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Wednesday, November 2, 2011

The Law of the Accelerating Euro Bailout

I have now discovered a new economic phenomenon: the law of the accelerating euro bailout. Each crisis summit leads to an increase in guarantees, haircuts and bailout loans by a factor x, but its lasts only 1/x months as long as the last bailout before collapsing. The announcement of the Greek referendum yesterday may finally truncate this geometric series to its limit point and bring about the disorderly default of Greece I predicted in the last post. If European leaders thought that Zeno's paradox would postpone the day of reckoning forever in an infinite series of bailouts, they will now have a rude awakening. The tortoise of underlying economic reality has finally caught up with the hare of financial trickery. (At a dinner party recently I was asked to summarize in one sentence what that underlying economic reality behind the Euro crisis was. My answer: German wages are too low. Do the math...)

More and more economists, and even ordinary people, both in the Eurocore and the Europeriphery, have finally come around to the realization that only some combination of the following steps will restore economic balance and reopen a growth perspective out of the threatening debt death spiral:

  1. First, Greece  needs to exit the Eurozone to devalue, and second, it needs to default on its Euro-denominated debt. It needs the former to restore export competitiveness (a Greek hotel room now costs twice as much as a rival Turkish one for a Mediterranean holiday, an indication of how much it needs to devalue). It absolutely needs the latter to prevent its sovereign and private debt from ballooning by exactly the proportion it devalues, plus to reduce the debt burden to a sustainable level. A haircut while staying in the Eurozone, or devaluation without default (or vice versa) are no longer enough. The dangers are a domestic run on Greek banks, which incidentally is already in accelerating progress, and inflation, which unfortunately will be unavoidable. In a word, Greece needs to do an Argentina. It will make Greece a pariah state for awhile, but it will at least be a sovereign pariah state with some growth prospects. In the inimitable words of Andrew Lloyd Webber's "Don't Cry for Me, Argentina":

    I had to let it happen
    I had to change
    Couldn't stay all my life down at heel
    Looking out of the window
    Staying out of the sun
    So I chose freedom

  2. The Eurocore states need to appreciate with a C-Euro, the Europeriphery states to devalue with a new P-Euro.
  3. The new zones will have to redenominate their sovereign debt in their new currencies. This will be hell for the C-banks holding bonds from the  P-Eurozone or Greece, and a windfall for P-banks holding C-bonds (minus their losses on Greek bonds), but it now seems the only way to restore competitive balance in lieu of implementing my German domestic expansion/Euro devaluation plan of last January.
  4. The three new zones will need central banks that are finally willing to act like ones, that is, act as lenders of last resort for their currencies. The present ECB has been fighting this battle with one hand tied behind its back (see Paul de Grauwe on this) as a policy vestige of the German hyperinflation of 1923. Yes, central banks should not monetarize the irresponsible fiscal deficits of their governments. But no, they need to be able to deter a run on their currency's sovereign debt, like is now occurring in Italy and Spain, with the prospect of infinitely deep firepower.
Call it what you will - an avoidable fiasco (as I did last January), a train wreck, a meltdown. There is little consolation in being a Cassandra proved right. The job now is to get through this nightmare without sinking the ship, by which I mean not only Europe but the whole world economy. I can't help reflecting that the 1931 worldwide financial crisis was set in motion by the bankruptcy of a single bank, the Austrian Creditanstalt, located just a few kilometers from where I am now sitting in Vienna. Complex systems have a nasty habit of unraveling in the blink of an eye if you don't watch them!

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