Tag Archives: Angela Merkel

Understanding the Euro Crisis

My favourite contemporary economist is UCL’s Professor Wendy Carlin.  She was my tutor at UCL, and led my second year macroeconomics course, and a third year course on European institutions.  Her patient, dispassionate analysis is worth so much more than all that shoot-from-the-hip banging on by celebrity economists, Nobel Laureates and all.  It was her analysis, well before the current crisis broke, that demonstrated to me that the last government’s economic “miracle” was unsustainable (the combination of an appreciating real exchange rate and a trade deficit being the giveaways).  She also helped me understand the Eurozone, and pointed out the trouble ahead, again well before it happened, arising from diverging real exchange rates within the currency bloc – in other words Germany was becoming more competitive while Italy, Spain and others were becoming less so.

So I was delighted to read her summary of the Eurozone crisis – 10 questions about the Eurozone crisis and whether it can be solved.  The is a wonderfully clear summary of the whole situation, written in early September.  Her central point is that the zone’s banking system is at the heart of the crisis, and tackling the banks will the heart of any solution.  European politicians have been trying to avoid this, no doubt because it shows that Northern European countries have played an important role in creating the crisis.  However, not least thanks to the new IMF chief Christine Lagarde, this is changing.

Of course Professor Carlin cannot point to an easy escape.  She points to two alternatives paths, other than the breakup of the zone:

Scenario #1 – a more decisive approach based on current policy (bailouts)
Policy-makers need

  • the existing bailout schemes to be successful and to be seen to be working in the next year
  • to keep Italy out of the bailout regime
  • to develop a replacement for the high moral hazard regime for banks and for governments but to do this in a way that does not undermine the bailout regime in the meantime.

Scenario #2 – large-scale restructuring of bank and government debts (defaults)
Policy-makers need

  • to move decisively now to end the high moral hazard regime by accepting that default on bank and government bonds on a much larger scale than envisaged in Scenario #1 is necessary
  • to engage in restructuring sovereign debt and bank debt by, for example, forcing bond-holders to swap existing short-term bonds for long-term
European politicians are attempting the first path, but the problem is contained in Professor Carlin’s third bullet: devising a financial scheme that avoids moral hazard by banks and sovereign states – this reckless behaviour in the belief that it will be underwritten by everybody else.  The favoured answer of many is a “Eurobond” – i.e. government borrowing underwritten collectively, combined with a toothier version of the failed Stability & Growth pact.  But this decisive step towards a more federal Europe runs well beyond any democratic mandate.  The German Chancellor, Angela Merkel, is rightly suspicious.
Which leaves the second scenario, which is favoured by American commentators, based on their experiences of Latin American debt crises.  This is surely much more convincing, and I hope that the IMF will use its influence to push down this path.  Bank regulation clearly needs to change, but beyond that it doesn’t need a more federal Europe.  We can use bond spreads to act as a break on government profligacy – which is how the Eurozone should have been run from the start.
A final point worth making from Professor Carlin’s analysis is that dropping out of the Eurozone wouldn’t really help Greece or any other country that much.  They would still have to run a government surplus, and so still have to go through a very painful reform programme sucking demand out of their economies.  Of course the hope is that a rapid devaluation would kick start exports – but it does not stop the need for painful supply-side reforms if these countries are to recover anything like their former standards of living.

Europe’s financial crisis gets dangerous

While the British news media and politicos alike obsess with the unfolding of the News of the World hacking scandal, Europe’s financial crisis enters a dangerous stage.  In fact this crisis seems to unfolding just as quickly, and with much more important potential consequences.  Was I being too sanguine last Friday, when I blogged that it was a learning curve rather than a fundamental problem?  Well, probably.

I had hardly posted it than a flood of dire articles about the crisis came out.  One of the best is by  eminent US economist Larry Summers in this morning’s FT(£); alongside it an equally gloomy article from FT regular Wolfgang Munchau (£).  Mr Summers points to the critical issue of confidence that could be destroyed in a default, drawing a parallel with Lehman in 2008.  He then offers quite a plausible way out.  But the problem, as Mr Munchau points out, is:

I often hear that Ms Merkel in particular has moved a long way from her original position 18 months ago, when she ruled out any money for Greece. This is true. But the crisis now moves at a rate that exceeds her political speed limit.

There’s clearly a problem.  One issue is the expectation that European leaders will muddle through, as they always have.  This, unfortunately, is a self-destroying prophesy.  Because Europe’s leaders expect everything to come right in the end, they don’t have the incentive to make it actually happen.  Actually Europe’s greatest achievements have required some strong leadership, with Helmut Kohl, Germany’s Chancellor in the 1990s standing out.  Mr Kohl achieved German unification on his own terms, pushed through monetary union and the massive eastward expansion of NATO and the EU right into the former Soviet Empire.  Mrs Merkel does not fill his shoes.

Still, there are plenty of bright ideas for ways out, without the Eurozone collapsing, Mr Summers’s among them.  They will all require Mrs Merkel to shift her current stance.  Things could get worse before they get better.  At any rate it looks more soluble than the US budgetary stand-off.