(Update) The Fire Next Time: The Euro Financial Crisis

Posted by AzBlueMeanie:

I warned you about this a few weeks ago. The Fire Next Time: The Euro Financial Crisis. European leaders have been trying to come to a multi-government agreement on dealing with European sovereign debt, in particular Greece which stands on the precipice of default, and recapitalizing European banks. As you might imagine, it has not been going well. European leaders have set this week as a deadline of sorts to come up with a plan.

When, not if, the European financial system collapses it will effect the world's economy just as the American financial system collapse in 2008 effected the world's economy. It is a preventable crisis, but European leaders lack the foresight and the will to do what is necessary, the same as their American counterparts.

Paul Krugman writes in his column The Hole in Europe’s Bucket – NYTimes.com:

If it weren’t so tragic, the current European crisis would be funny, in a gallows-humor sort of way. For as one rescue plan after another falls flat, Europe’s Very Serious People — who are, if such a thing is possible, even more pompous and self-regarding than their American counterparts — just keep looking more and more ridiculous.

* * *

[A]t this point, Greece, where the crisis began, is no more than a grim sideshow. The clear and present danger comes instead from a sort of bank run on Italy, the euro area’s third-largest economy. Investors, fearing a possible default, are demanding high interest rates on Italian debt. And these high interest rates, by raising the burden of debt service, make default more likely.

It’s a vicious circle, with fears of default threatening to become a self-fulfilling prophecy. To save the euro, this threat must be contained. But how? The answer has to involve creating a fund that can, if necessary, lend Italy (and Spain, which is also under threat) enough money that it doesn’t need to borrow at those high rates. Such a fund probably wouldn’t have to be used, since its mere existence should put an end to the cycle of fear. But the potential for really large-scale lending, certainly more than a trillion euros’ worth, has to be there.

And here’s the problem: All the various proposals for creating such a fund ultimately require backing from major European governments, whose promises to investors must be credible for the plan to work. Yet Italy is one of those major governments; it can’t achieve a rescue by lending money to itself. And France, the euro area’s second-biggest economy, has been looking shaky lately, raising fears that creation of a large rescue fund, by in effect adding to French debt, could simply have the effect of adding France to the list of crisis countries. There’s a hole in the bucket, dear Liza, dear Liza.

You see what I mean about the situation being funny in a gallows-humor fashion? What makes the story really painful is the fact that none of this had to happen.

Think about countries like Britain, Japan and the United States, which have large debts and deficits yet remain able to borrow at low interest rates. What’s their secret? The answer, in large part, is that they retain their own currencies, and investors know that in a pinch they could finance their deficits by printing more of those currencies. If the European Central Bank were to similarly stand behind European debts, the crisis would ease dramatically.

Wouldn’t that cause inflation? Probably not: whatever the likes of Ron Paul may believe, money creation isn’t inflationary in a depressed economy. Furthermore, Europe actually needs modestly higher overall inflation: too low an overall inflation rate would condemn southern Europe to years of grinding deflation, virtually guaranteeing both continued high unemployment and a string of defaults.

But such action, we keep being told, is off the table. The statutes under which the central bank was established supposedly prohibit this kind of thing, although one suspects that clever lawyers could find a way to make it happen. The broader problem, however, is that the whole euro system was designed to fight the last economic war. It’s a Maginot Line built to prevent a replay of the 1970s, which is worse than useless when the real danger is a replay of the 1930s.

And this turn of events is, as I said, tragic.

* * *

[T]he European elite, in its arrogance, locked the Continent into a monetary system that recreated the rigidities of the gold standard, and — like the gold standard in the 1930s — has turned into a deadly trap.

Now maybe European leaders will come up with a truly credible rescue plan. I hope so, but I don’t expect it.

The bitter truth is that it’s looking more and more as if the euro system is doomed. And the even more bitter truth is that given the way that system has been performing, Europe might be better off if it collapses sooner rather than later.

Krugman fleshes out his column at his blog in several posts. There's A Hole In The Bucket – NYTimes.com:

The answer to the whole conundrum is to back the rescue, not with French guarantees, but with the power of the printing press — to put the ECB behind the effort. But the ECB won’t and maybe can’t (under current rules) do that.

And meanwhile, austerity programs are leading to severe slumps in Greece and elsewhere. Who could have imagined that?

What a tragedy. A rich, productive continent, which has produced arguably the most decent societies in human history, is tearing itself apart because its elite insisted on embarking on a dubious monetary project, and now can’t bring itself to take the steps necessary to give that project a chance of working.

In Meanwhile, Greece – NYTimes.com Krugman writes:

At this point Greece almost seems like a sideshow. Yet the scale of its coming default matters, especially with some players still denying that such a default is conceivable. So I would be remiss not to mention the awesomely depressing report of European Commission economists, which is marked “strictly confidential” but has, of course, gone viral.

The opening:

Since the fourth review, the situation in Greece has taken a turn for the worse, with the economy increasingly adjusting through recession and related wage-price channels, rather than through structural reform driven increases in productivity.

That in itself is quite a revelation; did they really believe that structural reform was going to save the day? Even aside from doubts about Greek ability/willingness to carry through on promises, the fact is that nobody knows how much if any payoff microeconomic reforms will yield, and nobody in his right mind builds such payoffs into a fiscal plan.

In Deck Chairs, Titanic – NYTimes.com Krugman writes:

OK, yes, European banks do need more capital. But their problems are a symptom of the underlying sovereign debt problem, which can only be resolved, if at all, with ECB lending AND a commitment to reflate. Without that, the losses on sovereign debt will blow right through any amount of newly raised bank capital.

So when I read

Europe’s big banks will be forced to find €108bn ($150bn) of fresh capital over the next six to nine months under a deal to strengthen the banking system agreed by European Union finance ministers.

I think, this is a band-aid — and one that’s going to be applied gradually, over six to nine months! — when the patient is at risk of dying in a few weeks from damage to his internal organs.

Finally, in More Grim Euro Thoughts – NYTimes.com Krugman writes:

Look at the June 2010 monthly report of the ECB (pdf), specifically the discussion of “fiscal consolidation” on page 83 and following. Basically, the ECB pooh-poohs any notion that austerity would have major negative effects on the economy, suggests that it’s quite likely that the confidence fairy will make everything OK, and specifically says that

Determined action on the part of governments to undertake fiscal and structural reforms is necessary to preserve stability and cohesion in the euro area. A sustained commitment to consolidation, possibly including a speeding up of current plans and their delivery, is required from all governments to ensure that the time afforded by the exceptional measures is used to put public finances on a permanently sounder footing.

[emphasis added]

So the ECB was calling for austerity everywhere. Was any concern expressed about how that would affect Europe-wide growth? Was there any suggestion of expansionary monetary policy to offset such a coordinated fiscal contraction? No and no.

And now they’re shocked, shocked that the Greek economy is plunging into a hole.

Meanwhile, I see that Wolfgang Munchau is appropriately horrified by what he hears about the plans for a rescue fund. As he says, the notion of leveraging up funds from the remaining AAA Europeans amounts to creating either a super-AIG or a super-CDO — basically trading off the AAA rating of those countries to make private investors feel safe. The problem is that taking on that commitment could very quickly push France into non-AAA status, collapsing the whole thing.

It really has to be the ECB, for this to have any chance of working. But that’s apparently off the table.

It's looking more and more like the financial elites who view themselves as the "Masters of the Universe" are about to plunge the world into another deep recession because of their adherence to failed and discredited conservative economic theory. We need a new economic paradigm, but the financial elites are not ready to accept this. It is going to take a tragedy of their making to usher in a new economic paradigm.