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FT.com: Intolerable choices for the eurozone (Martin Wolf, May 31 2011)
The eurozone, as designed, has failed. It was based on a set of principles that have proved unworkable at the first contact with a financial and fiscal crisis. It has only two options: to go forwards towards a closer union or backwards towards at least partial dissolution. This is what is at stake.

The eurozone was supposed to be an updated version of the classical gold standard. Countries in external deficit receive private financing from abroad. If such financing dries up, economic activity shrinks. Unemployment then drives down wages and prices, causing an "internal devaluation". In the long run, this should deliver financeable balances in the external payments and fiscal accounts, though only after many years of pain. In the eurozone, however, much of this borrowing flows via banks. When the crisis comes, liquidity-starved banking sectors start to collapse. Credit-constrained governments can do little, or nothing, to prevent that from happening. This, then, is a gold standard on financial sector steroids.

Wait, by design the Eurozone was supposed to deliver depression in the deficit countries which already had lower wages and prices and higher unemployment?

Now look at the charts

(upper left) The size of the intra-EU central bank balances is analogous to what currency reserves would have been had there been no Euro. In particular, the bundesbank would have had to accumulate €325bn in non-DM Eurozone currency reserves in its effort to keep the DM's exchange rate down.

(upper right) Until the end of 2007 the "Euro reserve accumulation" required by the exchange rate regime was mostly in the private sector, also because the Euro fiscal rules prevented the public sectors from getting into debt at the rate that would have been necessary. But, since 2008, the private sector has been deleveraging resulting in the current central bank balances.

(bottom left) Note that Germany started accumulating other nations' liabilities in the latter part of 2007, before the public sector deficits blew up in response to the recession. This is the signature of the 2007 banking crisis.

(bottom right) Liabilities of the Central Bank are the result of runs on the respective private banking systems. They are an accumulated signature analogous to foreign currency reserves as a signature of exchange rate intervention.

Debt restructuring looks inevitable. Yet it is also easy to see why it would be a nightmare, particularly if, as Mr Bini Smaghi insists, the ECB would refuse to lend against the debt of defaulting states. In the absence of ECB support, banks would collapse. Governments would surely have to freeze bank accounts and redenominate debt in a new currency. A run from the public and private debts of every other fragile country would ensue. That would drive these countries towards a similar catastrophe. The eurozone would then unravel. The alternative would be a politically explosive operation to recycle fleeing outflows via public sector inflows.

Events have, in short, thoroughly falsified the premises of the original design. If that is the design the dominant members still want, they must remove some of the existing members. Managing that process is, however, nigh on impossible. If, however, they want the eurozone to work as it is, at least three changes are inescapable. First, banking systems cannot be allowed to remain national. Banks must be backed by a common treasury or by the treasury of unimpeachably solvent member states. Second, cross-border crisis finance must be shifted from the ESCB to a sufficiently large public fund. Third, if the perils of sovereign defaults are to be avoided, as the ECB insists, finance of weak countries must be taken out of the market for years, perhaps even a decade. Such finance must be offered on manageable conditions in terms of the cost but stiff requirements in terms of the reforms. Whether the resulting system should be called a "transfer union" is uncertain: that depends on whether borrowers pay everything back (which I doubt). But it would surely be a "support union".

Hindsight is 20/20, but the design of the Eurozone was pre-Gread-Depression macroeconomic nonsense.

Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Thu Jun 2nd, 2011 at 08:36:24 AM EST
[ Parent ]
(Google link - not all the results may work)

Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Thu Jun 2nd, 2011 at 08:41:01 AM EST
[ Parent ]
What is the difference with what happened through devaluations in the past?

From Jake


Inflation is a tax on net creditors and those wage-earners and benefits claimants that are in a weaker political position than they were when their wages and benefits were originally instituted (due to the high downward rigidity of nominal wages and benefits). It is a subsidy to net debtors and employers who are in a stronger bargaining position than they used to be. That makes it a net loss for the financial sector, lazy money and weakly organised labour, and a net gain for the industrial sector and homeowners.

Devaluation or depreciation is a tax on imports and a subsidy for exports. Overall that translates to a net benefit for people associated with primary or manufacturing industries and a net loss for people associated with the financial or service sectors.

Contractionary interest rate policy is a tax on the future and a subsidy to the present. Homeowners and the industrial sector lose, because they are capital intensive; lazy money and the financial sector win because they are capital-extensive.

Contractionary fiscal policies are a tax on labour and the industrial sector, both of which are sensitive to the state of demand.

Inflation and devaluation (which tend to go together) were bad for the financial sector (the domestic one, presumably) and good for price-sensitive export-oriented industries, but beyond that, we see that there's nothing that could not be dealt with through re-distributional policies - and with right wing (or equivalent) governments, devaluations also end up hurting labor.


Wind power

by Jerome a Paris (etg@eurotrib.com) on Thu Jun 2nd, 2011 at 09:05:21 AM EST
[ Parent ]
Devaluations are a recurrent feature of fixed exchange rate regimes without surplus recycling mechanisms.

The Euro is a currency union without a surplus recycling mechanism, and with the "no bailout, no default, no exit" clauses it is simply a macroeconomic impossibility.

The European Union's industrial policy is to deindustrialise accession countries to protect core industries, which only strengthens the trade imbalances and is the reverse of what a suplus-recycling mechanism would induce.

The Gold Standard failed, Bretton Woods failed, the European Exchange Rate Mechanism failed and the Euro has failed, all for the same reason. The refusal of gold bugs in surpus countries to countenance the idea that they, too, are responsible for setting up negative feedback loops on trade imbalances.

Critics of the Euro used to say it would not withstand an asymmetrical shock. The fact is that the Euro manufactures asymmetrical shocks and then fails to withstand them. So the Critics of the Euro were right all along.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Thu Jun 2nd, 2011 at 09:26:57 AM EST
[ Parent ]
But the original sin was that Italy and the others begged to be let in.

Germany did not want them in, because the Germans did not expect the Italians and other peripherals to be able to live with the euro - and in that they were not wrong.

And even back then, more than 20 years ago, they were not willing to make the political arrangements that would have made a currency union with structural deficit countries possible.

Wind power

by Jerome a Paris (etg@eurotrib.com) on Thu Jun 2nd, 2011 at 09:44:06 AM EST
[ Parent ]
Italy and the others were already in the Exchange Rate Mechanism.

The poriphery's political commitment to European integration amounts basically to a Stockholm syndrome in the case of monetary policy.

It appears Germany of all countries has no political commitment to European integration, of which maybe France is to blame as they managed to prevail over Germany in the first EEC constitutional crisis, in which Germany was Federalist and France Nationalist.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Thu Jun 2nd, 2011 at 10:02:59 AM EST
[ Parent ]
Homeowners and the industrial sector lose, because they are capital intensive

Homeowners are not capital intensive. Buildings are slowly turning capital and the production cost are low. Small apartment costs less than a small car.

by kjr63 on Thu Jun 2nd, 2011 at 10:27:50 AM EST
[ Parent ]

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