Europe's spectacular own-goal

The latest Euro summit was meant to build a firewall around Greece, and to isolate it from the other weaker members of the Eurozone. One week later, it is clear that this has failed spectacularly. Yields on Italian bonds are rising; the IMF has now been called in to monitor the budget. What is going on? Why does even the extended bailout fund not do more to stabilize investor confidence? The truth is actually very simple. The 50% "haircut" imposed on the private sector lenders to Greece is a gross violation of everything that European politicians promised until a few months ago. That's a bad way of reassuring investors.

Remember all the claims that no member of the Euro zone would ever default? That speculators betting on this would go bankrupt? That there would be no touching the creditors before 2013? All of this has gone out of the window, as a result of an ugly display of political strong-arming. Just as Germany's first post-war Chancellor Adenauer once said - "what do I care about the rubbish I talked yesterday". True, the politicians had the banks over a barrel; Ackermann could not say no to Mrs Merkel when she insisted on this voluntary write-down. But the obvious implication is that all other promises and declarations are equally empty - that bondholders of Spain and Italy might find themselves in exactly the same spot as the ones who hold Greek paper. Guess what? If you know you can lose up to 50% (up from 21% just 3 months ago -- latest update in November - Greece would now like to default/"voluntarily restructure" 75% of its debt in NPV terms), you don't feel that confident. About anything. How this was meant to solve the deeper crisis is anyone's guess.

With the benefit of hindsight, it's pretty clear that Europe should have just written an XXL-sized cheque for Greece a year ago. The Financial Times Germany is citing a few economists - Aghion, Alesina, me - saying precisely that. Austerity isn't working, and won't work. A single bad day on the exchanges destroys more value than all of Greece's external debt. Yes, Greece don't "deserve" another penny, but that's not the point. Europe has to do what is right for itself, without worrying about moral hazard (let's be honest - how many countries would want to follow the Greek route even if they get a big cheque?) It's time to switch from moralizing and punishing to actual crisis prevention.

My CNN soapbox

A small op-ed piece of mine over at CNN, on whether true Finns, Dutch, or Austrians will break the Euro...

If you really want to know

what is going on in the Spanish economy, read Edward Hugh [long post].

The bright side of the Irish crisis

These days, it is easy to remember why economics used to be known as the "dismal science". The EU finance ministers are meeting today, to put the fine print for the Irish rescue package together. One European bailout is following another; growth is mostly poor, and even where it isn't, output is not returning back to trend; and unemployment is stubbornly high. News that the last big private Irish bank was being nationalized last week seems like a small wrinkle. And yet, one can think of this detail as possibly a first ray of sunlight.

Whenever the future of the Euro is discussed, the practical difficulties of leaving are pointed out. In particular, as soon as there is a good chance that a country might leave, its banks will face a massive run on deposits; converting assets and liabilities into the new national currency will be tricky, as any mismatch will zap bank capital. But how do these problems look in a country whose banks have blown up already? Where the capital injections for the banks are so gigantic that they more or less double the national debt? And where banks mostly live on liquidity support from the rest of Europe? That place is Ireland, and somewhere, someone is hopefully thinking what I am thinking -- this is the time to get out.

The euro was a gigantic mistake in the first place, a vainglorious triumph of politics over sound economics. When the financial crisis broke out, the Queen famously asked during a visit to the LSE - why didn't anybody notice in advance? On this one, for once, many economists were actually acutely aware just how bad an idea the euro was. Barry Eichengreen wrote many articles and a book warning about foisting a new gold standard on advanced economies with massive nominal rigidities. Nobody listened.

Ireland will have to suffer massively in years to come as it is for the folly of its bankers and the stupidity of its housing bubble. It will have to live with IMF-EU imposed austerity. Why not try to get something in exchange for all that pain? A new Irish pound, introduced overnight, would quickly devalue and restore Irish competitiveness. An independent central bank could set appropriate interest rates while anchoring inflationary expectations. The banks would still have to struggle with potential asset-liability mismatches, but the problem cannot be large compared with the capital injections necessary already. And depositors have been taking their money out already. Once the new currency is in circulation, they can put it back in, as there is no uncertainty about the Irish future of the euro left.

What would this do to the rest of Europe? An Irish exit from the nightmare that the euro has become would surely see Greece, Spain, and Portugal leave, too. Depositors there would run on their banks to get euros out while they still can. Banks in some of these countries are healthier than in Ireland; an Irish exit would impose some real costs on the Club Med. And yet, much of the "health" of Spanish banks is illusory anyway, as it depends on fantasy valuations of all the brick and mortar on their balance sheets (something that the Bank of Spain is increasingly concerned and unforgiving about). A quick exit may still be better than a decade of slow, grinding deflation combined with Zombie banks and Zombie household balance sheets being kept on artificial life support before the inevitable rise in interest rates at some point pulls the plug.

When Britain left the gold standard in 1931, the governor of the Bank of England famously declared (having been aboard a ship and out of contact when the decision was made): "I didn't know we could do that." Leaving the euro may seem similarly unimaginable to many, but it may be just as feasible. In the 1930s, cutting the link quickly led to a recovery of demand, by reducing deflationary pressures. Far from the shattering blow to confidence feared by many, exiting the gold standard was actually great for business. Leaving the euro may be every bit as good.