It has long been said that the eurozone faced a choice in this crisis between coming together – and breaking apart. At the end of last year, Chancellor Merkel and President Sarkozy said emphatically that they would hold it together. But in practice they have continued the previous strategy of attempting to muddle through.
What has happened in the past week or so is that it has become clear – to the IMF, to the Obama administration, and to many other interested parties – that the muddle-through option is not viable. Worse that that, it is counterproductive.
Why? Because in the process of muddling through you create so much uncertainty you actively cause the contagion you’re trying to prevent.
I agree with that assessment. My argument has been that the extend and pretend route to prevent contagion doesn’t work. The contagion is already all around and no one has defaulted yet. Indeed, it is precisely because Greece has not defaulted that there is contagion to begin with. People want to know who is insolvent and who isn’t. Once they do know, the creditors writ large i.e. holders of bank debt, depositors, and taxpayers, can fight over how to apportion the losses.
At this point in the crisis, the ECB is the difference. Only the ECB has the liquidity necessary to prevent yields from rising and creating a doom loop of negative growth expectations, rising yields, and budget cuts. If Europe is to survive, it first needs to tackle the liquidity crisis and only the ECB can do this by buying euro zone bonds in the secondary market.
However, this is not just a liquidity crisis, it is a solvency crisis and we need to see differential treatment of solvent and insolvent debtors as soon as possible to overcome the lingering doubt that created the liquidity crisis in the first place. After making this distinction, the euro zone can move forward with the institutional structures to support a single currency.
Gavyn Davies suggests the following:
some of today’s problems are beset by genuinely intractable elements which any generation of Europe’s leaders might have struggled to resolve. These all come down to one central fact: the eurozone is not a single nation state, yet it has some of the elements and institutions of a nation state. It is a halfway house, and therein lies the problem.
Imagine what would happen if the eurozone were a genuine single nation. The debt issued by that nation would of course be backed by the taxpayers of the entire union, and sitting behind them would be a mighty central bank, the ECB. Viewed as a single nation, the public accounts of the eurozone (EZ) would look very good. The EZ public debt ratio would be 88 per cent of gross domestic product, compared with 99 per cent for the US. The EZ budget deficit would be 4.4 per cent, compared to 10.8 per cent in the US. In other words, if the EZ were a nation state, sovereign default would be inconceivable, and bond yields would be around 3 per cent.
Surely, then, the solution to the European debt problem is fairly straightforward. Why not just create pan-European organisations which are backed by the entire EZ, and have them absorb all of the debt issued by the weaker sovereigns such as Greece? Many economic commentators have proposed mechanisms which would do precisely that.
The only problem is that those countries, such as Germany, which would have to foot the bill for a budget sharing plan (or a fiscal transfer union, or a eurozone bond issue, which are all variations on the same theme) show no appetite for sanctioning such action on the scale needed to solve the problem.
The Germans will never have any appetite for a transfer union. You may hear pro-European noises coming from Germany’s old guard including former Chancellor Kohl, but it is clear that these people are not talking about fiscal union. They are talking about cross-border financial regulation or bailouts via a European Monetary Fund that ensures adherence to the existing stability and growth pact. No Eurobonds, no central treasury, no transfer union. Nein.
Only when all other options have failed and the euro is about to break apart will any of these ideas be entertained by German policy makers. As I have argued on two occasions, that’s the psychology of change and the political economy of large, hierarchical systems like corporations or nation states.
I believe the sovereign debt crisis will deteriorate further for just this reason. And then we will just have to see what the politics of the individual countries in Euroland look like. If austerity brings the economy to a crawl and europopulism is well advanced, the euro will collapse. If not, the Europeans will push forward with greater integration.