It's a mess. As Carlo Bastasin says over at Baseline Scenario: "You cannot imagine really solving the Greek imbalance without – at least somewhat – correcting the German imbalance." Germany does not want to correct its imbalance. So Greece is probably screwed.

(edited for correct attribution, 8:41)

UPDATE: Felix Salmon sees this as a simple hedge. He's probably right.

ECB on Wire

Felix Salmon is worried about the eurozone:

Will Greece be giving up fiscal independence in return for bailout funds or German guarantees? I’m sure it’ll agree to stringent conditions, while claiming that it would have kept to such a plan in any case. The question is what happens when — inevitably — it ends up breaking its fiscal promises, or trying to play silly games to get around them. What will Germany be able to do, in that case, to snap Greece back into line? And do the Germans really want to play the role of Europe’s fiscal disciplinarian in any event?

It probably doesn’t matter: Greece is the Bear Stearns of Europe, seemingly too big to be allowed to falter or default, and therefore it must be bailed out somehow. Of course this sets an important precedent for when Spain and/or Italy find themselves in a similar situation — and it’s likely to make countries like Latvia feel a bit miffed, seeing how much fiscal pain they’ve inflicted on themselves with no bailout to show for it at all. The hazard here is that countries, seeing the Greek precedent, refuse to take tough fiscal steps unless the path is sweetened by Germany and France. This isn’t the end of the euro crisis: it’s only the beginning.

That is one hazard. But there is an opposite hazard as well: one of the primary selling points for eurozone members is that their interests will be well-served by a credible, independent central bank. The past two years, however, have illustrated the downsides of a monetary union that is committed to low inflation above all else. Some states in the eurozone clearly need monetary expansionism and currency depreciation to get their economies back on track, but those policy tools have been removed from them.

If the major states (Germany and France) in the monetary union insist on maintaining the policies that benefit them even if they harm other members, but then also refuse to fulfill the "lender of last resort" obligation of a regional monetary hegemon, then the credibility of the union is called into question. And if the major European states keep pawning off their troubled states onto the IMF, they risk drawing the ire of the U.S., Japan, and other major contributors to the IMF. What would Frankfurt say if the U.S. took IMF funds to bail out California?

So Germany and France must simultaneously reassure member states that they will be well-served by the union when they need it the most, without writing a blank check that could encourage moral hazard. It's a very fine line that the ECB hasn't had to walk before; we'll see in the coming year how good their tightrope act is.

Coulda Seen This One Coming

Rogoff:

But the problem is not only the numbers; it is one of credibility. Thanks to decades of low investment in statistical capacity, no one trusts the Greek government’s figures. Nor does Greece’s default history inspire confidence.

As demonstrated in my recent book with Carmen Reinhart This Time is Different: Eight Centuries of Financial Folly, Greece has been in default roughly one out of every two years since it first gained independence in the nineteenth century.

It's bad:

Most Greeks are taking whatever action they can to avoid the government’s likely insatiable thirst for higher tax revenues, with wealthy individuals shifting money abroad and ordinary people migrating to the underground economy. Greece’s underground economy, estimated to be as large as 30% of GDP, is already one of Europe’s biggest, and it is growing by the day.

In the case of Argentina, a pair of massive IMF loans in 2000 and 2001 ultimately only delayed the inevitable harsh adjustment, and made the country’s ultimate default even more traumatic. Like Argentina, Greece has a fixed exchange rate, a long history of fiscal deficits, and an even longer history of sovereign defaults. Nevertheless, Greece can avoid an Argentine-style meltdown, but it needs to engage in far more determined adjustment.

One might think that the socialist government would not have the political will to make the necessary adjustments. And they might not. But there is some literature showing that left parties are more able to push through adjustment programs than right parties, precisely because it runs against their ideology: it's a costly signal with a high degree of credibility behind it.

To me the most interesting thing is not the potential for default; as Rogoff says, this is common even in Greece. What interests me is to see the interplay between the Greek government, the EU, and the IMF. The IMF seems ready and willing to jump in, but the EU wants to maintain credibility. At the same time, the EU doesn't want to create moral hazard, so they favor internal adjustment over a bailout, and are pressuring the Greek government to enact those policies. As Edward Hugh says, the EU is acting like a "local 'mini-IMF'" towards Greece after not having done the same with Hungary, Latvia, and Romania.

The roles of supranational and international institutions may be changing in important ways. This is worth keeping an eye on.

Is Greece Too Big to Fail?

We've talked about the dire situation in Greece here before, and now the situation has come to a head: Greece has chosen austerity, much to pleasure of EU officials and displeasure of Greeks, who begun massive strikes. Whenever I hear about a macroeconomic development in the EU, I turn to the indispensable A Fistful of Euros for comment. Edward Hugh doesn't disappoint:

[Public statements from EU officials] have been widely interpreted in the international press as a “no” from Germany and France to any EU bailout of Greece. But is this interpretation justified? Before going further, I think it should be pointed out that the whole argument depends on what you consider a bailout to be. If you take the view that a bailout involves a restructuring of Greek Sovereign Debt, with the EU itself offering to pay a part, then this is clearly not on the cards, at least at this point, and let’s take things a day at a time. But if you consider the “bailout” which is under consideration at the present time to be simply a loan, which in some way shape or form (yet to be determined) would be guaranteed by the EU institutionally, and would thus be available at a cheaper rate of interest than the one the markets are currently charging, then it is hard to see how British or German taxpayers would be having to finance anything, except in the unikely event that Greece were unable to repay.

In other words, the EU is now facing a situation with the sovereign debt of its member states somewhat similar to what the US Treasury and Fed faced with American banks in late 2008: they don't want to fully bail them out and thus exacerbate the moral hazard already in the system, but they also don't want to let them fail and spread contagion throughout the system. Like the US banking "bailouts", there is reason to think that both fates can be avoided by extending credit at attractive rates to cover a short-term liquidity crunch, and that this can be done at limited taxpayer cost (or even potential profit).

But unlike the US Treasury and Fed, the EU seems to be holding out for its pound of flesh: austerity measures, or no funding. Normally this is the purview of the IMF, and that organization is waiting in the wings:

“The IMF stands ready to support Greece in any way we can,” Mr Lipsky said. “It is a matter for the Greek authorities to decide, in collaboration with the European Union, but we are here to help if we are wanted.”

But the ECB seems to want to keep this in-house, perhaps in an attempt to shore up the credibility of the union and forestall the possibility of contagion: if Greece can't get its house in order, then other troubled eurozone economies like the other PIGS (Portugal, Italy, Greece, Spain, to which we can maybe add Ireland) may find their costs of borrowing rise, making it more difficult to service their debts. The ECB is quite rightly concerned about the integrity of the union. The Greek debt crisis may have far-reaching ramifications for European politics.