Posted on May 3, 2012 - by invest
IN A Tuesday post on potential alternatives to austerity in Europe, I wrote:
What, then, are the alternatives to austerity? Well, first up would be an integration that would help break the diabolical loop now gutting the periphery. Creating a euro-zone-wide safe asset and a euro-zone-wide set of institutions to stand behind damaged banks would help accomplish that. America doesn’t expect Delaware to shoulder the costs of failures of banks headquartered in Delaware. That’s an important contributor to the stability of the American federal system. The euro-zone must recognise that it is the failure to build appropriate euro-zone-wide institutions—equal in scope to the considerations and resources of the central bank—that is contributing to soaring yields around the periphery and creating the illusion of the need for dramatic austerity in places that could do without it.
Tyler Cowen says I fail to put forward a workable solution:
I call this the “Germany pays for everything and accepts all the risk of moral hazard” approach. Potential German liabilities could run in the trillions of euros and the “ball and chain” lasts forever. I know all about Connecticut and Mississippi, but without a common electorate, not to mention a common national identity, I don’t see how this is possible. Keep in mind that Eurozone-wide deposit insurance in essence serves as an implicit guarantee to the parent national governments as well, for Modigliani-Miller-like reasons.
This strikes me as mistaken for a few reasons. First, the recommendations in the cited paragraph are workable in the sense that they’re among the future policy shifts most likely to occur. I think it’s far more likely that the euro zone gets a eurobond in the next year or so than that it solves its competitiveness problems.
Second, Germans no doubt see solutions like this as putting them on the hook for trillions in potential losses, but I think they’re wrong to do so. The problem at which the above solution takes aim is the fact that the euro zone has slipped into a bad equilibrium, in which loss of confidence in the sovereign affects the banks which affects the sovereign. If the periphery manages to escape that equilibrium the total costs of the crisis fall dramatically. And my recommendation goes a very long way toward achieving that. That’s partly because of fiscal risk-sharing, but mostly because a euro-zone-wide backstop will be fully supported by a central bank. Ireland failed in its game of chicken with markets because it had no printing presses to support its blanket bank guarantee.
I am hopeful of progress on this front because ultimately it is the cheapest way to escape the crisis—far cheaper than adopting a massive system of fiscal transfers. And the Germans are already working on ways to develop eurobonds that should minimise moral hazard.
Mr Cowen is right, however, that the lack of shared national identity is a problem. It is primarily a problem because it encourages governments to adopt a moralistic view of the crisis. Germans are tempted to think that their relative success is due to Spanish sloth or Italian corruption, which reinforces support for “punitive” efforts to address the crisis. Spanish and Italian workers resent the moralistic German approach and resist austerity, striking in opposition to cuts and so on. This reinforces the view in the core that the south is full of lazy, state-dependent leeches.
Fine. Mr Cowen implies that perhaps there is no alternative. That’s no good; in my view, continuing on the current path is tantamount to advocating for a break-up. My solution is certainly cheaper than that! And, I continue to think, more likely to occur. My broader point is that the dynamics Mr Cowen cites—the problem of a lack of common national identity—will in hindsight make the end of the euro zone look inevitable. It isn’t. Men and women are responsible for their actions, and different actions would make survival of the crisis far, far more likely, which would in turn buy substantially more time for the process of European cultural and political integration. Every ECB meeting in which Mario Draghi stands by and does nothing is a preventable step along the road to the end.
Incidentally, Mr Cowen’s suggestion that inflation well above 4% would be necessary to fix the euro zone’s problems seems dubious to me, or at least in need of supportive evidence. At any rate there is no excuse not to try 4% inflation, given the probable magnitude of the costs of break-up.
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