Just as Paul Krugman has argued that we know how to get out of the American and European recession, we also know how to get out of the Eurozone (EZ) crisis—and could do so at the G20 meeting in Mexico today and/or at EU summit on 28-29 June. The crisis is entirely self-inflicted. For example—and this is only one of several possibilities—an announcement that all nationally emitted eurobonds are to be replaced by jointly guaranteed Eurobonds (E-bonds) would stop the crisis in its tracks, giving the EZ much-needed time to debate and set up the required institutional structure. It goes without saying that continued austerity is senseless.
The problem is that Germany needs to agree. Faced with the prospect of chaos in the EZ (or at least in countries ‘too large to fail’ such as Spain and Italy), the costs of emitting bonds—a small rise in Germany’s 10-year benchmark rate, currently close to zero real terms—is certainly worth paying relative to the much greater cost of breakup.
There are basically four views of why the EZ crisis has happened. The first is based on Merkel’s ‘profligacy’ argument: ie, all the countries in trouble have ‘lived beyond their means’ and must accept tough austerity measures which alone will appease the markets and revive member-states’ economies. Such an approach forces the entire burden of adjustment on the public sector of the peripheral countries while ignoring that austerity leads to GDP contraction and a higher debt/GDP ratio. Nobody in their right mind believes the austerian view any more, least of all the markets—or indeed some German opposition political figures.
The second is that the euro could never have succeeded under any circumstances; the basic one-size-fits-all-is-wrong argument. This argument is far too broad and woolly and can therefore be dismissed.
The third is the ‘faulty euro architecture’ view; ie, that a monetary union required a fiscal union to complement it, and that the latter required some form of ‘federal’ EZ permitting—just as in the US—transfers to be made between states and fiscal policy to be used contra-cyclically as first suggested in the 1977 MacDougall Report. A corollary is that mechanisms would be created to ensure intra-eurozone trade remained reasonably balanced and that temporary imbalances could be financed. This is a view I expressed in my book and various articles on Europe published in 2005-06.
Although I still favour this view, on reflection my book failed to identify what I now consider the crucial weakness of the EZ, namely, that each member-state emits its own sovereign Eurobonds. This simple fact has made the EZ critically vulnerable since, robbed of autonomous monetary policy (including devaluation), member-states have been left entirely at the mercy of financial markets.
These markets will attack the weaker members not because they are inherently ‘evil’, but simply because they are risk-averse, particularly in present circumstances. And of course, once a member-state is viewed as in danger of sovereign default and contagion spreads, the risk of massive default is perceived to arise and the crisis becomes self-perpetuating.
What is to be done? Various commentators—perhaps most prominently Paul De Grauwe— have urged some form of joint guarantee, whether in the form of EZ-wide bank insurance, the direct recapitalisation of EZ banks by the ECB, common E-bonds and so forth. Although such measures would take time to implement, the mere announcement by Germany (and implicitly by the ECB) that it stands fully behind such measures would slow or even halt speculation.
At present, Ms Merkel’s stubborn insistence that such measures can only be countenanced once ‘closer economic and political union’ is achieved is a recipe for disaster. The apparent lesson of Merkel’s economically incoherent stability compact is that no member-state can act before Germany approves it. The irony is, of course, that Merkel’s stubbornness will so damage the EZ that further economic and political integration becomes impossible—we are now dangerously close to that tipping point.