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The European Financial Crisis

February 26, 2012

A spectre is haunting Europe — the spectre of default. All the powers of old Europe have entered into a holy alliance to exorcise this spectre: ECB and IMF, FMS Wertmanagement and BNP Paribas, Belgian bureaucrats and German pundits.

Eternal Bailout
Eternal bailout is not really an option. No matter how much the Germans give the Greeks, the Greeks can always spend more and push themselves to the edge of bankruptcy. How much would you spend if someone promised to pay all your expenses, so long as your bank account was nearly empty? Incentives matter. The Greeks will continue to run a corrupt and inefficient government so long as they do not bear any of the costs of doing so. And after Greece, what then? The leaders of Italy, Portugal, Ireland and Spain will all see that if you are irresponsible, you get free money, and they’ll line up with their hands out. Half of Europe cannot provide the other half with free money forever.

Austerity is where a country goes through a set of reforms designed to allow them to repay their debt. Tax revenue is around 20-40% of GDP is most developed nations, and it can be quite difficult to devote more than about 20% of government revenue to paying down the debt, so a debt of even 50% of GDP could take decades to pay down. If markets lose faith that a government will pay them back, interest rates can spiral upward, making the cost of servicing the debt quite high. The selectorate in Greece is quite used to getting perks from the Greek government and is loathe to surrender them to foreign governments and banks without a fight. The Greek government has never been all too stable and harsh austerity measures could potentially destabilize it. I am very wary of austerity measures imposed by outsiders, as they will lack legitimacy. How many deaths would avoiding a default be worth? In my opinion, not many.

Leaving the Euro
Another option available to the Greeks/Italians/Spanish/Portugese, is to leave the Eurozone entirely. Each sovereign nation has the ability to define what is used as currency within their borders. Each country could declare that its past debts are payable using the new currency, which would allow them to pay off the debts and devalue their currency simultaneously. While a common currency may lower tranactions costs, the ECB had pursued inappropriately contractionary policies for the southern European states, making “internal devaluation” (price adjustment) far more difficult than it would have been otherwise. A less valuable currency would help reduce unemployment and encourage exports. The main disadvantage of this option is that it would get rid of Greece’s access to the more disciplined monetary policy of the French and Germans and increase transactions costs for intercountry trade.

Eurobonds would be issued by all European governments and would be treated identically between countries. To avoid a total tragedy of the commons situation, with everyone rushing to issue as much debt as possible to screw over other countries, the bonds would be broken up into two “tranches”, or groups. Debt up to 60% of GDP would be considered “senior“, and debt issued over 60% of GDP would be considered “junior“. Senior debt only takes losses if the junior debt is totally wiped out. The junior debt would provide a buffer so that the senior debt would be protected.

There are three main problems with this approach. First, the junior level would be totally worthless. Countries with over 60% of debt to GDP would rush to spend as quickly as they could to impose most of the losses at the expense of other countries. Secondly, France and Germany are over 60% themselves (in the chart above, DE is Germany [Deutschland] and FR is France). They would have no reason to support such a solution, since it would prevent them from borrowing and lump them together with the higher risk southern European states. Lastly, it would not solve any of the immediate problems, because Greece and Italy would still face high interest rates on their marginal borrowing. While the eurobond might be stable in the senior tranche, it would not stable at all in the junior one.

Further reading on the eurobond here.

United States of Europe
A federal union requires more than just a treaty. A federal union requires the will and the ability to violently put down rebellion. When a ruling coalition within a state in a federal union decides that secession is in its best interest, the loyalist states must be able to muster enuf capacity for violence to put them in their place. The issue of secession was decided in the United States by the Civil War, which cost 212,000 lives and over 600,000 wounded. What if a current EU member tries to opt out at the very beginning? Would the core Euro states be willing to militarily conquer them?

Europeans are quite attached to their socialized medicine and welfare states, but social safety nets require empathy for and solidarity with one’s fellow citizens. Would a Polish farmer making $5,000 a year be willing to pay the 60% taxes required to fund a $50,000 British surgery, or the retirement of a 60 year old Italian? European incomes are far more dispersed than U.S. states, from Luxemburg ($79,500) to Bulgaria ($4,800), vs. Maryland ($69,272) to Mississippi ($36,646). If the Germans are this upset about paying for the Greeks now, just wait until they share a Congress or Parliament with them. Fiscal union will mean more transfers to poor countries, not less, if there is any sort of democratic representation. And if there is not democratic representation…. well, I’d prefer to simply say that’s an outcome I’d like to avoid and leave it at that.

The United States encountered a similar problem in the early 1840s. The federal government refused to bail the states out and many banks and individuals took losses, just as they will if the European governments default. When people lend money, take the risk that the loan will not be paid back. That’s one of the reasons why you earn interest. To bail someone out is to make an ex post transfer to the owners of those loans.

Yes, banks will take losses if European governments default, but they explicitly took on that risk when they made the loan. The idea that any loan, even to a government, is risk free is absurd. Governments have been defaulting as long as people have been lending them money. Default is a deflationary shock, which will drive much of the European banking sector out of business. As most of the major institutions in Europe are intellectually captured by the banks, this is seen as a horrible scenario. The ECB can issue enuf currency to offset the deflationary effects of the unwinding of the money multiplier, altho doing so will likely result in high inflation for many consumer products and reduce the availability of loans. The worst case scenario is not a few banks taking a haircut and some inflation. The worst case scenario is the collapse of the Greek government or a war in Europe. Countries can survive default, but a loss of democracy and/or lives would be far more tragic.

Further reading:
Kantoos on the crisis.
Tyler Cowen comments.

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