Thursday, April 29, 2010

How to Solve the EuroZone Crisis

The current EuroZone crisis is fast approaching a monster size that will be too0 big to solve, or at least solve in a manner  that &nbspsp;  the founders of the EU would like it to be worked out. i.e. a via global bailout.

Simon Johnson, former chief economist at the IMF, has an excellent run down of the problem:
There are three possible scenarios.  First, the ECB may be allowed to really let loose with “liquidity” – and somehow buy up all the bonds of troubled eurozone nations.  But this is exactly the process that always and everywhere brings about high inflation.  The Germans would fight hard against such a policy, although it would prevent default.

Second, officials still hope that bond yields for weaker governments widen but then stabilize.  This is bad news for troubled eurozone countries, but they manage to avoid default.  The rest of the world grows by enough to pull up even the European “Club Med + Ireland”.  Call this the trickle down scenario or just a miracle.

Most likely, the situation is about to turn much worse and a third scenario unfolds.  The nightmare for Europe is not at this point about Greece or Portugal – it is all about Italian and Spanish bond yields.  This week those yields are rising quickly from low levels, while German yields are falling – so this spread is widening sharply.  The yields for Spain – for example – are rising because hitherto inattentive investors, who always thought these bonds were nearly as safe as cash, suddenly realize there are reasonable scenarios where those bonds could fall sharply in value or even possibly default.  Given that Spain has 20% unemployment, an uncompetitive exchange rate, a great deal of public debt, and a reported government deficit of 11.2 percent (compared with headline numbers for Greece at 13.6 percent and Portugal at 9.4 percent), everyone now asks:  Does a 5% yield on Spain’s ten year bonds justify the risk?  The market is increasingly taking the view that the answer is no, at least for now.  So, we can anticipate Spanish (and Italian) yields will keep rising.  In turn, this causes other asset prices to fall in those nations, thus worsening their banking systems, and hence leading to credit contraction and capital flight.  It is a dismal prognosis.

Then it gets worse.  As rates rise, traditional investors in euro zone bonds, which are pension funds and commercial banks, will refuse to take more.  There will be no buyers in the market and governments will not be able to roll over debts.  We saw the first glimpse of this on Tuesday, when both Spanish and Irish short term debt auctions virtually failed.  Once this happens more broadly, the problem will be too big for even Mr. Trichet or Ms. Merkel to solve.  The euro zone will be at risk of massive collapse.
After this solid analysis, Johnson then makes the astounding call for a trillion dollar bailout of the PIIGS.This magical sum would be paid for by citizens of this planet. (Simon is apparently taking Stephen Hawkings advice not to talk to aliens).

Bottom Line: The EuroZone Crisis is too big to be solved by bailouts without huge pain inflicted, via taxation and/or inflation, on citizens of this planet who had nothing to do with creating the crisis.

Here's the only realeconomik way out that makes sense.

The EU should be  split up from it's current form. It should simply become a trade organization (Think NAFTA). Each country reverts back to its own national currency. Each country then solves its own debt problem. If a country wants to print their way out of the crisis, and suffer the inflationary consequences, good luck to them.

The best solution, under this scenario, would be for each of the PIIGS  to restructure their debt, i.e. default. The lossess would be limited to the debt holders, largely European banks. Each country would then have to decide whether or not to bailout the the banks in their own country that would come under pressure. The recommended solution would be to allow them to fail, but each country should be allowed to handle this in their own way.

For the countries that make the  wise choice of default, without a bailout for the banks, they would find themselves in a situation with a strong currency and the potential for putting their financial house in order, as union leaders could no longer argue that the budget cuts were only a payoff to global banksters.

There are no easy solutions, but unified global action is oppressive, potentially inflationary, and only a stop gap measure. Compartmentalizing the problem, country by country, provides incentives for each country to put its own financial house in order. But most importantly, it builds firewalls around the countries that refuse to bring their financial houses in order, so that  crises do not spread in terms of bailout demands. Therefore, incentive turns not to countries to provide bailouts, but for countries in trouble to adopt sounder fiscal practices.


  1. Wenzel - excellent solution and there is definitely an opportunity for someone to step in and lead these lost souls to the promised land. But you are an American and they would never listen to you. Likewise Bill Clinton who is clearly looking for a cause, but again he is American.

    I think the best candidate to lead this charge would be from Spain. Perhaps your readers know of some good candidates.

  2. No real reason to dump the Euro for the core countries of Germany, France & Benelux. Dump the PIIGS and this will become a strong reserve currency. Key other change is not letting ECB accept all national bonds at par. PIIGS may rejoin the euro in 2020 or so after they get their acts together with much lower currency valuations.

  3. What benefit does thrifty Germany get from a monetary union with profligate France? Germany is the only euro currency country of note that is even close to stable fiscally.

    Even if the eurozone manages this storm, the next will be even worse and will break the euro. If Germany, or France, leave then it is over.

    A NAFTAesque free trade and travel zone in the Euro area would be possible and highly desirable even if (when) the euro dies. Germany would have to toughen residency laws, and limit public assistance, but a new DM would come out of this as THE reserve currency of choice for many.