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