Going Dutch – One Possible Solution To the Euro Debt Crisis?

Looking back over the last 18 months of Europe’s debt crisis, European Central Bank Executive Board member Lorenzo Bini Smaghi recently invoked Winston Churchill’s famous quip, “You can always count on Americans to do the right thing — after they’ve tried everything else.”

Europeans too, he assured his audience would also get it right, eventually. Unfortunately all the coming and going, procrastination, denial and half measures we have seen since the Greek crisis first broke out have not come without a cost, and this cost can be seen in the growing lack of confidence in the markets that a lasting solution to the underlying problems of the common currency will finally be found. Only adding to the problems, even the Americans seem to be having difficulty finding the right thing to do this time round, or at least doing it at the right moment, as the market turbulence following the S&P downgrade has served to underline.

It’s probably too soon to say whether what Europe’s leaders are about to agree on what will ultimately be the “right thing”, but at least there now does seem to be a general recognition that a defining moment is fast approaching, and fundamental changes to the continent’s institutional structure are now on the table. Among the options now being openly advocated and debated is to be found a measure thought unthinkable a year ago — ending Europe’s 13 year experiment with a single currency. But even if this ultimate possibility – the so called nuclear option – were to come to pass, as always there would be a right way and a wrong way of going about it.

Few Now Doubt The Gravity Of The Situation

The latest round in the European sovereign debt crisis has been, without a shadow of doubt, the most serious and the most potentially destabilising for the global financial system of any we have seen to date. Pressure on bond spreads in the debt markets of the countries on Europe’s troubled periphery have become so extreme that the European Central Bank (ECB) has been forced to make a radical and unexpected change of course, intervening with “shock and awe” in the Spanish and Italian bond markets. During the first week following the change in policy the bank bought bonds worth a minimum of 22 billion euros. To put this number in some sort of perspective, the entire bond purchasing programme to date for Greece, Ireland and Portugal has only involved some 74 billion euros, and this in over a year of intervention.

Along with earlier interventions in Ireland, Portugal, and Greece, the central bank has become the “buyer of last resort” of peripheral Europe’s bonds, but this can only be an interim measure, since the volume of bonds which would need to be purchased on an ongoing basis simply to stop the Spanish and Italian bond yields rising is so massive that it would put the bank well outside the limits of its original founding charter. It would also put the central bank in need of substantial recapitalisation should Italian and Spanish debt need to be restructured at some point.

And as if all this was not enough, adding urgency to difficulty even core countries like France are now finding themselves drawn into the fray, while the risk of contagion spreading to the East is now far from negligible. The French spread, the extra yield investors demand to buy 10-year French debt rather than German bunds, has jumped to 87 basis points, even though both carry AAA grades from the major rating companies. According to Bloomberg data, this is almost triple the 2010 average of 33. Credit-default swaps on France now trade at around 175 basis points, more than double the rate for protecting German securities.

In addition pressure in both the US and Europe over the debt issue have lead other currencies like the Swiss Franc or Yen (in addition to gold) to very high levels, which in the case of the Franc has a direct impact on households and companies in those East European where borrowing in CHF has been prevalent. This surge in the Franc has already produced worrying repercussion in Hungarian financial markets raising the spectre of contagion spreading to the East.

The gravity of the situation was highlighted when the European Commission President Jose Manuel Barroso explained to waiting reporters at the height of the latest crisis that the current “tensions in bond markets reflect a growing concern among investors about the systemic capacity of the euro area to respond to the evolving crisis.”

To be clear, the issue involved is no longer one of the mechanics of Greek debt restructuring, or of the extent of private sector involvement in any such debt adjustment, or even the of the value of the already agreed upsizing of the capacity of the European Financial Stability Fund (EFSF, the bailout mechanism). The current crisis is an existential one, which if left unresolved will rapidly become a matter of life of death for the single currency. In a portent of what may now be to come, at the very same moment in which the board of the ECB was reaching agreement on its latest programme of bond purchases preoccupations were already being aired in Berlin that the sums involved in a generalised rescue might be too large for even the richest countries in the core to accept.

In fairness to Mr Barroso, what he was suggesting was not that the Euro itself was on the verge of collapse, but that there had been a deep and significant shift in market perceptions of the crisis, and that this shift required a new and much more fundamental response from Europe’s leaders and institutions. It is the capacity of these leaders to agree on even the broad outlines of a viable and effective response which is at the heart of all the market nervousness, and in this sense the recent decision by the rating agency Standard and Poor’s to lower downgrade the US sovereign has only served to complicate further an already complicated situation.

So why this abrupt and dramatic change in the way the game is being played? Undoubtedly the lion’s share of the explanation is to be found in the arrival of a new, and to many unexpected, elephant in salons of European power. With something like 1.9 trillion Euros in outstanding debt, Italy is the planet’s third largest issuer of sovereign bonds (following Japan and the United States) and although the relatively high savings rate of the Italian private sector (both families and corporates) means that much of the debt is in Italian hands, the deep interlocking of Europe’s financial system (which is a by-product of the deep and liquid bond markets which came into existence following the creation of the common currency) means that a considerable portion is not.

In a certain sense the Italian crisis has crept up on market participants and caught them unawares. The reason for the relative unexpectedness of the scale of Italy’s problems is in part historical accident (that it was Greece, and not say Ireland, that got into trouble first) and in part a reflection of the need for market discourse to find a single and unified focus, and in this case the focus was on deficit and not debt. To put it simply, all too often market discourse could be described as suffering from some kind of “one track mind” syndrome.

The high profile given to the Greek issue meant that to a large extent Europe’s problems were perceived as being fiscal deficit ones, with more fundamental issues like lack of convergence, current account imbalances, cumulative debt and low economic growth all being pushed well into the background. Now things have changed. As former UK Prime Minister Gordon Brown put it recently: “Now no number of weekend phone calls can solve what is a financial, macroeconomic and fiscal crisis rolled into one”. Solving the crisis involves “a radical restructuring of both Europe’s banks and the euro, and will almost certainly require intervention by the G2O and the International Monetary Fund”.

Historic Issue With The Euro

Perceived by many as being ill-gotten and ill-born, the issue of Euro parentage has long been a topic of intense debate and controversy, most notably between economists on one side of the Atlantic and those on the other, and between micro- and macroeconomists. There simply has been no consensus on what in fact the problem is, and criticisms from the United States of the way the crisis has been handled in Europe are often felt to be unfair and misplaced. As ECB Executive Board Member Lorenzo Bini Smaghi put it in July speech to the Hellenic Foundation for European and Foreign Policy, in the United States a significant financial crisis does not call into question the whole institutional and political set-up, and the dollar itself is not considered to be at risk. In Europe, in contrast, a crisis is often considered by outside observers as putting the euro, and the Union itself, at risk of disintegration. “Academics and other experts deliberate on whether the euro area is viable and how it can be rescued. Closet eurosceptics suddenly reappear, dusting off their I-told-you-so commentaries”.

Whilst Mr Bini Smaghi undoubtedly puts his finger on the core of the issue in this statement, and most certainly reflects the level of frustration felt by key players in European decision making, analogies with individual states in the Union simply fail to get to the heart of the reason for much of the preoccupation. It is not simply a question of “closet” (or open) eurosceptics suddenly reappearing, but of the monetary union repeatedly showing fault lines exactly where many of those much berated macroeconomists had expected they might appear. This is why Mr Brown is undoubtedly right to focus on the fact that beyond an immediate fiscal crisis, what we have in Europe is also a crisis of macroeconomic management and of financial stability. As he so eloquently puts it, what many were worried about was the fact that the initial Euro design contained “no crisis-prevention or crisis-resolution mechanism and no line of accountability when things went wrong”.

Naturally Gordon Brown is far from being the first to have voiced such views. The fact that economies in Europe’s core and those on the periphery far from having converged have actually been diverging under the watchful eye of ECB monetary policy has long been a cause for concern in macroeconomic circles. In particular, at the heart of the monetary union’s current problems lie the huge imbalances which have been generated between the economic “surplus” countries in the core, and the external deficit ones on the periphery. Europe’s leaders have long avoided biting the bullet, and indeed could be considered to be in deep denial, over the significance of this issue. Referring to the prevailing voices among European policymakers former IMF Chief Economist Simon Johnson put it this way:

“I vividly recall discussions with euro-zone authorities in 2007 — when I was chief economist at the I.M.F. — in which they argued that current-account imbalances within the euro zone had no meaning and were not the business of the I.M.F. Their argument was that the I.M.F. was not concerned with payment imbalances between the various American states (all, of course, using the dollar), and it should likewise back away from discussing the fact that some euro-zone countries, like Germany and the Netherlands, had large surpluses in their current accounts while Greece, Spain and others had big deficits”.

The fig-leaf of Europe’s nations being somehow equivalent to US states has long been held up to justify the idea that the common currency was in general working well, and that the problems involved in managing it were being greatly exaggerated. With the arrival of the Italian elephant onto the centre stage at a stroke this argument has become as outdated as the institutional structure which lay behind it, since few of core Europe’s leaders are really willing to accept the responsibility for giving full and lasting guarantees for the country, quite simply because it is not just one more state in a fully integrated union, but a sovereign nation with all that that implies.

Having said this, there can be no doubt that Europe’s leaders have made huge strides forward in their attempts to get to grips with the issues as they have presented themselves, even if the measures taken so far continue to fall woefully short of what will eventually be needed. As the crisis has moved on from the initial concerns about Greek accounting methods, the piecemeal approach adopted by European policymakers has lead them to erect what is now a veritable production line of crisis resolution instruments and departments, with each of the needy patients being situated at different stages of the treatment process. In the Greek case the underlying issue is now acknowledged to be a solvency one and teams of experts are hard at work in a seemingly endless struggle to try to decide just what degree of restructuring (and/or reprofiling) Greek debt will finally need. In the Irish and Portuguese cases the task still remains one of monitoring programme implementation, with the focus being on whether or not they will eventually require (Greek style) a second stage bailout package. Meanwhile in the antechamber, the Spaniards and the Italians patiently wait their turn, while the doctors and health system administrators hold a heated debate as to whether there is enough space available in the emergency ward, and whether the patients have sufficient insurance to cover them should the surgery need to be drastic.

Too Big To Fail (Or Save)

What now brings a renewed sense of urgency to the whole process is the question of whether Spanish and Italian bonds could soon find themselves shut out of the financing markets in the way their smaller predecessors were before them. The latest ECB decision to intervene in their bond markets would seem to make it more rather than less likely that they eventually will be, since it is hard to see how they can now move back to unsupported market prices.

One of the curious anomalies about how the debate is currently being framed is the way in which banks and money funds who have invested in Europe’s periphery are being told that it is only right they should now assume some part of the anticipated debt restructuring burden due to their earlier policies of “irresponsible lending”, while these very same investors are also being urged to purchase new issues of just this very debt, on the argument that risk is exaggerated since the countries concerned have essentially sound economies, and are only suffering from short term liquidity and balance of payment type problems.

The underlying dilemma for such institutions has been highlighted by the decision of the Italian market regulator Consob to request information on the recent move by Deutsche Bank to reduce its exposure to Italian government debt. Banks have some responsibility to their clients, and will not normally knowingly take decisions which will lose money for them. So it is only rational for them to try to “lighten up” their positions on some of Europe’s weaker sovereigns. What isn’t credible is for political leaders to at one and the same time tell the banks that they are lending irresponsibly and urge them to purchase debt which may well end up being restructured. Thus the recent insistence on private sector involvement in Greek restructuring is often not unnaturally seen as one of the triggers for financial institution flight from Spanish and Italian bonds.

The Deutsche Bank case is a good illustration of the problem being faced by both the banks themselves and by those trying to maintain confidence and stability in the sovereign debt markets. According to data from the bank’s quarterly results it reduced its net exposure to Italian sovereign debt from 8 billion euros in December 2010 to 997 million euros at the end of last June. To put this in some sort of perspective, over the same period it cut its exposure to Spanish debt by some 53% (to 1,070 million euros) while the reduction in their Italian debt holdings was of the order of 87.5%. It is this difference in velocities of sell-off which in large part explains the recent surge in Italian bond yields, making it now potentially more expensive for Italy to finance itself than it is for Spain. And the reason for this is simple: previously Italy was seen as effectively isolated from contagion problems on the periphery, while Spain was not.

While yields on 10-year Italian government bonds have now fallen back significantly from their earlier euro-era highs, Spain’s have fallen further, and before the ECB intervention Italian yields had risen 1.26 percentage points since the end of June while Spanish yields had only risen by about half that amount.

Really the Italian situation is by far the most complex one facing the Euro system at this point in time. In the years prior to the outbreak of the financial crisis in 2007 Italy’s debt had long been a focus of attention among those who were worried about the effectiveness of the Euro Area’s Stability and Growth Pact whereby countries were expected to maintain deficit levels below 3% of GDP annually, and cumulative debt levels below 60% of GDP. In fact, according to IMF data, gross Italian government debt hasn’t been below 100% of GDP since 1991, and the country entered the financial crisis with a level of around 103% of GDP. During the crisis the country remained beyond the searching gaze of financial market interest by keeping its annual deficit at comparatively low levels, but a combination of recession, low growth and a substantial interest payment burden on the already accumulated debt has seen the level rise steadily to an estimated 120% of GDP this year.

Effectively Italy is poised on what is often termed a “knife edge”, since in order to stop this percentage snowballing upwards the country needed a growth rate in nominal GDP (that is uncorrected for inflation) of around 3% a year, and this at the rates of interest being paid before the recent surge. This effectively means a growth rate of 1% and an inflation rate of 2% (on average, and over a significant period of time). This growth number may not sound too ambitious, but as the Italian economist Francesco Daveri points out, Italy’s average annual GDP growth rate has been falling by around 1% a decade since the 1970s, and average growth between 2001 and 2010 was only around 0.6% per annum.

After falling by something like 6.5% during the crisis the Italian economy did manage to grow by 1.3% in 2010, but growth in the first half of this year has already been weak, while all forward looking indicators suggest it will be weaker in the second half. Thus analyst estimates of an eventual 2011 0.8% growth rate seems if anything optimistic, and with the IMF forecasting 1.9% inflation during the year, the numbers just don’t add up.

And that, of course, was before interest rates started to rise. While the new higher interest rates won’t have a huge impact in the short term, as existing debt needs to be steadily refinanced the extra cost will simply mount and mount. Which is why the Italian government is in a huge bind. It doesn’t have a debt flow problem, it has a debt stock problem, and as the risk premium charged on Italian debt rises and rises, and as the growth outcomes fail to meet the often optimistic targets, then the snowball of debt steadily slides its way down the mountain side with little the government can do to stop it growing as it moves. Like some modern Sisyphus, they are condemned to struggle with a monumental task where advance seems well nigh impossible. Out of good taste it would be better not interrupt them in their labours to ask whether, Camus style, they are still able to maintain a smile on their face.

They Ain’t Coming to Bailout, No…, No…, No…, No…, No!

Those who most definitely are not smiling at this point in time are German politicians and voters. As Christian Reiermann comfortingly informed Der Spiegel readers recently: “The euro zone looks set to evolve into a transfer union as it struggles to overcome the debt crisis. There are a number of options for the institutionalized shift of resources from richer to poorer member states — and Germany would end up as the biggest net contributor in every scenario”. These are emotive times, but feelings of outrage are not necessarily the most reliable guidelines to steer by in the search for durable solutions to complex problems.

The Italian hit may well be the most recent and the most spectacular the common currency has suffered in the 10 short years of its existence, and it may have created the problem which is quite literally too big to handle with the present institutional structure, but it really is only the latest example of that complex mix of fiscal, macroeconomic and financial issues that have come to plague the Euro which Gordon Brown draws attention to, and these issues do, by and large, go back to a design fault which was in there from the start. So while Europe’s unhappy families may all be unhappy for a variety of different reasons, the root of the problem is that the project as it was set up contained all the mechanisms for creating the problems, but few of the ones which would be needed for resolving them.

Large structural distortions were able to build up over the earlier years of the currency’s life, but now it is very hard to see where the much needed remedies are to come from. Some sort of fiscal union is now widely if belatedly seen as forming a necessary part of a well-functioning monetary union, but trying to introduce one at this stage in the game, when many of the countries along the periphery have suffered a substantial competitiveness loss in relation to those in the core seems to lead to only one conclusion, the kind of transfer union that so worries Christian Reiermann and so many of his fellow citizens.

Europe already has examples of just this kind of transfer union between higher growth and richer regions and their lower growth and poorer neighbours in Germany, Italy and Spain, and in no case can it be said that such arrangements have proved popular with those who are asked to be the net contributors. So it is not hard to reach the conclusion that this kind of fiscal union would be simply unsustainable in the Euro Area context at the present time.

The only real way forward is for those who have lost competitiveness to somehow regain it. This, as we are seeing, is far easier said than done. Most of the proposals which have come from the EU Commission and the IMF to date involve some kind of micro-level productivity-enhancing structural reforms, but these are not able to raise growth rates sufficiently quickly (indeed there is very little real evidence of the extent to which they are able to do this in any event), and inevitably involve the countries involved trying to “out-Germany” the Germans, which culturally on the face of it seems to present them with an almost impossible challenge, especially when German companies are hardly marking time themselves.

Normally, the classic solution in this situation would have been some kind of devaluation, but obviously these countries have no currency left to devalue. Another possibility would be the kind of “internal devaluation” process which has been tried in the Baltics, and a number of macroeconomists (myself included) have been arguing for this, but the complete lack of any kind of positive response makes the viability of even this approach hard to contemplate, and anyway, systematic deflation would in many cases only make the debt problem worse.

Euro At The Crossroads

So the Euro is now at the crossroads, and important decisions need to be taken. Preserving the Eurozone — as it is now — might be workable if it were possible to transform the Eurozone into a full fiscal union where budgetary policy was coordinated across nations by a central treasury in the way major programmes are between states in the US. But such an arrangement is a now a political impossibility, as Europe’s core economies would inevitably reject what would be seen as a permanent transfer union between high-growth regions and their poorer neighbours.

However the present debate about creating Eurobonds is resolved, these alone will not solve the problem at this point, and, as many observers are noting, may even make matters worse by weakening the sovereign credit ratings in the core. In the longer run they could form part of a more general solution, but the moral hazard dimension they entail means that in the absence of a fix for the immediate competitiveness problems on the periphery they only risk making the common currency project even more politically unstable. Such is the price for so much procrastination and denial. As Citibank’s Chief Economist Willem Buiter so delicately put it recently, attempts to transform the current bailout mechanisms into a transfer union would be doomed to failure since “the core euro area donors would walk out and the periphery financial beneficiaries would refuse the required surrender of national sovereignty”.

So, with fiscal union effectively off the table, there are basically three possibilities. The first is to stay more or less where we are, maintaining and even expanding the bond purchasing programme of the ECB, and simply trying to hang on in there. The stability fund could be increased, but the more numbers start being accounted in detail the further away the various parties get from being able to agree. If this continues the ECB is likely to reach a ceiling beyond which it will be more than reluctant to continue buying, since the bank takes the view that the resolution has to come from the politicians.

But with Italy and Spain’s combined sovereign refinancing needs between now and the end of 2012 totalling something like 660 billion euros, and the financing needs of the banks to take into account on top, reaching agreement to expand the bailout mechanism on this scale looks like a pretty improbable outcome, especially when you consider that once you are that far in you will simply have to continue all along the road. So at some point the spreads will start to widen again as markets force the issue, with the inevitable outcome that the monetary union is pushed towards the brink of breakdown.

The second possibility would be to disband the union entirely, leaving everyone to go back to their own national currency. This would be a disastrous outcome for all concerned, and for the global financial system. Coordinating the unwinding of cross country counter liabilities would be a nightmare given the level of interlocking in the corporate and sovereign bond markets, and the sudden disappearance of one of the major global currencies of reference would cause havoc in financial markets. The dollar would most likely be pushed to unsustainably high levels in the rush for safety, and it is only necessary to look at what is currently happening to gold, the Swiss Franc and the Japanese Yen to catch a glimpse of what would be in store.

Evidently this kind of violent unwinding would never be undertaken voluntarily, but that does not mean that it is an eventuality which might not take place, if solutions are not found and the force of market pressure continues and even augments.
Fortunately there is a third alternative, even if it is one that at first appears no more appetising than either of the other two: the Eurozone could be split in two, creating two different euro currencies. Naturally the composition of the groups would be a matter of negotiation, since some countries do not easily belong in either one group or the other. The broad outline is, however, clear enough. Germany would form the heart of one group, along with Finland, Holland and Austria.

In addition Estonians have been making it pretty that they would also be up for the ride. Spain, Italy and Portugal would naturally form the nucleus of the second group, with Slovenia and Slovakia being possible candidates. Some countries, Ireland and Greece for example, might simply choose to opt out.

The big unknown is what France would do. In many ways it belongs with the first group, but cultural ties with Southern Europe and political ambitions across the Mediterranean could well mean the country would decide to lead the second group. Naturally if what was involved were not ultimate divorce but temporary separation, then French participation with the South would also have a lot of political rationale. The term Franco-German axis would gain a whole new meaning.

Naturally the technical challenge would be enormous, but it would not be insurmountable. The great advantage of such a move would be that two of the major burdens under which the monetary union is labouring – the lack of price competitiveness on the periphery and the lack of cultural consensus between the participants – would be resolved at a stroke.

No one knows the values at which the two new currencies would initially operate, but for the purpose of a thought experiment let’s assume a Euro1 at around U.S. $1.80 (the euro/USD is currently around US$ 1.40), and a Euro2, at around $1. Obviously, in the short term the winners of this operation would be the members of Euro2, who would get the devaluation their economies have been yearning for. Why would this be? At a time when the countries concerned are loaded down with debt and domestic demand is correspondingly weak, export growth is the only way for their economies to move forward, and the change would allow cheaper labor and production costs, giving them an enormous push in this direction.

And it would encourage growth in other ways. Take Spain as an example. The country has at the present time a large pool of surplus property, on many estimates of around 1 million unsold new housing units. Many have criticised the banking sector for not dropping prices sharply to enable the market to clear, but the banks are understandably reluctant to do this due to the impact this would have on their balance sheets, and due to the knock-on effect on their existing mortgage books. The beauty of this solution is that no further drop in price would be needed, since for external buyers the real price of all this housing would suddenly become much cheaper.

The case of tourism would be somewhat similar, since not only would more tourists come to Spain, they would come for longer and they would spend more. The shopping bags would certainly not be empty on the plane home.

Spain’s troubled savings bank sector has been desperately looking for foreign investors to help them recapitalise, but while many have shown interest virtually none have participated to date. After the devaluation all this would change since they would be able to buy shareholding at attractive prices, and without having to worry about a sudden drop in prices and hence loss of capital.

Spain’s 4.5 million unemployed would gradually start to go back to work, new investment could steadily be attracted for other productive projects in manufacturing industry, no one would doubt the solvency of the Spanish state, and the private sector would be in a better position to start paying back its debts as the economy grew.

Now obviously, as we all know, in economics as in life there are no free lunches, so there must be a catch here somewhere, and of course there is. In fact there are two big “catches”. In the first place those countries who joined together to form Euro1 would be making a big sacrifice, since many of them also depend on exports for their livelihood, and their manufacturers would suddenly and sharply find themselves at a disadvantage. In particular Germany would suffer.

However, assuming that all can agree at some point that the current arrangements are unworkable, and that going back to individual national currencies would be a disaster, then the German sense of responsibility and the country’s commitment to the European project might well make the acceptance of some sort of sacrifice (and especially if it were a sacrifice which offered longer term solutions) bearable. Fortunately, recent German historical experience provides us with two concepts which might just help everyone see their way through this. The first of these is the Treuhandanstalt, the Privatisation institution (and bad bank) which was created to handle East German assets between 1990-1994. The second is Lastenausgleich, or burden sharing, and this refers to the mechanism which was used to share the unequal outcome of WW II between Germans who found themselves living in the West: between those who had come from the East and lost everything and those who were from the West and had retained something.

The Treuhandanstalt experience is useful in helping us to think about how to handle the common set of assets/liabilities acquired during the initial Euro stage. Think about Spain’s banks and their property assets. These would now be sold in Euro2, but many of the liabilities which correspond to them are in fact liabilities with institutions who will find themselves in Euro1. Marking them to market immediately, and in Euro2, would produce sizeable losses in the Euro1 financial sector. Some of these losses are inevitable and to some extent correspond to the kind of restructuring haircuts which are now being contemplated. But in the initial period (and for reasons which will become clearer below) it would be advisable not to mark them to market, but to hold them for a specified time in a common institution of the Treuhandanstalt kind.

As I say, some losses are now inevitable, and this is where the second concept from recent historical experience – Lastenausgleich, or burden sharing – becomes important. Despite protests to the contrary from Lorenzo Bini Smaghi (link) the Euro experience to date has not been a success for any of the participants once you add-in the potential losses which are now looming. At the same time the common currency has been a shared experience, in which all have taken part, so it is not unreasonable to assume that all should share when it comes to the downside. The problem with the measures adopted to date is that they are perceived on both sides of the fence as unfair. Those who are funding the bailouts feel that they are being asked to pay for the “excesses” of the recipients, while those who receive feel that what they are getting is not help, but loans which make it easier for the financial sector in the donor countries to avoid declaring losses. This “communicational impasse” is one of the major reasons the current approach won’t work.

What is needed at this point is an appeal to the European spirit of the Euro1 countries, in a way which helps them to see that some costs are unavoidable, but that any agreed costs will be shared, and above all that the game-changing solution is workable and offers some sort of constructive positive future for all Europeans. Put in other words, what we need is a mechanism which contains both realism and idealism in just sufficient proportions.

The advantage that the split Euro option has over all the other proposals on the table at the present time is that it would address the growth issue head on. The countries on Europe’s periphery could return to growth, and once the economies involved start growing rather than shrinking the proportion of the liabilities incurred during the earlier period which they will be able to pay rises significantly. It is much more difficult to collect debts from an unemployed household than it is from one which is gainfully employed.

Another attractive feature of this proposal is that no “in principle” decisions would need to be taken about the long term structure of the European financial system. The ECB could be retained as a kind of holding entity and clearing house for the outstanding financial mismatch, and the current national central banks could be grouped into two separate sub-entities. This would leave open the possibility of reconvergence at a later date should conditions obtain which would make the move viable. The first stab at creating a currency union has failed, but this doesn’t mean that any possibility of creating one in the future should be abandoned. Hard and costly lessons have been learned, and what is now needed is a full and open discussion of the reasons for failure, precisely to avoid similar mistakes being made in the future.

Having the move co-ordinated by pan-European institutions has another advantage, and that is to do with the degree of conditionality the process must involve. Devaluing their currency would, as I have suggested, give a great short term boost to growth in countries along the periphery, but this short term boost would only be converted into a long term sustainable improvement in trend growth if a lot of other things were done too. It is very easy to laud the great advance Argentina made on breaking the dollar-peg, but look where Argentina is today. This “short sharp shock” treatment only has a lasting impact (as it did in Scandinavia in the 1990s) if measures to improve institutional quality (reformed labour and product markets, productivity and innovation drives) are implemented and maintained. Here again partnership is needed, since while giving back to the periphery “ownership” over its own reform programmes would be another significant advantage of the arrangement, the reform process would need to remain under the auspices of a common European project, one which could lay the basis for a consensually grounded lasting political union, a union which would be the essential precondition for any future attempts to move back towards greater monetary integration.

Effectively Europe’s leaders are caught in a kind of Pavlovian trap. There are no easy choices, although there are good ones and bad ones. Staying where they are leaves them in a kind of permanent electric shock zone where their constant feeling of failure only serves to further deteriorate their own sense of personal and political worth. Advancing also seems painful, but more than the intensity of the shock it is the sensation of fear and angst which dominate. Still there is no alternative but to advance, since you cannot stay where you are. Simply applying administrative measures to force stability onto a financial system which resists with all its might will only result in increasingly destabilizing behaviour (read “speculation”) by the agents within the system. Administrative fiat simply represses and pushes forward instability (read” kicks the can down the road”), leading the system itself to become ever more inefficient. In any malfunctioning financial system, as the late Hyman Minsky famously said, “stability is itself destabilizing”.

Perhaps it is appropriate to close this essay where it started, with a quote from ECB Board member Lorenzo Bini Smaghi: “as J.K. Galbraith observed: “Politics consists in choosing between the disastrous and the unpalatable”. To see disaster looming before choosing the unpalatable is a dangerous strategy”.

This article is an expanded version of one which was originally published on the website of the US magazine Foreign Policy, under the title “The Euro and the Scalpel

Appendix – The Way To Split The Euro

This article was written during 4 days I spent in Marbella earlier this month in the home of my friend and colleague Detlef Gürtler (author of the recent book Entschuldigung! Ich Bin Deutsch (Sorry, I’m German, Mermann Verlag GmbH, Hamburg).

While I was busying myself with the text, Detlef was working on the images (which can be found above), and on some illustrative material for the technical side.

These graphics only give some illustration of just how complex any unwinding of the commen currency would be, given how interlocked the financial sectors of the participating countries have become.

Some sort of holding entity would need to accept responsibility for a whole range of problematic assets during any transitional period. This entity could be the ECB. The though behind the idea that not everything should be marked to market immediately is that the Euro2 countries are nothing like so weak as the initial value of the new currency would suggest, nor are the Euro1 countries so strong as is often thought. So inevitably the parity at which the two would exchange would converge towards a much tighter band, which would be much closer to the real competitiveness difference between the various countries. Naturally it would make a lot more sense to mark to market at this point, since the losses to be borne on both side would be that much smaller.

It is also worth stressing that this solution is far from perfect. We do not live in an ideal world. It is only one possible way of breaking the vicious circle into which the Euro Area countries have now fallen. It is one possible way, and as far as I can see the only viable and realistic one.

This entry was posted in A Fistful Of Euros, Economics, Economics: Country briefings, The European Union by Edward Hugh. Bookmark the permalink.

About Edward Hugh

Edward 'the bonobo' is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

36 thoughts on “Going Dutch – One Possible Solution To the Euro Debt Crisis?

  1. So what sane Spaniard, Italian, Portuguese would keep their money in a bank knowing that its going to be converted to an Euro2 and depreciate versus every currency?

  2. well done.

    you forget the 4th option, which has to come first before any other solution: send in the police to put all the thieves in the piggies countires in a chain camp

  3. The first stab at creating a currency union has failed, but this doesn’t mean that any possibility of creating one in the future should be abandoned. Hard and costly lessons have been learned, and what is now needed is a full and open discussion of the reasons for failure, precisely to avoid similar mistakes being made in the future.

    That’s pretty final. Never expected to read those words at afoe.

  4. The main advantage of the Euro from a business perspective is elimination of monetary exchange and the associated risk, isn’t it? That benefit must be the larger the larger the Eurozone is.

    The disadvantage is not having the ability to devalue and not having monetary rates fitting the economy. So the members of the groups may be more similar to each other than in the whole Eurozone, but still, shrinking the Eurozone seems to retain more of the disadvantages of a common currency than of the advantages.

    So could you explain why going the whole way would be so much worse?

  5. Edward, thanks for this paper that shows a clear inflexion of AFOE position. I would go one step further and argue that possibilities 2 (complete breakup of the EUR) and 3 (breakup into EUR1 and EUR2 plus some opting out) are essentially the same, except from an emotional / political / cosmetic point of view of course. Certainly, whatever is true of possibility 2 (disastrous outcome for all concerned… nightmare given the level of interlocking in the corporate and sovereign bond markets… sudden disappearance… violent unwinding…) is probably also true of possibility 3. Do you really believe that having Germany and Holland (and Finland if you like) keep the same currency is enough to make a significant difference to the ‘havoc’?…

    Maybe we are at a point where realistic Euroenthousiasts do realize that they are an oxymoron, and therefore do what it takes to change their mind without giving the impression that they do. Cutting the euro into pieces that would still be called the euro would do the job quite nicely.
    If this comes to pass, the solidity of euro1zone (basically the old deutsche mark area) seems more garanteed than that of euro2. Would Greece want the same currency than Portugal? Maybe, maybe not. Finally, I would argue that France should opt out. With an EUR1 at 1.8 $ and possibly more, France would find itself very quickly in the position where Italy is now.

  6. Excellent piece, Edward… A positive point not mentioned here could be Denmark and Sweden possibly joining Euro 1. A vast majority of the politicians in both countries have always been in favor of joining the EUR, but the pesky voters disagree. Getting them to agree to joining Euro 1 could well prove feasible (though not at the current exchange rate). In the end your proposition may well just lead to the old system of one country/one currency, but creating a halfway house, with the institutions in place you talk about, would make eventually make a breakup of the two Euros into the original currencies manageble as well, I think.

  7. Well, the record of keeping secrets in European governments and communication between them is quite bad. How would one avoid terrible bank runs?

  8. This is a very well researched & considered piece & worthy of respect for all that.

    But… & I’m sorry it is a ‘but’ of gigantic proportions….

    Both the options of Euro break up at this stage are likely near impossible without triggering a complete, near global meltdown of the banking & the financial sector, completely integrated as they now are.

    Any untangling of cross border positions will inevitably force mark to market of all the toxic assets still lurking on a massive scale near everywhere in the system. What I mean by this is not just the ‘base’ assets but all the massively leveraged derivative positions as well. And these extend on a serious scale across to the US & UK, which would further trigger a massive crisis in those areas.

    This is why debt restructuring, that in any sane scenario should have taken place, has not. If anything, the austerity approach, particularly in the eurozone, and its consequent contractionary effects, ‘bail-outs’ etc., has put us in a worse position than 3 years ago. US & UK stimulation efforts, too little and poorly constructed as they were, are ending & we are now seeing contraction take hold again.

    This is a very, very bad situation. The only possible way out of this was, and remains, growth. Likely with some inflation to help things along. Only when those bubble assets at the core of the problem have recovered sufficiently to see daylight again will we have any sense of real recovery.

    The eurozone needs to remind itself collectively of the enormous advantages to all of standing together. Or if any didn’t quite accept that previously, get on board now.

    After all, the EU has long recognised imbalances among member states & +has+ operated a transfer union of sorts since its inception. Highly productive economies need to realise that transfers to less productive ones often come straight back as export demand in significant quantity. As is well known, the (EMU external) export position of those highly productive states is also greatly enhanced in the currency union.

    The key, and the only real solution in my view is to stop arguing over a smaller (& decreasing) ‘pie’, & see if we can’t make the ‘pie’ bigger. That is done by removing the enormous blight & economic burden of unemployment – a huge under utilisation of resources. (We should also remove the unproductive & capital misallocation activities of the speculative financial sector & revert it to an appropriate size. And remove what remains from retail banking.)

    We must reverse the downward spiral of austerity & recession. Moreover, we must put in place a system that is robust & sustainable.

    I know of only one way to do this. Change the monetary & fiscal system. Adopt MMT monetary principles & ‘functional finance’ fiscal management. These +are+ the correct tools.

    I also believe, that if properly explained, the citizens of Europe will see the obvious benefits of working together creating prosperity for all, in a fiscal union that leaves no one behind.. And, importantly, is capable of addressing the urgent transformation of a society facing serious key resource supply, & other ecological constraints.

    For those not familiar with MMT, see the work of leading proponents Professors Randall Wray (US) and Bill Mitchell (AUS) & others.

  9. James:

    “So what sane Spaniard, Italian, Portuguese would keep their money in a bank knowing that its going to be converted to an Euro2 and depreciate versus every currency?”

    That is why they had better do it over a long weekend. A lot of sane Spaniards, Portuguese, Italians and others (plus a pack of speculators) are already buying German bunds (which are kind of pseudo DMs) as a bet Germany won’t be in the same currency as the South that much longer. This capital and deposit flight is already part of the problem.

    Naturally, Sarkozy and Merkel could walk out of today’s meeting and announce that Europe’s banks are closed till Monday. They won’t, but one day they might. In fact, if they don’t act before, one day they may find themselves forced to.

  10. Hello Henrik,

    “A positive point not mentioned here could be Denmark and Sweden possibly joining Euro 1″.

    Definitely, Detlef and I even made a chart showing just this possibility. I didn’t include it to avoid complicating further an already complicated argument. I also agree that one of the good arguments for making a “half-way house” structure would be to give us all time to breathe and think, so we could take decisions without having the markets permanently beating on our doors.

  11. @ Edward

    Yes, I’m aware of Krugman’s rather poor effort at, well, what exactly? Hardly a very serious or academicly appropriate response & effectively a refusal to hardly engage at all, let alone in a scholarly manner with the leading proponents, Professors all, of good standing.

    In the comments to that article I note that carefully reasoned responses, in refutation, to Krugman are made . Asserting (actually obvious) misrepresentation of MMT & straw men arguments.

    Equally curious is the lack of any well reasoned response in support of Krugman’s notions of real world monetary operations. One might have thought that there would be some industry insiders at least who would take the opportunity to back him up & denounce MMT’s assertions, were they false? Apparently not.

    On the other hand, one of MMT’s leading advocates is Warren Mosler, a man of considerable reputation & knowledge in the commercial world of finance & fed operations.

    In many respects, particularly fundamental strategy, MMT & Krugman are in agreement. The question of whether the necessary & substantial stimulus needs to be furnished by creation of more debt, with accompanying debt service & repayment, or not, is crucial one. Perhaps even vital to whether such a needed strategy can work, or not. Surely this is worthy of proper scrutiny & debate?

    I think it’s fair to say that almost to a man (or woman) the establishment economics practitioners, neither saw the crisis coming, nor have had much to offer by way solution. Indeed, 4 years on, it is arguable matters are even worse.

    I remain astonished that there has been little or no re-examination of monetary & fiscal systems to determine why such a monumental failure has occurred. Or to consider what lessons could be learnt going forward.

    Is there a crisis in economics thinking? I’m inclined to believe there is.

  12. Edward, you get it right, but I think there is a better, and simpler, solution to the asset/liabilities match : All existing nominal liabilities stay denominated in Southern Euro, which is the continuation of the present Euro.
    The Northern Euro balance sheet starts from scratch.
    Possibly, a limited amount of Southern Euro to Northern Euro swap would be offered to Northern Euro resident to sweeten the deal (it would be politically astute to fund that from all eurozone states as a “burden sharing” exercise), but that would add some complexity to the deal.
    Such a solution :
    - avoids a politically difficult bail-out of German and French banks
    - Doesn’t make a favor to the Greek Shipowner or Asian SWF who parked its money into bunds.
    - reward those, including in the infamous hedge fund world, who stuck to southern euro government bonds.
    Everybody out of Europe would be furious at such a solution, but hey : “Our Currency(ies), your problem !”

  13. Great Article. Is there a sense of the repercussions of Italy fully defaulting and the euro zone not bailing them out? Is that simply a non starter or if not, is there a feel for how many banks would be taken down with the default? Thanks.

  14. Edward

    Prof Bill Mitchell has responded in depth to Paul Krugman’s article (as you linked).

    I do hope you (& other macro economists reading) will take a look & give it consideration.

    http://bilbo.economicoutlook.net/blog/?p=15722#more-15722

    At the heart of the present crisis is a growing debt/austerity contraction squeeze. Seemingly one impossible to solve by write downs.

    If, as the MMT advocates suggest, curency issuers can stimulate demand free of debt burden or excessive inflation risk, surely their arguments should be given careful scrutiny & serious debate?

    I am not certain that Prof Yamaguchi’s modelling research is fully consistent with an MMT approach of its leading advocates, but does seem to have some key elements, notably government deficit spending free of debt. Most interesting are the results showing tolerance to inflation of substantial spending overshoot. It’s a ‘what if’ excercise for the Japanese economy.

    http://www.monetary.org/yamaguchipaper.pdf

  15. I think I disagree on this post on the whole.
    The main problem is, IMHO, that the reason of the fiscal umbalances in the EU are to be found in the “euro1″ countries, and not in the “euro2″.
    For example, Germany is a net exporter: it means that people in Germany consume less than what they produce, an that the remaining money goes to some financial asset.
    Why do they consume less than they produce? I have no idea, it has to have something to do with the politic and economic “structure” of Germany.
    However, as long that they consume less than what they produce, they have to sell stuff to other countries, otherwise they would face a very hard unemployment crisis.
    In the meanwhile, in a closed system, their “financial assets” will necessarily end up as “consumer financing” to the debtor nations: it is a necessary thing, since any credit is just the other side of the debt of someone else.
    So even if the EU splits up, the euro1 countries would be still forced to sell to euro2 countries, but they would be paid whith rapidly devaluing euro2s, which would be a problem.
    I think that what will really happen is: “nortern” countries will face very bad quarters because the southern countries will go on with “austerity”, and they will have very big political problems. In the end they will realize that they too need a weaker euro to boost sales outside the Eu, and thus the whole problem will be solved by a burst of inflation (not before a lot of social sufferings in the south and then in the north, anyway).

  16. Pingback: Notes on the Euro Debt Crisis « Choice Rules.

  17. “Maybe we are at a point where realistic Euroenthousiasts do realize that they are an oxymoron,”

    Maybe you are, but I’m not and the markets very, very definitely are not. Have you actually looked at the value of the Euro lately, or followed its progress through this crisis? It’s actually done extremely well, has more than held its value, and is extremely stable. It’s actually done better through this crisis than any currency in European history. Compare, if you will, its performance to the German mark during the 1930s depression, where it utterly collapsed, leading the rise of Hitler and WWII.

    This focus on the Euro as the source of the problem seems to be an attempt to avoid confronting the real issue, which is the incompetence and corruption of the banking industry, most especially those in the northern European countries. There has been endless propaganda, mostly by people who have their money in other currencies, to convince us that it is the Euro that is the problem, not the banks. They also want to convince us that it is the northern countries who are bailing out the southern ones, when in fact it is the people in the southern countries who are being forced to bail out northern banks.

    Sorry, but until I see some evidence that the Euro itself is in trouble I will continue to have faith in it, just as the world’s markets do. I simply see no evidence to indicate that so-called fiat currencies have a place inn a globalized economy, and continue to believe that multilateral currencies are the future. As an American I have much more faith in the Euro than in the dollar. Infinitely more. At least the European countries have functioning governments.

  18. Edward

    what is the thought process which makes you think Ireland will go with neither E1 nor E2 but something else (presumably punt)?

  19. “So what sane Spaniard, Italian, Portuguese would keep their money in a bank knowing that its going to be converted to an Euro2 and depreciate versus every currency?”

    Exactly… none. Because that is just a load of bollocks theory. There has been people prophetising the end of the euro since its inception… when a euro was worth less than a dollar and you needed 2.5 of them to acquire a sterling pound. Now a Pound is worth 1.15 euros and they give you 1.4 dollars for every one of the “doomed” euros.

    Spanish bonds in circulation are in an all time high giving double de yield than their german counterparts and everytime the goverment holds a sale it gets double the demand than the bonds it has on offer.

    Edward has been obsessed with the demise of spanish economy since… since for ever. Before Greece, Portugal, Ireland,… Lehman, Northern Rock,… And it always explodes in his face.

    The graphs above are utter bollocks as well. If you are going to draw graphs for 1992 to 2007 comparing Germany and Spain do them about growth and discover that spanish economy has tripled germans growth. Do them about employment and discover that Spain created half the employment in the eurozone in those 20 years.

    Last year Edward was going on an on about Spain returning to recession… imminently. It did not happen, now we grow as much as the UK or the USA. Does he ever mention those countries as doomed? Hmmm… Nope.

    At any rate it is always funny that what ever happen any where in the world …. ends in Spain for Edward. Now it is Italy… a country with double the public debt to GDP ratio than Spain.

    If you want to understand what is going on with sovereign debt in europe and you read spanish… read the chief economist of Nomura, Richard Koo explaining spilling the beans:

    http://www.publico.es/dinero/392327/no-existe-razon-para-que-espana-pague-los-altos-tipos-de-interes-actuales

    The solutions is not less europe but more europe…. and that is what will happen.

    PS: Come on Edward if you are going to talk about the spanish current account balance do us a favor and use current data. Do not make it so evident that you disregard reality for your conclusions:

    http://www.bde.es/webbde/es/estadis/bpagos/balpag.html

    http://www.bde.es/webbde/es/estadis/infoest/e0701.pdf

  20. Pingback: Ukraine and a tiering of the EU? | OdessaTalk

  21. Pingback: Ukraine and a tiering of the EU? « Odessablog’s Blog

  22. Hello Reg,

    “what is the thought process which makes you think Ireland will go with neither E1 nor E2 but something else (presumably punt)?”

    Well, to be honest Reg nothing very profound. It was just an illustrative example really. I mean, there is the idea that culturally Ireland is not part of Southern Europe, and is in someways nearer to the “Anglo Saxon” world of the US and the UK, but I wouldn’t run that argument very far.

    All I want to leave open is the possibility that some may choose to opt out. I think the only way to decide who belongs in which group would be to lock all the finance ministers of the Euro Area in a room, and tell them they won’t be allowed out till the issue is decided (they could of course take their mobile phone with them to consult).

    Then I would send the German representative to one corner, and the Italian one to another, and ask them to try and form groups. Those who either didn’t want to join or weren’t allowed in to either of the resulting groups would be “opt outs”.

  23. Pingback: Euro árfolyamok, € árfolyam, euro

  24. Pingback: electronic payment solutions

  25. Pingback: Sortir de l'euro ? by stanjourdan - Pearltrees

  26. Pingback: finest weight loss site and also item review

  27. Pingback: build

  28. Pingback: finance

  29. Pingback: ulrainian business

  30. Pingback: маша и медведь скачать letitbit

  31. Pingback: Zwei neue Namen für den Euro | tazblog

  32. Pingback: Eurozonenparlament | tazblog

Leave a Reply

Your email address will not be published. Required fields are marked *

*

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>