The End Game for the Euro: German Rules and Bondholder Revolts

by Mark Blyth on January 18, 2011

Things Continue, `Till they Don’t …

The end game for the Germans, and the rest of Europe, in terms of resolving the current Eurozone crisis is pretty straightforward. There are four ways to deal with a financial crisis: devalue, default, inflate, or deflate. For any country in the Eurozone who transferred private debt from the banking sector to their public balance sheets, and thus blew a hole in their debts and deficits, neither inflation nor devaluation were options. That leaves default, which pushes the costs onto bondholders, or deflation, through domestic wages and prices via the public balance sheet, which places the costs onto taxpayers. For a host of reasons, as guardians of the Eurozone, as an inflation-averse savings-culture, we would expect the Germans to prefer austerity to expediency, and force deflation, but there are real and obvious limits to any such strategy, which is what I have found puzzling since the crisis began just over a year ago.

The first and most obvious limit is that currency unions should not be suicide pacts. There should be exit-clauses; otherwise the only way to adjust is through deflation. Unfortunately, as the 1920s demonstrated clearly, and as anti-austerity protests across Europe today continue to make plain, democracy and deflation do not mix well together. Hard money commitments such as the Stability and Growth Pact, the ECB’s inflation targeting regime, and the Maastricht criteria, were supposed to serve as a check on profligate governments. But what we have in this case, with the Greeks as a possible exception, is not state profligacy. Rather, the situation is akin to a giant ‘bait and switch’ operation where massively leveraged financial institutions wrote deep out of the money options on other financial institutions, and when it all went wrong tax receipts dried up at the same time as huge amounts of private debt were transferred to the public sector balance sheet to keep various national payments systems operating.

What was a crisis of banking became, in short order, a crisis of state-spending via a massive taxpayer put, and with sovereign bondholders’ interests being held sacrosanct while their investments were diluted (if not polluted), the taxpayer had to shoulder the costs twice: once through lost output and new debt issuance; and then twice through the austerity packages held necessary to placate the sovereign bondholders. But if the EU is at base a democracy then the problem is clear. Is it reasonable to expect mass publics to pay for the mistakes of private elites on a multi-billion dollar and multi-year scale? As the Irish example shows, publics may be able to take some of the pain, but eventually they can vote against it. The Germans must know this, so why insist on it?

Second, the preferred German policy to get us out of this mess, austerity for others and exports for them, cannot work even in its own terms. As the ECB’s much trumpeted June 2010 report admits, examples of successful ‘growth friendly fiscal consolidation’ are few and apply mainly to small export dependent states whose budgetary consolidation was cushioned by export led growth. Crucially, such states had their own currencies and could devalue as well as deflate, giving them more room to move. Poster child for this policy was Ireland in the late 1980s. Ireland today is discovering that not only is it much harder to do this when everyone else is not growing, and is therefore not importing, you can actually cut so much that the policy cannibalizes future growth via debt deflation.

The problem of exporting your way to success is, as Martin Wolf has ably demonstrated in his FT columns, essentially similar. We can’t all export at once. Someone has to be importing, and for that to happen a state needs to either be able to import capital to cover their current account deficit, as in the cases of the US and the UK, or blow a whole in their current accounts. Now, if I assume that there is no existential reason for Germans not to understand the notion of a fallacy of composition, why do they wish to follow a policy course that is so obviously flawed on both grounds of political sustainability as well as basic economic logic? It can’t work and it will not work, so why keep doing it?

“Spain/Portugal/Italy/France is just another Greece/Ireland Waiting to Happen …”

The joke doing the rounds a year ago was, “what’s the difference between Ireland and Iceland?” The answer was, “one letter and six months.” The unfunny and better answer should have been “not much.” Both of these countries are exceptions, not rules. Both of them turned their economies into Ponzi-schemes so highly levered that all it needed was a less than three percent turn against their biggest banks’ assets to make them insolvent. Both were far too small to absorb such losses. Icelandic and Irish bank indebtedness now hovers between $18,000 and $35,000 per person, depending on how you count it.

This is however, simply not true for any of the other Eurozone states, even the biggest of the problem cases – Spain and Italy. Italian debt is large but it is long term and mainly held domestically. Their banking system is notoriously closed and conservative. Spain certainly got hit hard despite having prudential banking regulations in place at the time of the crisis and being the Eurozone ‘best in class’ for debts and deficits in the years up to the crisis. However, having effectively deindustrialized, it turned its economy into a real estate and financial services hub. So when (external) demand dried up, the current account went awry, and the banking sector stopped paying taxes, and the ‘best in class’ became the last of the PIGS. Portugal did not have a financial crisis, it had an Eastern European-style current account crisis when exports collapsed and consumption came through imports.

For those outside the Eurozone, for example, the UK, whose public debt is still below the 60 percent Maastricht threshold, the claim makes even less sense. Yes, Greece and Ireland are in bad shape, but that’s no reason to start a continent wide austerity movement. It simply will not do anything for growth. But maybe that’s not the real problem.

“The Real Problem is Avoiding the Mother of all Bank Runs”

Another possible explanation for German behavior is more plausible. Putting regional elections and other such trivia to one side, there is a reasonable fear of a general run in the European bond market, similar to what we saw in the US repo-market crisis in 2008. The basic problem is twofold: institutional mismatches and portfolio correlations. First, on a macro level, the European political project was based around a deliberately incomplete contract that allowed agreements to change over time in accordance to circumstances since the final shape of the EU could not be established ex ante. The European financial project was, on the other hand, based on a complete contract that attempted to specify ex ante all possible states of the world via sets of rules and monitoring institutions on the assumption that behavior is a function of rules plus incentives and can be programmed as such.

Unfortunately, such a design does not consider the possibility that private sector actors might, for example, develop swap contracts with governments that allow said governments to perform fiscal prudence while practicing fiscal profligacy, a la Greece and Goldman. Consequently, the possibility that the European bond market might suddenly suffer widely divergent, rather than convergent prices, wasn’t considered at all likely. This contract-mismatch became a problem when bondholders, including some of the biggest European banks, dumped low yielding Northern bonds for higher yielding Southern bonds on the assumption that the risk premium priced in a credible commitment by the ECB to maintain the value of the bond via monitoring the fiscal policies of the member states.

Unfortunately, the ex ante mechanism designed to make this happen, fiscal rules and self-disciplined behavior, fell by the wayside during the last decade. So when the banking crisis hit and the true state of public finances became apparent, the risk premium for holding Southern bonds was revised upwards quite spectacularly. The political incomplete contract had flexibility built into it to deal with contingencies. The monetary complete contract denied contingencies could arise, until they did.

At this point the obvious thing to do would have been for the Germans to buy and hold the troubled bonds, thus denying the markets a piñata strategy, thereby limiting the possibility of a bank run through the bond market where attacks on weak currency leads to attacks against the next most weak currency in anticipation of a short sell. But the Germans did not do this. There were many reasons for not doing this: moral hazard vis-à-vis other countries, upcoming regional elections, schadenfreude. But there was also one very good reason for doing just this, which is the other side of the bank-run story.

What the Germans Know and are Afraid to Admit

You can get a run through a bond market in two ways. The first is to discover that the real price of the bond is not reflected in the risk premium and dump it or short it. The other lies through contagion mechanisms. If banks have essentially similar positions in similar assets, in this case Southern Bonds, the chances are that they also have similar hedges. If so, and these assets are in demand, Southern European bonds in this case, bond rates go down as demand goes up, leading to lower risk premiums as far as the bank is concerned. But if there is a shock that leads to a rapid revision of prices, as there was in 2008 and 2009, the temptation is to look to the hedge to take up the strain. Unfortunately however, by 2010 other available asset classes, real estate and equities are on the floor. So to avoid taking these losses banks will have to liquidate similar assets in an effort to cover their losses, if their hedges will not cover their losses. But it gets worse. If those losses are anticipated in advance, then the temptation is to ‘dump good to cover bad.’ But if my ‘good’ asset is also your ‘good’ asset, then I will try to dump them ahead of you doing the same. You can see where this story of asset correlation goes.

If I know you want to dump Greece, I will dump Ireland, and you will dump Italy to cover the anticipated losses, and I will dump Spain to get ahead of you, and as we all try to cover the bad with good, we all try to find liquidity, when in fact it is a community property, thus creating illiquidity in the bond market, just as happened in the repo market in the US in September 2008. This is why any talk of exiting the Eurozone has to be quashed and austerity is the only game in town. With billions of dollars of risk held in a myriad of banks in dozens of EU countries no one is immune from contagion effects. So if anyone gets wind of someone printing a new currency, for example, the whole thing unravels at light speed as investors try to liquidate ahead of the pack. Investors don’t want to do this in the main. Speculators aside, most bondholders want to ‘be made whole’ rather than blow up their portfolio. But if someone is going to shout fire in a crowded theater, then it pays to be close to the door, the signal for which is the increasing pressure on spreads that we see today.

So if the Germans are smart enough to see this bank run coming, and that they know austerity politics cannot work as advertised, and if the ‘rescue’ vehicle of choice is a $750 billion SPV with no actual cash in it supported by new ‘restructuring mechanisms’ that are seen as less-than-credible by bondholders, and if we can assume that at some point mass publics will vote against austerity, then what is the end game? I think that it might be the case that the Germans are ‘performing austerity’ to buy some time for the inevitable bank run that lies ahead.

Passing the Put Around: Eventually Someone has to Pay Up

Go back to the macro story laid out above for a moment. About two and a half years ago highly levered companies trading deep out of the money options with massive amounts of leverage blew up. For heavily financialized economies (UK, Ireland, Iceland) this ended up on the public sector balance sheet via lost tax revenues, higher interest payments, deficits and debt increases. Globally, two trillion dollars was lost and someone has to pay for it. For those countries that didn’t have a banking crisis, the true extent of their budgetary imbalances (Greece), structural current account deficits (Portugal) or export dependence (Germany, Austria) was revealed in short order. When this happens the way out is, again as noted above, devaluation, default, inflation or deflation, and the EU chose deflation of wages and prices, and the Germans at least talked a good game concerning austerity politics. What they practice was something else entirely; but if other states really did it then its all the better. But why do so if its only performative, and it cannot ‘do what it says on the tin,’ as the Brits like to say?

If the Germans read the game as I do, then they only hope is delaying the bank-run that is coming with promises of SPVs filled with magic Euros and bailouts for the Irish and the Greeks as they slash themselves senseless. But if you know that it’s coming, then so must the bondholders. And if they do, their interests are clear. They bought sovereign debt, not the crappy corporate debt that is now bloating the balance sheets of their sovereigns and increasing their risks, so they really don’t want to take the hit for finance’s `put’ on the state.

So the state put that ‘put’ on the taxpayer. But in a democracy there is only so much you can put on the taxpayer before they throw out the rascals and vote for someone that promises to put that ‘put’ elsewhere, and the only place left is back on the bondholders. So if the bondholders know that the haircut is coming, they can try and put the put back on the banks, but given the state of the bank’s balance sheets and overall business model (it’s bust – and its not coming back), that’s not going to happen. So bondholders have only one out. They pressure the EU, and the Germans in particular, by squeezing peripheral bonds to make sure that taxpayers there take the hit that they don’t want to. But this of course, has a limit. That limit is called Spain. When you put $750 billion in a bag and say ‘bailout funds’ that tells everyone how much you are really willing to lose. It’s a chunk of change and it will take care of Ireland and Greece. But if everyone is, metaphorically speaking, trying to get towards the door in case someone shouts ‘fire’ in the crowded theater, then there is no guarantee it will stop there as contagion mechanisms take hold. In which case Spain’s liabilities, dotted across the bond portfolios of major Eurozone banks, blow through the bag of cash and the limit is reached. When that limit is reached, the mother of all bank runs will begin and the endgame for not just the Euro, but also the EU, will enter its final act.

{ 34 comments }

1

mpowell 01.18.11 at 6:01 pm

I don’t disagree with any of the economic presented here, just the political ones. You are ascribing a lot of unitary intent on Germany which seems to me like a great way to misunderstand how crisis that interact with state actors develop. First, I’m not sure that any of the most relevant German politicians really understand the economics. They are politicians not economists and assuming they will reach valid conclusions about what is possible and what will happen is not very reasonable with an issue that is as complicated to the lay person as this one. They are hearing a lot of different things from different experts and they don’t really have the analytical tools to figure it out for themselves. And also, politicians tend to act in their best short term interests which, in a difficult crisis situation like the one in Europe today, may differ significantly from the interests of Germany in the abstract or even the subset of voters that support that particular politician. I think that it’s true that German politicians are trying to buy some time, but not because it will result in a sensible endgame for the EU or Germany. But just because they don’t have any better options available to them at the moment.

2

mpowell 01.18.11 at 6:53 pm

Er, that first sentence should read economic claims I suppose.

3

shah8 01.18.11 at 9:24 pm

I think third world inflation in China, India, Indonesia, Brazil, and Turkey will drive the euro crisis to its conclusion. Switching from deflation exporting via wage arbitrage to inflation exporting via resource consumption will change the profitability of many corporations and the aggregate debt holdings will change its compositions as world businesses adjusts.

I also wonder if this game isn’t driving a pan-Euro taxpayer conscious (maybe the recent brouhaha with Wikileak and tax-evaders is an indication).

4

Detlef 01.18.11 at 9:28 pm

Much too complicated for this German.
Also what mpowell said.

Simply put any German government would face 2 problems:

_1. Feelings /”conventional wisdom” about the Euro in Germany._

I might be wrong but I believe many (possibly most?) German voters remember the following about the Euro and the last 15 years.(Note: I´m NOT saying that everything is true):

* France (Mitterand) asked for the currency union in return for German reunification.
* Kohl and essentially all existing political political parties in the German parliament agreed. While knowing that a majority of German voters were against it.
* To pacify the voters the German government insisted on the no-bail-out clause and the stability pact.
* When the Euro was introduced as an “accounting unit (1999), it was already obvious that several countries (including Germany) had “massaged” their budget numbers to comply with the stability treaty conditions. Confidence building?
* When the actual paper money was introduced in 2002, people felt that prices had gone up. They were told by politicians and Central Bankers that they were wrong. The inflation rate had actually gone down a little. Which was true for the whole basket of goods. Problem was that some food (goods that you buy almost daily and therefore notice first did go up in price (at least locally). That dismissal of concerns didn´t help to build confidence.
* In the early 2000s Germans faced stagnant wages, high unemployment, cuts in the social safety net and rising taxes. All in the name of becoming competitive again and balancing the budget. (Plus of course lectures from countless domestic and foreign economists and journalists what we were doing wrong. )
* In 2006/07 the German economy finally started to grow again. Unemployment went down. Followed in late 2008 by the financial crash.
* Hello Wall Street and City of London which invented these financial WMDs. And hello economists (domestic and foreign), who´d like to trash the German economy while overlooking the housing bubble in their countries?
* And hello US ratings agencies. Who slapped AAA ratings on any MBS (mortgage backed security) if your fees were met. No questions asked. And who are now really concerned about sovereign risk (after the countries in question have assumed the bank risks formerly rated by you as AAA).

* AND HELLO SEMINAR MEMBERS. Who are now trying to find out why Germans might be a bit irritated right now. Given the fact that most experts/economists didn´t see any housing bubbles at all? And weren´t concerned with trade and current account deficits during the 2000s? Just where were you in the last 10 years?

There are state elections in 7 of the the 16 German states 2011. And voters are furious. They made sacrifices for most of the last decade. Now they had to bail out with tax money some German banks while reading that some of the bankers still insisted on their bonuses (and suing the state for it). Plus, some of the banks had created subsidiaries in Ireland (which then blew up and crippled the German bank) because of less regulation there.

They read about Greece lying about their budget for years. They read about housing bubbles in Ireland and Spain. Do you really think these German voters feel rational right now?

Quite simply put, if Merkel would commit to an unconditional bail-out she´d lose every single one of the 7 state elections this year. Translated = political suicide.

_2. The German Constitutional Court_
There were judicial challenges to the introduction of the Euro in Germany. (Given that we didn´t have a plebiscite this was the only way to challenge it.) IIRC the Court essentially said that the Euro was okay because it didn´t involve a fiscal union (no-bail-out clause, financial stability pact proudly presented by the then German government). Because they seem to view the “budget right” (vote on revenue and spending) one of the basic rights of a democratically elected government and parliament. And right now, they say that the EU Commission and parliament don´t have the same democratic legitimation than a national one (one man, one vote). (A German parliament member represents 859,000 voters, a Maltese one 67,000 for example. )

5

Henry 01.18.11 at 9:50 pm

Detlef – have reformatted 4 to make it more comprehensible. We aim to please. For future reference – you can use Brad Choate’s Textile markup language (but _not_ Textile 2, cos it eats processor time like nobody’s business) to format comments.

6

James Wimberley 01.19.11 at 12:34 am

Who are you, Mr Blyth? No bio, not even as guest blogger. This isn’t a criticism. Fine post. I wish it weren’t so convincing.

Any thoughts on the Chinese imperator ex machina, on which Spain is relying? The Chinese have to park their huge trade surpluses somewhere, as long as their policy is captive to the exporter lobby. US treasuries are safe (ignoring the debt default sabre-rattling from Rand Paul etc), but Beijing must be anticipating a huge loss – a quarter trillion? – from dollar deavluation. The Eurozone is controlled by German austeriacs, so the euro will stay up or explode. The Chinese seem to think that the risk of explosion (which would hurt their exports) is low enough to justify diversification of their bond portfolio.

7

James Wimberley 01.19.11 at 12:44 am

Ops, belay the question about identity, I’ve just found the post introducing the seminar. CT regulars: pleae label your guests better, this is a blog for low-attention-span dippers as well as regulars who read it cover to cover every day.

8

politicalfootball 01.19.11 at 3:52 am

When that limit is reached, the mother of all bank runs will begin and the endgame for not just the Euro, but also the EU, will enter its final act.

I think there is reasonable room for disagreement about the politics that led to this, but can someone make a persuasive case that this isn’t where things are inevitably headed?

To put this question another way, I quote Mr. Wimberly:

so the euro will stay up or explode.

What’s the case for “stay up”?

Also: What’s the best way for a nonprofessional investor to profit from the disintegration of the EU?

9

PHB 01.19.11 at 4:47 am

What surprises me is that there is no talk about dumping Germany out of the Euro.

At this point every country in the Euro apart from Germany needs to inflate. The contagion has not yet spread to Italy and France, but neither economy is in good shape.

If Ireland, Greece, Spain are forced to drop out then the dominoes will continue to topple. If Germany is going to be the only country left in the Euro at the end then why not kick them out at the start?

10

Stark 01.19.11 at 8:16 am

This was extremely informative and frightening, Mr. Blyth, thank you.

11

IM 01.19.11 at 11:14 am

At this point every country in the Euro apart from Germany needs to inflate

I doubt that is true for the Netherlands or Austria, Luxemburg, Belgium, Slovenia and Slovakia. (Estonia perhaps needed to inflate, but that is bit point less now)

So you would kick out about half of the members.

12

chris 01.19.11 at 1:58 pm

PHB has a point though: the Germans are the ones driving the current hard-money hardline (since, as I said on another of these threads, they’ve become vampire squid financiers to the whole continent). If you dump them but keep control of the euro, then you can lighten euro-denominated debt load with inflation, and Germans holding euro-denominated debt can’t stop you.

Even outvoting the Germans would seem to be sufficient to wrest control of euro monetary policy away from them, but it seems like the PIGS and other peripheral countries haven’t even managed that.

13

IM 01.19.11 at 3:37 pm

>Even outvoting the Germans would seem to be sufficient to wrest control of euro monetary policy away from them, but it seems like the PIGS and other peripheral countries haven’t even managed that.<

The obvious solution and so the member-states have only to blame themselves: They have sent the wrong people to Frankfurt.

"The fault, dear Brutus, is not in our stars,
But in ourselves, that we are underlings."

14

mpowell 01.19.11 at 4:24 pm


The obvious solution and so the member-states have only to blame themselves: They have sent the wrong people to Frankfurt.

Okay, I guess you can blame the voters, but isn’t the process for determining EU leadership notoriously vague? My understanding is that the EU is more of a technocracy than a democracy and that this is either a good thing or a problem depending on how you look at it. And in that case, if the EU technocrats want to survive, they need to engineer some inflation and stat. As a group they are fairly autonomous in their decision-making. But technocrats tend to be extremely inflation-averse. You have to get a populist running things before you get any inflation enthusiasm and it seems like the EU is constructed so as to make that impossible.

15

mpowell 01.19.11 at 4:25 pm

On second thought, vague isn’t the word I was looking for. Opaque, I think.

16

chris 01.19.11 at 4:54 pm

My understanding is that the EU is more of a technocracy than a democracy and that this is either a good thing or a problem depending on how you look at it.

If the technocrats are sufficiently in the grip of anti-inflation ideology to ignore the economic problems created for substantial parts of Europe by hard money in a crisis (let alone if they’re actually embracing Mellon-ish liquidationism), then it’s definitely a problem. Governmental institutions exist to serve the human members of society, not vice versa.

17

mpowell 01.19.11 at 5:23 pm

Well I think it is certainly a problem in this case and it may sink the entire effort. But the entire EU effort is sort of an effort by a group of elites to do something good even though they don’t have a lot of popular democratic support. Whether it is really healthy or not, I think there are some policy areas where the technocratic nature of the EU has resulted in better policy outcomes than a more democratic structure would. But this is really a distraction from the topic at hand. I just wanted to point out that the EU is generally less responsive to democratic pressure than national political institutions. If you want to change the direction of a technocracy, you don’t need to blame voters for their decision-making. You just blame the technocrats and directly pressure them to do things differently, I think.

18

David 01.19.11 at 6:49 pm

14 is clearly a misreading of 13. The member state governments have sent the wrong people to Frankfurt, to the ECB.

19

David 01.19.11 at 6:52 pm

“What surprises me is that there is no talk about dumping Germany out of the Euro.

At this point every country in the Euro apart from Germany needs to inflate. The contagion has not yet spread to Italy and France, but neither economy is in good shape.

If Ireland, Greece, Spain are forced to drop out then the dominoes will continue to topple. If Germany is going to be the only country left in the Euro at the end then why not kick them out at the start?”

Edward Hugh has called for the Germans to leave. It’s also the solution to Eichengreen’s dilemma. Kicking them out would surely be unconstitutional though.

20

mpowell 01.19.11 at 7:02 pm


14 is clearly a misreading of 13. The member state governments have sent the wrong people to Frankfurt, to the ECB.

I guess you’re right. I immediately read that as the voters having only themselves to blame, but was thinking, hey that’s not fair, they don’t vote for those guys directly!

21

chris 01.19.11 at 7:24 pm

Edward Hugh has called for the Germans to leave. It’s also the solution to Eichengreen’s dilemma. Kicking them out would surely be unconstitutional though.

There’s no provision for removing a member by vote of the other members? 2/3, 3/4, even unanimity except for the member to be removed? Seems like poor institutional design, if so. What are the provisions for constitutional amendment (to create an expulsion power, which could then be exercised as provided for in the amendment)?

Regardless, though, the EU constitution itself has force only as long as its participants agree to continue abiding by it.

22

IM 01.19.11 at 9:32 pm

I did indeed talk about the bank. The EU after all is run by the governments. Other institutions have power too, in descending order: The court, the commission, the bank, the parliament. But all these institutions, with the exception of the parliament, hav one thign in common: Their members are appointed by the national and mostly on one state, one member basis. So the governments of the member states and perhaps especially the smaller states, should never complain about Brussels or Luxemburg or Frankfurt: They appointed these people.

If you appoint a lot of inflation hawks to the top of your central bank, the current ECB is that you get. After all, even the Bundesbank has only one vote.

23

Detlef 01.19.11 at 11:00 pm

PHB,

What surprises me is that there is no talk about dumping Germany out of the Euro.

The rest would still need loans. Interest rates for them would certainly rise.
And – given that it would probably be seen as a start to lower the value of the Euro – how many of them could then place Euro-denominated bonds?
Or would some of the (smaller) countries be forced to place bonds denominated in foreign currencies? Coupled with high interest rates?
I really don´t know.

Likewise I don´t know what some other Eurozone countries would do.
The “BeNeLux” countries, Austria, Slovakia?
Doing okay and with strong ties to the German economy?

Not to mention how “dumping Germany” would be received in Germany?
If I were the EU I would worry given that Germany is the largest EU net-payer.
I could see calls to copy Norway, EFTA member, associated to the EU, but not a part of it. Which probably would add additional fuel to similar sentiments in the UK.
Difficult to say but the risk shouldn´t be overlooked.

@Henry,

Thank you!
I posted comment 4. Then saw how messy it looked. Tried to repost it using more breaks. And then saw too late that comment 4 now looked tidied up. :)

24

The solution is obvious 01.20.11 at 12:00 am

The Euro was well meant, but it didn’t work. The countries, cultures and economie are to different from each other.
So why not make new currencies. A solid one fpr Germany, Skandinavia, Austria, Netherlands, a weak one fpr all those countries that don’t get their shit done, like Greece, Spain and whatnot and one for the young rising economies to the the east. There: problem solved.

Kicking Germany out of the Euro: Please do!

25

Detlef 01.20.11 at 12:05 am

mpowell,

Well I think it is certainly a problem in this case and it may sink the entire effort. But the entire EU effort is sort of an effort by a group of elites to do something good even though they don’t have a lot of popular democratic support. Whether it is really healthy or not, I think there are some policy areas where the technocratic nature of the EU has resulted in better policy outcomes than a more democratic structure would. But this is really a distraction from the topic at hand.

Not at all.
I think that is the main problem right now.

I remember reading newspaper articles in the past quoting “EU technocrats” how past crises made the EU stronger. How it gradually gave the EU more powers.
The point is the past crises were a lot smaller – compared to today – and it usually involved just some “small” gradual tinkering around the edges. Almost invisible to the voters in the member states.
Voting rights for countries, distribution of EU funds, rights of EU regulation etc.

Coupled of course with national government members (in every member state) voting for some EU regulation in a closed non-public EU meeting and then back home blaming the EU if said EU regulation was unpopular at home. Which of course didn´t help the EU reputation.

But that involved – in the public eye – a few dozen millions here, a few hundred millions there. Easily forgotten.

A lot of EU things are really popular. Free movement, right of residence and work across the EU for example.

But now we´re talking about dozens, maybe hundreds of billions of Euro.
Billions that somehow weren´t available to improve conditions domestically?
And people look around and say wait a minute, nobody told me that. In fact, I was assured that this would never happen.
In that case not having “popular democratic support” is a problem.

Simply put, you can´t go on ignoring popular support in a democracy for years or decades and then act surprised if the voters refuse to sacrifice on your order.
Things might be different if citizens might have been allowed to vote on them. In that case it might have been more like a “we voted for it, now we have to accept the responsibilities”.

The European “group of elites” deliberately(?) decided not to try and convince their voters. And now we have a problem…

26

PHB 01.20.11 at 12:24 am

Detlef,

Since the basic problem with the Euro is that the designers didn’t really think about the problem we now face there is no solution that does not involve some degree of change to the institutions.

So why not open discussion on the German option? It is at the very least a way to put pressure on the German government.

There are two ways in which Germany could be kicked out. One is that they find a way to throw Germany out, the other is that everyone else leaves and joins the Uero. If the contagion issue keeps dumping countries out of contention that is what will happen any way.

27

hix 01.20.11 at 12:41 am

You hate Germany, Phb so much i get. Shouldnt your plans to hurt Germany involve Germany getting hurt more than anyone else in that case?

28

heterophilous 01.20.11 at 1:47 am

Bravo! This is a fabulously lucid and witty explication of various political and economic dynamics driving the current Eurozone banking crisis. But like Mr. Wimberley, I too am curious about your thoughts on a possible Chinese backstop?

Dollar diversification motives aside, it would make eminent sense for the PRC to get a hold of some (potentially) higher yielding, productive assets via an SWF recapitalization of the Euro banking system – as opposed to sticking to their current debt-centric portfolio of low-yielding, Treasury bills.

So might we also want to factor in the possibility of a Chinese put on Eurozone sovereign / Eurozone banking debt as well?

To be sure, China’s earlier SWF forays into currency / asset diversification (e.g. Blackstone) did not at all go particularly well. But that’s not to say they might not yet pull off a more hard-knuckled, Warren Buffet style deal on restructured EMU bank debts – and one that would offer up far more value to Chinese taxpayers than those spineless terms negotiated by the Paulson and Geithner Treasury Departments in their pricing U.S. taxpayer guarantees.

Andy Xie: http://bit.ly/emtVDg

Ambrose Evans-Pritchard: http://bit.ly/fER88G

Simon Johnson: http://bloom.bg/eMmnAA

Niall Ferguson: http://bit.ly/guiWHr

29

Hoover 01.20.11 at 12:59 pm

“what we have in this case, with the Greeks as a possible exception, is not state profligacy”

Sigh.

Of course we have state profligacy. The welfare state couldn’t go on in the manner it was going on.

“Is it reasonable to expect mass publics to pay for the mistakes of private elites on a multi-billion dollar and multi-year scale? “

Mass publics aren’t paying for the mistakes of private elites. They’re paying for all those decades of child support payments, the housing benefit, the public sector salaries and pensions they receive, the attractive unemployment benefits, the free university education for 50% of youth, and so on and so on. And finally, of course, the fact that old age lasts twice as long as it did when the welfare state was introduced.

30

Marvin 01.20.11 at 2:58 pm

29

Sigh

It’s always the poor people’s fault. Our sort of people can’t possibly do anything wrong. The fact that these systems persisted for decades until our sort of people had their little incident (which was probably the poor people’s fault too), whereupon they collapsed, gives a bit of an indication as to whose side of the bargain was unsustainable.

31

IM 01.20.11 at 5:58 pm

But if that theory is true the scandinavian countries should be in trouble and not neoliberal darling Ireland. Funny that you mentioned no numbers.

32

john the pessemist 01.22.11 at 10:50 am

After Dr Bini-Smaghi’s comments, and Barroso’s outburst, One really does wonder.

But of course this wouldn’t be the first time I’ve scratched my head and wondered what on earth they suppose may happen.

I’m thinking that the deflation of the periphery (you could say it was enforced, but only insofar as e.g. Ireland wishes to continue borrowing in order to underwrite the status quo) has as an end-game the unification of fiscal authority in the eurozone, with the discredited ‘anglo-saxon’ model left out of the party.

But isn’t the ailment of conspiracy theorists, to fantasize that hidden motives exist behind incomprehensible acts?

33

George Irvin 01.22.11 at 1:10 pm

This is an absolutely first-rate piece. I do disagree with one point, though: ‘For any country in the Eurozone who transferred private debt from the banking sector to their public balance sheets, and thus blew a hole in their debts and deficits, neither inflation nor devaluation were options. ‘

The truth is that the ECB could fund a massive soevereign debt purchase (directly or indirectly through a new ‘eurobond’) by QE (obviously without sterilisation). With weak trade unions and high unemployment, the chances of this spilling over into serious inflation are minimal, and even were home-grown inflation to take hold, the pain would be less than that caused by ‘passing the put to the taxpayer’.

If the Germans (as argued) are merely buying time because they do in fact anticipate a taxpayer revolt followed by a massive bank run, a monetisation strategy would now be sensible—but of course, as somebody has noted above, that does impute a degree of economic sophistication to the current crop of German politicians which they don’t seem to have!

34

mark blyth 01.24.11 at 2:39 pm

Dear All:

Thank you for taking the time to read the article and engage with it. I do appreciate it and have enjoyed reading the comments. I would have posted some replies earlier but a bureaucratic matter at Brown has taken up much of my past week. Anyways, some thoughts on your thoughts…

m powell at 1 – You are quite correct that I impute a unitary action to German leadership on the grounds that I should hope that they can act as such. If they can’t they shouldn’t go around setting up pan-continental institutions for which they are the ultimate backstop. Politicians everywhere are short-termist and econophobic, but frankly, I expect better from a country that toots its horn more than infrequently concerning its Wirtschaftwunder, export prowess, and inflation control. Leading by example is one thing, but real leadership requires more than shouting ‘you suck’ from the sidelines. They do have better options, but that requires acting rather than critiquing others.

Shah8 at 3 – I hadn’t really considered the effect of an inflation regime switch. You would have to factor in the effect on import inflation on the core economies too, which would further dampen exports without, probably, doing much to offset imbalances, hence the downside of this for the Euro. Good point. Will give it more thought. A lot of this is going to come from oil prices, which seem to be going up despite global supply going up and demand being weak. Anyone else think this smells like 2006-7? Every other asset class on the floor or too pumped up – so get those institutional investors buying shedloads of commodity ETFs and roll them forward with calendar forwards? Enter the righteous indignation of EMH true-believers everywhere – part two…will do a Huff Post blog on this soon if I can find a n hour to write it up.

Detlef at 4 – What a fabulous history of Europe in 500 words. Truly. The point about the conventional wisdom being so powerful is bang on. I was in Berlin last week for my Schwegerbruder’s 40th birthday and I pointed out to the crowd that their banks dumped lots of their own bunts and bought periphery ones to profit on the spread. This gave the periphery a lot of cheap money to buy their BMWs. You should have heard the howls of protest! “Are you serious – its our fault – is that what you Americans tell yourselves because we are successful and make things people want?” sigh…(I’m Scottish BTW…)

I just don’t understand why these folks don’t understand fallacies of composition – really. I explain it every time and I always get the same answer “that’s too simple” to which I suppress the reply “then it must be true since you can’t understand it.” We cannot all export our way to success. Someone has to import.

You are right about angry voters. Ireland is one again blazing a trail in this regard. Remember the old political business cycle arguments where politicians promise austerity but pump the economy to win, then deflate, then reflate, all the while pushing the LRPC out to the right? The new version is to resign before the shit really hits the fan and let whoever is left standing take the blame, let them get voted out and come back in saying it was the other guys fault all along as the LRPC goes flat.

As for the constitutional court, as CT bloger DD has argued, Germany can make loans and forgive loans to whomever they like. Karlsruhe is a bit like their football team – they seem scary from a distance but will fold under any real pressure.

James Wimberly at 7 The Chinese and the Euro option. You are right, and it happens to be good politics in that it gives China good press in Europe, allows diversification, takes the pressure off the Germans, and make the US look weak and China a leader. There is just one problem. Low risk does not mean no risk. And if US T-bills are going down by as much as you say, that’s less of a loss on a better probability than a catastrophic loss on a much lower probability. So what happens if they diversify, Spain goes in the tank, and T-Bills go south? Not without risk.

Political Football at 8 – I am not telling you my trading strategy. All I will say is be very careful be careful with currency ETFs. I know this from experience last year.

Various – kicking out the Germans . I hadn’t thought of that, but it does smack a little of ‘the operation was a success but the patient is dead.’ If the basic problem is that the institutional mismatch between the political and economic unions needs to be fixed, chucking out the only folks who can fix it is not going to help. Moreover, if the other basic problem is that there in no real LOLR except the Germans through the ECB, who really want everyone to stop saying that they are the LOLR, then chucking them out means the ultimate cut you losses strategy. And if I were a big German bank and saw that coming, I would be on your bonds like a priest in a playground.

Chris at 16 – Anti inflation Ideology – bang on. The ECB has been fighting an inflation that died 25 years ago for the past 12 and bit years. It is destructive and lies at the core of the austerity thinking in Germany and elsewhere. Consider that in 1960 a four percent inflation rate was regarded as excellent work. It now signals a crisis the requires a raising of interest rates in the middle of a recession.

Hoover at 29 – Thanks for reminding me that simple ideas are not always true. There’s a nice pie chart on p. 14 of the IMF fiscal monitor for May 2010. You can get it at:

http://www.imf.org/external/pubs/ft/fm/2010/fm1001.pdf

It explains how across the OECD average debt has gone up by 39.1 percent and only 12 percent of that 39.1 percent is due to stimulus spending. The rest of it – over 80 percent of the 39.1 percent increase – is the direct result of lost revenue, bailouts and financial sector recapitalization. Bailing the Rich. Yeah – housing benefit – that did it. Not.

George Irwin at 33 – Great point. The ECB could do QE (monetization now) but will not, due in part to the anti inflation ideology Chris noted, but also because that would make it a real LOLR and not just an inflation fighting agency. That is exactly what needs to happen, and that is exactly why its going to prove very difficult for exactly the reason you suggest.

Best to all

Mark

Comments on this entry are closed.