European shock and awe

Europe’s attempt at shock and awe exploded Sunday night, blasting the markets into a Monday of euphoria. Now the dust and debris are settling and we can inspect what just happened. In particular, we can ask whether Europe’s big move will solve the problem and what this means for the European Union going forward economically and politically.

To figure out whether it will solve Europe’s problem, we first have to decide what the problem is. That, in fact, is at the crux of the matter. There are two very different ways of thinking about the crisis along Europe’s periphery (Portugal, Ireland, Italy, Greece, and Spain — PIIGS):

1. It’s a solvency crisis. These countries have let their debts get out of hand. In some cases, it was government borrowing, in some cases private sector borrowing, but in all cases it looks unsustainable. The problem first became apparent in Greece, but investors soon recognized the same symptoms in the other countries. The spread of rising spreads (higher borrowing costs) was not so much contagion as it was a dawning recognition that a number of countries had been afflicted by the same syndrome. Or:
2. It’s a liquidity crisis. These countries have some debt problems, but they are really victims of ravenous and amoral speculators. Those speculators create crises, rather than recognize them. When they stampede out of bond markets and drive up interest rates, otherwise viable budget situations become untenable.

Europe’s solution of a trillion dollars of backup funds is aimed squarely at the liquidity crisis interpretation. By providing funds to the beleaguered countries at reasonable rates, those countries will have time to get their fiscal affairs in order and work their way out of this mess.

The difficulty is that the evidence seems to point to a solvency crisis. Paul Krugman put it concisely:

Consider what Greece would get if it simply stopped paying any interest or principal on its debt. All it would have to do then is run a zero primary deficit — taking in as much in taxes as it spends on things other than interest on its debt. But here’s the thing: Greece is currently running a huge primary deficit — 8.5 percent of GDP in 2009. So even a complete debt default wouldn’t save Greece from the necessity of savage fiscal austerity."

My colleague Desmond Lachman has stressed the other problem with letting countries work their way out of their debt mess.

(Prolonged austerity) will have the unwanted effect of increasing rather than reducing Greece’s public-debt-to-GDP ratio. Since if Greece’s nominal GDP were to decline over the next few years by 30 percent as a result of a deep recession and price deflation, Greece’s public-debt-to-GDP ratio would arithmetically rise from its present level of around 120 percent towards 175 percent."

So what happens if you misinterpret a solvency crisis as a liquidity crisis? You just pile on debt and postpone the ultimate reckoning. If you pile on enough debt, even the creditworthiness of France and Germany can be called into question.

It is hard to tell which is more striking — the economic or the political implications of Europe’s dramatic approach. From an economic standpoint, they have undertaken a massive economic bailout of dubious efficacy and put at risk the economic health of Europe’s fiscally sound nations. This risk comes not just from the added debt, but from the tattered idea of the European Central Bank’s independence.

On the political front, some of the founding premises of European monetary union have been rewritten. The Germans agreed to the whole endeavor on the understanding that there would be no bailouts and that their beloved Deutsche Mark would be replaced with a strong currency. Now bailouts are the new norm.

With these bailouts, supposedly, comes new discipline on countries’ fiscal policies. Anne Appelbaum, in the Washington Post, is impressed by the new discipline to be imposed on Greece:

… this visible imposition of E.U. power on Greece will also serve as a warning to others who want to enter the eurozone in the future. … if you don’t play by the rules, you risk coming under foreign financial occupation. Euro-neo-colonialism, in all its glory, has arrived."

I have just the opposite reaction. What leverage will the rest of Europe have over indebted countries? Ostensibly, European powers could withhold bailout funds if they disapprove of fiscal plans, but they have just demonstrated that they cannot tolerate the ensuing pain, even in the case of a small indebted country. This is as credible as the original stability pact which said: if you are unable to pay your debts, we will punish you by adding to your debts.

Europe’s new plan is certainly shocking, but perhaps not in the way they intended.