By L. Randall Wray
This post first appeared at "Great Leap Forward”, my EconoMonitor blog.
As I predicted last week, the run out of Euro government debt would spread from the periphery to the supposedly fiscally sound countries of the center and north. Today it happened. The inevitable was inevitable.
The problem was never one of profligate Mediterraneans with lax fiscal policy. No Euro nation should ever have run chronic deficits of any size; none should have run up any significant debt ratio. By design, these are not sovereign countries in the currency sense—they abandoned their own sovereign currencies years ago in favor of a foreign currency. And like any nation that gives up its sovereign currency, every one of them lost the ability to run chronic budget deficits.
It is commonplace to argue that no household can run chronic budget deficits. And it is more-or-less true—or at least more true than false. A day of reckoning will arrive when income cannot service the debt, and then Armageddon arrives when the banker shuts off the line of credit. Without access to new credit to pay the bills, including interest, the household must tighten its belt or default. No need to go through the various caveats that allow some belt loosening–so that households are not strictly constrained by income–as you get the picture.
Governments that use foreign currencies are cut a bit more slack than are households. First, their incomes are often more discretionary than are household incomes—with a stroke of the pen, government can increase tax rates. Unless Laffer Curve dynamics are operative, government revenues (“income”) increase. Hence lenders to government might be willing to believe that while today there is a deficit, tomorrow with sufficient fiscal rectitude government can pay its bills. Second, government spending today can help the economy to grow—raising revenue without a tax hike. In that sense, government is less like a household and a bit more like a firm that “invests” to increase future income that is required to service the debt. Third, lenders might simply rely on faith—the hope that somehow, some way, government will be able to make its unpayable commitments. Maybe a fairy godmother will come along—the IMF, the World Bank, the Fed, or the ECB—to provide lending the highly indebted government can use to pay off private creditors. Fourth, creditors might be fools—unable to understand the difference between a sovereign currency issuer and a government that uses a foreign currency.
In the case of the EMU I suspect all of these played a role in the mass delusion. Anyone who ever bought government debt issued by any euro-using nation was, in the memorable words of Kenneth Boulding, either a philanthropist or a fool. Probably both.
It’s over, folks. After Greece’s 50% haircut, the fools were exposed. No one with any fiduciary responsibility should be holding euro-denominated government debt any longer.
To be sure, the final act will play out over some period of time. First the PIIGS, then France, Austria, Finland and the Netherlands. But it will get to Germany. Germany! Yes, the mother of all fiscal rectitude. Its own debt ratio is orders of magnitude too high for a country that gave up its currency. (Remember Argentina? Adopted the currency board—essentially the same thing as adopting the euro. It always met the Maastricht criteria—unlike Germany—and collapsed into crisis all the same.)
Yes, Germany’s bond market will benefit for a while from the run on all the other euro nations—but the last bondholders holding the euro hot potato will realize Germany is in no better shape. And then they will run to the US dollar. The Japanese Yen. The UK pound.
Why? Currency sovereignty—as even Paul Krugman now agrees. It makes all the difference in the world. ()
Today a group of economists issued a petition to the (new, Berlusconi-free) Italian government. You can read it here. They set out what is mostly good advice based on the premise that Italy should remain in the EMU. Many of my friends signed the petition, but I had to decline. Here is the text of my response to them:
Dear Friends: I share your concern about the grave situation in Italy. I support much of the petition. In particular, I agree that the ECB must stand ready to buy government debt–indeed, it should announce its intention to drive interest rates for government debt of every member below 3%, and keep buying until it achieves the goal. I also agree that fiscal contraction must be abandoned. There are however three points discussed in the petition on which my views diverge:
a) The solution to the Euro crisis is not to be found in SDRs and the IMF. The ECB can immediately end the problem with government debt. No external help is required, nor should it be sought.
b) The petition should not call for stabilizing debt ratios at current levels. With an ECB backstop, the debt ratio disappears as a matter for concern. It is impossible to say in advance what debt ratio will be required for Italy (and others) to grow back toward prosperity and full employment. There is no point in tying government’s hand to any particular debt ratio.
c) The petition’s statement about “freeing resources” to direct them to promoting full employment is confused. It seems to be based on some loanable funds model. Europe’s problem is that it has far too many “free resources” that are idle–unused capacity: labor, factories–so it does not need to “free” any more. If the petition is discussing “financial resources”, then these are never a scarce resource that needs to be “freed”. I also do not like the statement about taxes. Of course tax evasion should be reduced–but that is a matter of fairness, not “financial resources”.
The first of these points is admittedly minor. The final two points are important. I would like to join my friends in signing the petition but I regret to say that I cannot support arbitrary debt limits (once there is a backstop–and without the backstop then all euro-using governments must reduce their debt ratios tremendously, perhaps to no more than 15% to 20% of GDP), nor a confusing statement on the necessity of freeing resources.
The EMU can be saved. But saving it will require that the ECB do something that goes against its DNA. The EMU was set up with its restrictions precisely to ensure that there would never be a rescue by the ECB. The separation of Euro-wide monetary policy (interest rate setting) from fiscal finances was to be inviolable. Hence, it is not at all clear that the EMU will be saved.
The more important question is this: Is the EMU worth saving?
Probably not.
I was never convinced that monetary union was a good idea, even in the best of circumstances. The arguments for it—that it would reduce all the transactions costs associated with exchanging currencies—were always overblown.
Greater integration of Europe—commercially, culturally, socially—did not require it.
And it is the EMU that is now tearing Europe apart.
Time to abandon the failed experiment?