waiting in the wings to swoop down and save the Euro – it will collapse. The Eurozone is trying to be a little pregnant, either you completely integrate, form a fiscal union and become “The United States of Europe” or you have to disband and let countries have their own monetary policy. The former is unimaginable therefore the latter will happen. In April of last year, I argued that the contagion would spread to Italy, that investors should purchase credit default swaps (CDS) on Italian debt and that this would be the destabilizing event that would eventually trigger the Euro’s collapse. Italian bonds just recently came under pressure.
In the absence of monetary policy, the only way that Greece, Italy, Ireland, Portugal, or Spain (PIIGS) can become competitive
with Germany is through a period of sustained deflation. This traps them in a vicious cycle. PIIGS cuts its spending and raises
taxes which lower aggregate demand; this leads to higher budget deficits which lead to cuts in spending and higher taxes which lead to lower aggregate demand. Rinse, wash, and repeat. Though I identified this problem a year ago, we can now see that this is what is actually happening in Greece. By way of comparison, Argentina tried to maintain a peg with the US dollar in the late 90s, experienced deflation that caused social upheaval and eventually went off the peg and defaulted on its debt.
Greece owes over $500 Billion Euros to French and German Banks. In commercial lending, we used to have a saying, “if you owe the bank one hundred thousand dollars that’s your problem, if you owe the bank a million dollars that’s the bank problem.” The Greek debt is no longer a problem of the Greeks. It is a problem of the French and German banks, which, just like the US policy response to their financial crisis in 2008, is being passed down to the French and German taxpayer. After Greece has implemented the much needed reforms that will allow for economic competiveness, stability and long term viability, the Greek bargaining position will start at “we will refloat the drachma and default on all our debt”. At that point, Germany, and the rest of the Eurozone will be in a very poor bargaining position.
Argentina only paid its bond holders 40 cents on the dollar. The latest bailout for Greece represents a 21% haircut so there is still much pain in the pipeline. And for those of you who might be inclined to think this type of can kicking can go on forever - don’t. To cover all the bad Eurozone debt some are estimating that Germany would have to issue debt as high as 133% of GDP.
The Eurozone was never built to last, and I warned my students in my International Macroeconomics classes, since 2002, that it would not likely survive due to differences in the various economies and their inabilility to make adjustments through monetary policy.
I was not the only one thinking this way.
So did Milton Freidman at a Bank of Canada conference in 2000 :
Milton Friedman:…I think the euro is in its honeymoon phase. I hope it succeeds, but I have very low expectations for it. I think that differences are going to accumulate among the various countries and that non-synchronous shocks are going to affect them. Right now, Ireland is a very different state; it needs a very different monetary policy from that of Spain or Italy. On purely theoretical grounds, it’s hard to believe that it’s going to be a stable system for a long time.
A curiosity of all this is that although the Eurozone was never an optimal currency zone, Robert Mundell, who won a nobel prize in part for this theory, has beeen a cheerleader from the Euro's inception.
More recently Mundell was quoted as saying:
"The euro is too strong. A weaker euro is the best news you could have for governments (in trouble)."
"The ECB should follow an easier policy. Of course they have a strict rule to safeguard against inflation but that is not correct. I have never believed that central banks should have rigid inflation targeting. That is not a good thing to stabilize. There is nothing in economic theory to back this."
He added it is folly to tighten monetary policy into a "deflationary" oil spike, (as the ECB did in 2008 and has just done again). "That is exactly the wrong thing to do".
While it is true that the ECB could of been following a looser policy, the value of the Euro is basically based on Germany's productivity which means that its equilibrium value, short of a massive inflationary policy by the ECB, will be too high for the competitiveness of the PIIGS. Only prolonged deflation, currently being prevented by the bailouts in the case of Greece, can bring these countries into international competitiveness.
What's more, these countries have to deal with the fact that the low wage manufacturing jobs that went to China and other developing countries and are not coming back. Germany is positioned in the high value added manufacturing sector and it will not be easy for these countries to carve out a competitive niche without some sort of sustained program of economic development, akin to that which Jeffrey Sachs is advocating for the United Sates. Given these realities, it will simply be easier to dissolve the Eurozone, float your own currency, and impose trade sanctions to establish jobs for the lower skilled workers.