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Friday, November 11, 2011

Krugman Gets Religion

Paul Krugman, in his blog today "Original Sin and the Euro Crisis", waxes biblical about why the Euro is like a bite from the poisoned apple in the Garden of Eden for Italy. But some wonkist background is required to understand what he is driving at.

Paul de Grauwe (as usual) has a good paper on why the Euro reduces periphery countries like Italy, Spain, Greece to the status of emerging market countries with hard currency debt. This makes them subject to "bank run" like crises of confidence like we have seen with, first, Greece, then Portugal, Ireland, and now Italy. If this continues without ECB intervention or a credible EFSF, it will swallow up France and in the end even Germany. The weaker domino undermines the next stronger one. In a true currency zone with a proper central bank, the latter can deter such runs by credibly threatening to buy up sovereign debt (it can print all the money it needs to do so). The threat is enough to prevent a run; it may never even have to be implemented. Just look at the USA, the UK or Japan, which are more indebted than the Eurozone taken as a whole. Their interest rates have even been falling. The "Rube Goldberg" construction of the Euro means that a cascade of unraveling can happen starting at the weakest link, like a run in a stocking.

In principle the ECB can stop this cold flat. But buying up Italian bonds in drips and drabs will just be wasting money. The ECB needs to announce a credible policy (like the Swiss National Bank did on its exchange rate) to buy up as much debt as needed for as long as necessary. However, this violates the "no bailout" clause of the Maastricht Treaty, as Nouriel Roubini points out in today's Financial Times (Gavyn Wright has further objections of his own). But then, so does the EFSF, so you either abandon the Euro now before more money is wasted, or you end the hypocrisy, stop pussy-footing around, and allow the ECB to do its job right.

Of course, this still leaves the underlying cause of the Eurozone crisis unaffected: the relatively low wage level in Germany (real wages have actually been falling as reported recently in a DIW study), the lack of a domestic expansionary policy there, and the overvalued Euro. The ECB would only be buying time until Germany pushes the switch from "full-speed behind" (self-defeating austerity) to "full-speed ahead" (expansion), something that is still not on the horizon. There's no point in my reiterating the logic of this policy since my 18 January NY Times article, but I'll just point out that Nouriel Roubini, Gavyn Davies (Financial Times), Stephanie Flanders (BBC), Peter Bofinger (German Economic Council, in the Süddeutsche Zeitung), not to mention Paul Krugman, have all been blowing into this horn. Unfortunately, the walls of Jericho, i.e., German policy Borniertheit, have yet to come tumbling down (to belabor another Biblical metaphor).

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