Some brief thoughts on the eurozone breaking up

Summary: Recently, Niall Ferguson reminded us of the eurozone pessimism of 2011 and 2012 in a recent polemic against Paul Krugman. Without getting into the Krugman-Ferguson war, I want to hone in on this subject because I think it tells us something about the way crisis politics work.

I had written only the summary above when my mother called, asking me about an investment advisor she heard on the radio who was predicting hyperinflation in the United States and the fall of the US dollar. This gentleman – who I learned in a brief Internet search, had been fined for running a fraudulent investment in the past – spoke for an hour, my mother told me. And he advised buying gold and silver, holding large amounts of cash and stocking food and water in non-urban areas in anticipation of the coming social unrest and riots in the United States.

Now, even before my mother told me of his extreme Armageddon prediction, I told her to always be sceptical when you hear someone pontificating on a subject where you are not well-versed. For me, it’s like healthcare. I like to think I am an informed citizen and know something about the topic. But I do know that I don’t know nearly enough and that it would be easy for me to latch on to someone’s healthcare message even though it was wrong because it sounded logical.  I thought it was pretty scary that my mother was being bamboozled by this man with tales of economic woe in order to get her and people like her to invest in his dubious economic investment schemes.

And I thought as well that it was appropriate that she called when she did since I was about to write on eurozone breakup, another Armageddon scenario. Early this morning, I read a piece at Noahpinion about the recent Niall Ferguson anti-Paul Krugman trilogy. Basically, Ferguson shows how Paul Krugman was very pessimistic about the eurozone at the height of the crisis and how he was wrong to be so pessimistic. The blogger at Noahpinion rightly agrees there is merit to Ferguson’s argument irrespective of what your personal views on Krugman and Ferguson are.

I was also pessimistic about the eurozone. I still am. So I looked back at what I had been saying and came across a good piece from January on Grexit referring back to my height-of-the-crisis view on Why the Greek deal will see the country through to 2014:

“When a crisis starts, political inertia means that the crisis will always get much worse before it is resolved. In some instances, the crisis doesn’t get resolved – and that then leads to economic collapse, hyperinflation, famine and war. But usually political leaders don’t let it get that far. We should always expect the full extent of crisis to be underestimated but to eventually be resolved. My mantra is that we should hope for the best, prepare for the worst and expect something in between.

“And so it is with Greece.

[…]

“…I would say my view is probably somewhat more dour here in that I believe Greece will eventually exit the eurozone. My baseline is for a disorderly breakup. However, I do believe that eurozone policy makers are committed to the euro. And given the lack of euro zone exit mechanisms, I do not believe that a Greek exit is possible in the near to medium-term.

“Now, the worst case scenario would be a disorderly default and exit by Greece, followed by copycat defaults and exits elsewhere in the periphery that would lead to the euro’s collapse. Bt this kind of Armageddon scenario would mean the end of one of the world’s leading exchange and reserve currencies. It would mean a complete about face by a number of leading European policy makers. And it would also mean opening up the European and world economies to an enormous wave of economic and political unpredictability. I see this as very far-fetched. It won’t happen.

“The most likely scenario for Greece is that we continue on the present path of varying levels of austerity and reform in exchange for bailouts. Along the way, the economic and political situation in Greece will become extreme, making an eventual Greek exit from the euro zone possible – and in my view probable. This exit would occur only after the general crisis had ended and Greeks understood that Greece still wasn’t prospering economically within the euro zone.”

I still fully ascribe to this view with the first paragraph being the most important point here. Politics is unpredictable. One never knows what will happen in an economic crisis because human beings often make poor decisions under stress in short time frames. We have to be prepared for worst case scenarios even though the force of consensus policy making almost always dictates a less extreme outcome, something that will protect the status quo.

In the American crisis from 2008, that is what we saw and also what we saw again in Europe. This is of course, what we expect to occur in the US with the debt ceiling crisis. But, again, human beings are unpredictable. Policy error is always a possibility. And so the U.S. could default and throw us into turmoil.

Now looking at the eurozone, Greece is still clearly the worst off economically. And the public debt burden is unsustainable within a non-sovereign currency framework like the eurozone. And note that the Germans have confirmed this recently, openly talking about restructuring in the lead up to the general election. Next year, the contraction in Greece will end and the long stagnation will begin. The political question goes to how much stagnation the Greeks are willing to suffer and how much debt relief the Germans are willing to give. It is still Germany in the driver’s seat on the Greek debt negotiation. And the Germans know to give Greece some leeway as the restructuring talk indicates. But will it be enough over the long-term? I say no. But this is a political question more than an economic one and we won’t know the answer for a long time to come.