European economic meltdown

Claims against European Central banks (Financial Times)

Paul Krugman in a blog post which refers to an article by Martin Wolf (which I cover below) says ominously: “the water level has now dropped so far that the fuel rods are exposed. We really are in meltdown territory.”

The core issue is whether European banking system is under a slow moving wave of default which will shake the foundations of the Euro. Krugman suspects that it is.

One way to summarize his [Wolf’s] argument is to say that slow-motion bank runs are already in progress in the European periphery, and that these countries’ banking systems are being sustained only by a process in which, say, Ireland’s central bank borrows from the Bundesbank and then lends the funds on to Irish private banks to replace the fleeing deposits. [The diagram above shows] claims among central banks as of the end of last year.

Martin Wolf, writing in the Financial Times, is very blunt. He says at the outset of his article that [my emphasis]:

The eurozone, as designed, has failed. It was based on a set of principles that have proved unworkable at the first contact with a financial and fiscal crisis. It has only two options: to go forwards towards a closer union or backwards towards at least partial dissolution. This is what is at stake.

His argument is really quite good and leads me to think through more clearly what I posted earlier on the gold standard. The issue is that the Euro was designed, in Wolf’s word to be a hard money standard.

The eurozone was supposed to be an updated version of the classical gold standard. Countries in external deficit receive private financing from abroad. If such financing dries up, economic activity shrinks. Unemployment then drives down wages and prices, causing an “internal devaluation”. In the long run, this should deliver financeable balances in the external payments and fiscal accounts, though only after many years of pain.

Greek Protestors on Parliament Square

Greek Protestors on Parliament Square

This means that the Euro works by putting the banker centric and not citizens or nations . (Our USA gold standard fans would need to think more carefully about their ideas since they will put the Fed more centric rather than less.) Financing drives economic activity. When the bankers squeeze a country the effect will be recession, unemployment, wage and price decreases. With the inability of the political class to create inflation by printing more money and increase the nation’s deficit spending to shore up demand, the unemployment drives down wages and prices causing years of pain. This pain will make the political class vulnerable in new elections, and of course lead to demonstrations on the streets like those we see currently in Greece. It also leads to the collapse of the banking sector in the affected country, and perhaps the collapse of the country as well. Wolf:

In the eurozone, however, much of this borrowing flows via banks. When the crisis comes, liquidity-starved banking sectors start to collapse. Credit-constrained governments can do little, or nothing, to prevent that from happening. This, then, is a gold standard on financial sector steroids. The role of banks is central.

The fear is, of course, the partial or complete unraveling of the Euro. Wolf talks about the assumption that a deposit in Euros in one bank is the same as a deposit in Euros at another bank no longer holds:

If this is a true currency union, a deposit in any eurozone bank must be the equivalent of a deposit in any other bank. But what happens if the banks in a given country are on the verge of collapse? The answer is that this presumption of equal value no longer holds. A euro in a Greek bank is today no longer the same as a euro in a German bank. In this situation, there is not only the risk of a run on a bank but also the risk of a run on a national banking system. This is, of course, what the federal government has prevented in the US. [So far – dp]

What happens then when the proverbial hits the ventilator? Once external financing of a country by private sector actors dries up, the central bank steps in as a lender of last resort, once the local country Central bank reaches it’s limits other creditors must step in. In the case of the Euro this means effectively that the strong countries loan to the weaker countries through the ECB. Effectively the German government underwrites the the losses and risk of the weaker Euro members.

Huge asset and liability positions have now emerged among the national central banks, with the Bundesbank the dominant creditor. Indeed, Prof Sinn notes the symmetry between the current account deficits of Greece, Ireland, Portugal and Spain and the cumulative claims of the Bundesbank upon other central banks since 2008 (when the private finance of weaker economies dried up).

Government insolvencies would now also threaten the solvency of debtor country central banks. [Read Greece, Ireland, Portugal, Spain] This would then impose large losses on creditor country central banks [read Germany], which national [German] taxpayers would have to make good. This would be a fiscal transfer by the back door.

This is why the German taxpayers are also in revolt. It is rather as if New York passed a tax to pay California’s debts.

Wolf then goes on to demonstrate the Domino Theory of the Euro’s unraveling.

Debt restructuring looks inevitable. Yet it is also easy to see why it would be a nightmare, particularly if, as Mr Bini Smaghi insists, the ECB would refuse to lend against the debt of defaulting states. In the absence of ECB support, banks would collapse. Governments would surely have to freeze bank accounts and redenominate debt in a new currency. A run from the public and private debts of every other fragile country would ensue. That would drive these countries towards a similar catastrophe. The eurozone would then unravel….

The eurozone confronts a choice between two intolerable options: either default and partial dissolution or open-ended official support. The existence of this choice proves that an enduring union will at the very least need deeper financial integration and greater fiscal support than was originally envisaged. How will the politics of these choices now play out? I truly have no idea. I wonder whether anybody does.



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