Thought du Jour

NYU economist Nouriel Roubini describes four options for the eurozone in this time of crisis.

Symmetrical reflation [the first and best option] … implies significant easing of monetary policy by the European Central Bank; provision of unlimited lender-of-last-resort support to illiquid but potentially solvent economies; a sharp depreciation of the euro, which would turn current-account deficits into surpluses; and fiscal stimulus in the core if the periphery is forced into austerity.

Unfortunately, Germany and the ECB oppose this option, owing to the prospect of a temporary dose of modestly higher inflation in the core relative to the periphery.

The bitter medicine that Germany and the ECB want to impose on the periphery – the second option – is recessionary deflation: fiscal austerity, structural reforms to boost productivity growth and reduce unit labor costs, and real depreciation via price adjustment, as opposed to nominal exchange-rate adjustment. ….

If the peripheral countries remain mired in a deflationary trap of high debt, falling output, weak competitiveness, and structural external deficits, eventually they will be tempted by a third option: default and exit from the eurozone. This would enable them to revive economic growth and competitiveness through a depreciation of new national currencies.

Of course, such a disorderly eurozone break-up would be as severe a shock as the collapse of Lehman Brothers in 2008, if not worse. Avoiding it would compel the eurozone’s core economies to embrace the fourth and final option: bribing the periphery to remain in a low-growth uncompetitive state. This would require accepting massive losses on public and private debt, as well as enormous transfer payments that boost the periphery’s income while its output stagnates.

Italy has done something similar for decades, with its northern regions subsidizing the poorer Mezzogiorno. But such permanent fiscal transfers are politically impossible in the eurozone, where Germans are Germans and Greeks are Greeks.

Nouriel Roubini, “Down with the Eurozone“, Project Syndicate, 11 November 2011.

Roubini predicts that the third option will prevail and “eventually lead to the eurozone’s disintegration”.

NYU economist Nouriel Roubini is worried that there is no credible lender of last resort in the eurozone, so Italy may have to leave the monetary union, triggering its break-up.

With interest rates on its sovereign debt surging well above seven per cent, there is a rising risk that Italy may soon lose market access. … [A] forced restructuring of its public debt … would not resolve its “flow” problem, a large current account deficit, lack of external competitiveness and a worsening plunge in gross domestic product and economic activity.

… [L]ike other periphery countries, [Italy may] need to exit the monetary union and go back to a national currency, thus triggering an effective break-up of the eurozone.

Until recently the argument was being made that Italy and Spain, unlike the clearly insolvent Greece, were illiquid but solvent given austerity and reforms. But once a country that is illiquid loses its market credibility, it takes time – usually a year or so – to restore such credibility with appropriate policy actions. Therefore unless there is a lender of last resort that can buy the sovereign debt while credibility is not yet restored, an illiquid but solvent sovereign may turn out insolvent. In this scenario sceptical investors will push the sovereign spreads to a level where it either loses access to the markets or where the debt dynamic becomes unsustainable.

Nouriel Roubini, “Why Italy’s days in the eurozone may be numbered“, The A-List, Financial Times, 10 November 2011.

Martin Wolf, like NYU economist Nouriel Roubini, thinks that Greece should default on payment of its sovereign debt. But – unlike Roubini – he wants Greece to retain the euro, because exit would reintroduce currency risk into the eurozone. The benefits of currency union, after all, come from elimination of currency risk, and this happens only when entry is irrevocable.

Greece has both a huge current account deficit and a depressed economy. A big real depreciation is required. It is far easier to achieve this via currency depreciation than cost deflation.

Yet the idea of exit is also vastly difficult to implement. Legally, it would require the country to leave the European Union. Would the latter then take the trouble of inviting the malefactor back in? Unlikely. The country would, as a result, probably be excluded from the single market, too. ….

[O]nce one country has exited, currency risk would be even more real for every other vulnerable country, including even Italy and Spain. Neither governments nor corporates in such countries could easily sell their debts. Banks would experience runs. The ECB would be forced to lend without limit. ….

Exit, then, even of a small weak country, is scary.

Martin Wolf, “Why breaking up is so hard to do“, Financial Times, 21 September 2011.

Martin’s arguments are compelling, but I am not convinced that Greece should keep the euro. Exit, indeed, is scary. But so is retaining the euro.

If Greece defaults without the ability to devalue its currency, it will remain uncompetitive, with high unemployment and the social unrest that this implies. Martin mentions the need for “aggressive economic expansion at the core, not least via immediate loosening of ECB monetary policy”, but this alone will not be sufficient. ** If Greece is not to implode, it will require help for a very long time, until cost deflation (falling wages) makes Greek workers competitive with those of EU partners. My fear is that this could be forever, with large numbers of unemployed workers continuing to live on the dole. In addition, there is the problem that cost deflation, unlike currency depreciation, increases the real value of private debt.

Greece must either stick with the euro, or exit. Each option has costs. If Greece keeps the euro, some costs will fall directly on other eurozone countries, which will have to transfer large sums to the Greek government. If Greece exits, eurozone countries could suffer indirect costs from the reintroduction of currency risk, with consequent bank runs and higher interest rates.

The costs of the two options differ, not least because they fall on different countries. The first option – retaining the euro – imposes direct costs on taxpayers in the strong core, including Germany, Austria and the Netherlands, who will pay much of the bill for supporting unemployed Greek workers. The second option – exit from the euro – imposes indirect costs on weak countries like Portugal, Spain and Italy, which could suffer currency risk as a result of contagion.

Martin thinks also that the exit option necessarily means exclusion of Greece from the European Union’s single market. I don’t agree. I fail to see why Greece with its drachma would not be allowed to participate in the EU, just as the UK and others with national currencies are allowed to participate.

I am not sure which of the two options is best, but either is preferable to preventing default by bailing out the Greek government – for example, by transforming its debt into euro bonds backed collectively by all eurozone governments. On this point Martin Wolf, Nouriel Roubini and I are in full agreement.

** Update (25 September): On further thought, Martin has a point. It is possible that sufficiently loose ECB monetary policy could allow Greece to become competitive without deflation. If the eurozone core inflates, say, at 4% or more a year, Greece could then become more competitive without deflation, simply by inflating at a lower rate, say 2% a year. But the core will never permit such a large inflation of prices, so this will not happen.

In most European Union countries, including Germany, the euro was introduced without securing the direct assent of voters. It was assumed that voters would learn to love their new currency, when they saw that it led to a more prosperous and powerful Europe. But now that the single currency is instead associated with pain, austerity and debt, the limits to European solidarity are clear.

So when Angela Merkel, the German chancellor, rules out “eurobonds” (debt issues backed by all nations using the euro), she is not being unimaginative or miserly. She simply knows German voters will never accept underwriting the debts of southern Europe on a permanent basis. The voters of Finland and the Netherlands – the other northern European creditor nations – are more hardline than the Germans in their rejection of this notion. Meanwhile, anger against the flinty and self-righteous northern Europeans is mounting in austerity-hit nations such as Greece, Portugal, Spain and Italy. ….

There is another possibility that might work, however. I have always believed that steps towards deeper European unity work best when they are technical-sounding, hard to understand and not subject to the approval of voters. The European Central Bank’s current programme to buy Greek, Italian and Spanish bonds – as endorsed by my colleague Martin Wolf last week – meets this description perfectly. But there is a problem. Germany is that rare country where central banking actually arouses deep political passions.

Gideon Rachman, “The single currency’s true fatal flaw“, Financial Times, 20 September 2011.

Journalist Gideon Rachman (born 1963) has been chief foreign affairs columnist at the Financial Times since July 2006. He joined the FT after a 15-year career at The Economist.

In December 2008, Rachman published a controversial blog post at FT.com with the title “And now for a world government“. Texas radio host Alex Jones (born 1974) has referred to this as proof of a plot to establish global governance and deprive Americans of their freedom.