John Hussman as usual has a great discussion of the reasons the European crisis has turned out to be so intractable. As we have suggested repeatedly, there are no good outcomes here. Normally such situations lead me to point pout that we need to concentrate on the least bad, or best outcome possible. Unfortunately, it is arguable what the best outcome is in this situation. We suggest you read the whole thing, but John gives us three outcomes in the relatively near term he feels are possible:
…we can expect to observe one of the following three outcomes:
1) A European Federal System emerges whereby each country surrenders its own fiscal sovereignty, losing the ability to set fiscal policy without broad approval from a central European authority. This is the only condition on which Germany would be likely to agree to a change in the ECB’s mandate to allow it to broadly purchase weaker European debt. It is difficult to see how a sufficiently binding enforcement mechanism could be created to prevent individual countries from acting in what they see as their own best interests. In my view, any hope for this solution has a shelf-life of about three months, because as a broadening recession becomes clearer, the willingness of individual European countries to give up their own fiscal reins may vaporize.
2) Heavily indebted European nations begin to adopt versions of a dual-currency system, issuing various forms of IOU’s or convertible debt, thereby creating the longer-term option of converting their debts into currencies that they can print and devalue individually. This is probably the best option for Europe, but is not one that distressed countries will choose on their own so long as bailouts can be extracted.
3) Germany adopts a version of a dual-currency system by itself. This is something of a “nuclear option” after failing all other approaches. The benefit of this is that it would effectively allow Germany to issue new debt at negative real interest rates in euro terms, as Germany’s own inflation and exchange rate credibility is greater than that of the euro itself. Indeed, Germany could likely convert its entire stock of euro-denominated debt to deutschemark-denominated debt within about a week, and could legislate DM as legal tender just as quickly. This would also free the ECB to print euros to its heart’s content, without extracting seigniorage from the German people. It would, however, accelerate the depreciation of the euro since a reinstated German mark would be viewed as a safe-haven, much like the Swiss franc. It would also create some difficulty for German companies with long-term contracts having revenues payable in euros, and would sharply narrow Germany’s trade surplus with the rest of Europe. The benefit is that technically, the peripheral European countries would be saved from default. Moreover, Germany could conceivably re-join the common currency on more favorable exchange terms, post-depreciation, so it would not necessarily be the end of the euro.
In short, if you can’t save the euro by restructuring the debt of the weak members, or by having the weak members leave, or by having the fiscal costs fall squarely on the German people, the remaining option is for Germany to leave, inflate the heck out of the euro to deal with the debt problem, and reinstate Germany on post-devaluation terms.”
You can read the full piece here.
Once again, there are no good options at this point. Let us look at three of the choices bandied about from Germany’s point of view:
1. The ECB prints money: Leaving aside the inflation issue, this reduces the cost of today’s debt load, but transfers resources from Germany to other countries. From a structural viewpoint this transfer has no constraint on spending and leads to further profligacy in the countries that are having the problem and endless transfers from Germany to the PIIGS. If accompanied by austerity and no ability for the PIIGS to depreciate their currency to become more competitive with Germany, the peripheral economies will enter depression (or continue the present one for some of these countries) and lead to endless transfers from Germany as the ECB will need to buy more and more bonds. The crisis becomes an expensive one for Germany and the issues never really goes away under any variation of this option. The PIIGS need to become more competitive in order to stop accumulating more debt and leading to crisis further down the road.
2. Germany leaves the Euro: The ECB will print money and the Euro will depreciate against the new German currency, the Deutschmark. German exporters lose their competitive advantage and the German economy tanks. Not good either, and often given as a reason Germany will never leave the Euro, though as Hussman has pointed out, leaving the Euro need not be permanent.
3. Full Fiscal Integration: Since all other solutions put in place circumstances that are unstable and merely kick the can down the road, the fundamental flaw in the Euro needs to be addressed. That is the lack of a unified fiscal policy. The answer then is the end of sovereignty, the creation of a US of Europe. An obvious objection is that Germany wants to be a sovereign nation. We’ll skip this niggling little detail, but even if they didn’t want to remain sovereign do they want to harmonize laws and economic policy with Greece and some of the other PIIGS? West Germany just integrated with East Germany and the experience was traumatic featuring massive transfers to East Germans. The PIIGS will still not be competitive with Germany. That means internal adjustments (internal devaluation or austerity) to allow them to become more competitive for the PIIGS’ or massive transfers. Thus unifying the Eurozone under a single fiscal policy means massive transfers from Germany to the PIIGS to harmonize the welfare states and unify the debt and avoid austerity throwing the entire Eurozone into depression. Germans will pay for the debt in one fashion or another.
Cullen Roche points out that in the US we don’t worry much about the need for internal transfers between states to keep the system sound. Today that is true, though it has led to large conflicts in our past, playing a role in civil unrest, uprisings, the conquest of a continent and near destruction of its former inhabitants and the Civil War. Our unity was easier to envision and still born of blood and tragedy.
I am not saying unification of Europe would lead to such tragedies and conflicts. However, we need to ask if Germany (or really all the countries) want to make the internal transfers that make such a system work? Germans would pay a great deal, Greece and the other PIIGS would suffer internal austerity to the extent that they contribute to the economic re-balancing. Do Europeans, or most importantly the Germans, view themselves as a people who will be responsible for paying all the bills to integrate the Greeks and others?
Are Europeans ready to think about their home countries in the same way Texans think of Texas? Their state, but completely subordinate to the US? Will they be able to secede? We answered that question in the US with a war of incredible savagery and destruction. My guess is a unified Europe would be far less stable. They will not choose a civil war comparable to the US, but instead countries leaving over time as well as never entering the union. That leaves us with all the problems we have now still being there. Without a European populace overwhelmingly in favor of a true union this will not work. We would be faced with a PIIGS like crisis with every election and the possibility of secession in each of the former countries.
There are other variations, but we won’t go into all of them here. The point is that there are no “good” options from Germany’s point of view. However, we should think rationally when analyzing this and admit that any final solution except breakup needs to result in the PIIGS becoming more competitive with Germany. A tanking economy may be a small price to pay compared to endless transfers to the PIIGS. It is often suggested and even out right claimed that the reluctance to print from the German’s is purely an irrational fear of inflation born of the 1920′s and 1930′s. However, the issues go so much deeper than that. The German’s are faced with a terrible set of options. The ramifications for Germany as a people are near existential. Germany may make the choice to accept the ECB printing for now, but eventually they will want to cut the cord. The cord is the Euro.