Options for Europe

This problem is not fixing itself.

Bob Barbera and Jonathan Wright offer this assessment of the situation in Europe:

Up until a few weeks ago, all European officials declared at all moments that there were no conditions that could lead to a nation leaving the euro. Suddenly that was no longer true. Contagion fears– if Greece can be thrown out, why not Spain and Italy– quickly appeared. This produced a quick calculation. If my money is in a bank in a nation at risk, I might go to bed with 10,000 euros and wake up with 10,000 pesetas. In other words, my deposit was guaranteed, but the currency value of the deposit was not. The simple remedy? Open an account in Germany. Wire transfer the money. Conduct business, still in euros, but from an institution that might convert your euros to deutschmarks. And in growing numbers, first businesses and then individuals have been making just this kind of transfer….

Central bank data makes it clear that as of April, a bank run was in full force in Greece and that a bank ‘trot’ was taking hold in Spain and Italy. Target2 statistics reveal that Spain and Italy borrowings from the ECB had mushroomed from roughly 150 billion euros to close to 300 billion euros, over the first four months of 2012. Germany, in mirror image, registered loans to the ECB of nearly 700 billion euros. May data is unavailable, but almost certainly witnessed a material acceleration of flows.

 

Source: Institute of Empirical Economic Research, Universitat Osnabruck.

target2_jun_12.gif


Barbera and Wright continue:

What compels Germany to send money to the ECB? Follow the flows. The Spaniard moves his money from Bankia to Deutschebank. Deutschebank, now awash in excess cash, deposits its excess reserves with the Bundesbank. The Bundesbank, in turn, lends these funds to the ECB. The ECB then lends them to Spain and Italy and … the result? The bank run, left unchecked, compels the Bundesbank to lend ever larger amounts to the periphery, via the ECB. Thus, without a vote in Germany, or a proclamation from Angela Merkel, the German monetary authority becomes the lender of last resort to frayed Greek, Spanish and Italian banks….

Just as there is a self-fulfilling prophesy in bank runs, the same applies to sovereign borrowing. As an example, Italy has a primary surplus. If Italy can borrow at low interest rates, then Italy is solvent, and investors are right to buy Italian bonds at low yields. But if Italy is forced to pay high interest rates, then the country is insolvent, and investors are right to charge high rates.

In the case of a run on private banks, it is not the case that self-fulfilling panics cause any fractional reserve financial system to be inherently unstable. I explained why when I was discussing the U.S. financial problems unfolding in 2007:

The way this problem is solved is to have the capital that the bank lends come not just from its depositors but also in part from the owners of the bank. These owners should have invested some of their own money to start the bank and reinvested some of the profits of the bank to allow it to grow. The capital that comes from the owners rather than depositors is known as the bank’s net equity. The idea is that if the bank takes a loss on its investments, that loss comes out of net equity, and there’s still money to pay off all the people who deposited money in the bank.

In the case of sovereign debt denominated in a currency that the government could not itself just print more of, the equivalent of the bank’s net equity serving as a buffer to prevent bank runs is the government’s ability to cut future spending or raise future taxes to halt a run on sovereign debt. If it’s not possible for a government to take those steps when called on, the unstable “bank run” equilibrium becomes a concern. A full-fledged financial panic centered in Europe seems a reasonable thing to be worried about at the moment.

How can a country thrown into that situation get out of it? Restoring budget balance and international competitiveness would usually require big real wage cuts for all domestic workers. Getting those wage cuts in the private sector typically doesn’t happen without a prolonged period of high unemployment, and getting big wage cuts in the public sector typically doesn’t happen, period. The traditional policy option is therefore to try to accomplish the same thing with a big currency depreciation, accompanied by debt restructuring, that is, accompanied by partial default on outstanding debt. One advantage of achieving real wage cuts through currency depreciation is that, although the loss in standard of living is still there, everyone in the economy– workers, lenders, businesses– can at least start to look forward to improvement from here instead of anticipating continued deterioration. Having some basis for forward-looking optimism can be a huge benefit in pulling out of this kind of situation.

The problem at the moment is that it is extremely difficult for a country currently part of the European monetary system to choose that route. As exit from the euro becomes contemplated or forced on one country, creditors fear it may happen elsewhere. And those fears could easily produce a replay of the credit crunch that brought the world economy to its knees in 2008.

I think it is inevitable that Greece and perhaps some other small countries will have to abandon the euro. But a firewall should be drawn around the larger basically solvent countries to avoid an unnecessary and potentially very destructive outcome.

Barbera and Wright conclude:

Euro bonds would be one way of resolving this problem. A quicker and easier way would be for the ECB to commit to buying the sovereign debt of all euro zone countries at a fixed small spread over corresponding maturity German bonds. The magic of this solution is that the credible commitment to do so might be enough– the ECB might not even have to buy bonds in size.

The strategy we describe would have a very good chance of resolving the immediate crisis. Unfortunately, if the past is any guide, European policymakers will prefer a “compromise” of taking a half-measure, thinking that this brings at least half of the gain. But half measures will do nothing. Policymakers will have to go back and try again at even greater cost (if they get another shot)….But following a hypothetical Greek exit, we would be in totally uncharted territory. Europe may well have only one shot at getting this right.

This post originally appeared at Econbrowser and is posted with permission.