Saturday, January 29, 2011

Roubini: Break Up of European Monetary Union Possible

Nouriel Roubini is out with his take on the EU financial crisis. As per usual, he is great on the facts but mostly terrible on policy. Here he is on the facts:
The contagion from the Greek and Irish crises has spread to Portugal, Spain and possibly Italy. Unless the eurozone undertakes radical reform there is a risk of disorderly defaults by fiscally stressed member states and even – eventually – of a break-up of the monetary union.

The current muddle-through approach to the crisis is to “lend and pray”: ie, provide financing to member states in distress (conditional on such states implementing fiscal adjustment and structural reforms) in the hope that their problems are of liquidity rather than solvency. But this could lead to disorderly defaults and a break-up of the European Monetary Union (EMU), unless institutional reforms and other policies leading to closer integration and restoration of growth in the eurozone’s periphery are implemented soon.

The periphery members all suffer from a loss of competitiveness, low economic growth (Italy, Portugal) or contraction (Spain, Ireland, Greece), and large private and/or public debts. Spain’s and Ireland’s problems started with too much debt in the private sector (due to a debt-financed housing bubble) and morphed into a public debt problem once the losses from the housing bust were socialised. Greece had a reckless fiscal policy for more than a decade, which led to a public debt crisis. Portugal and Italy have lower levels of private debt but large stocks of public debt. Distressed sovereigns that have already lost market access (Greece and Ireland) were bailed out by the IMF and the EU, but no one will come from Mars to bail out these super-sovereigns if the sovereigns end up insolvent.
On policy, though, he is way off. He calls for ECB money printing, a German fiscal stimulus, and German backed EuroBonds as a way to increase official EU resources for emergency bailouts. All these policy moves would turn the EuroZone into a stagflation pit. Remarkably, Roubini does admit the inflation part of the stagflation:
The European Central Bank (ECB) should pursue a much looser monetary policy; this would weaken the euro... 
However, because of a Keynesian/Mercantilist view, he doesn't get that this money printing only distorts the economy, that German backed EuroBonds would only crowd out private sector borrowers and that bailouts simply create moral hazards.

Surprisingly, while he does mix this mad policy cocktail that is not too far from what EU officials would like to see happen, Roubini also calls on some correct medicine:
...super-sovereigns such as the IMF and EU cannot and should not continue to bail out distressed sovereigns that are insolvent rather than illiquid. Thus, a third necessary reform pillar is for Europe to implement early, orderly restructurings of distressed sovereigns’ public debt....

..all unsecured creditors of banks and other financial institutions, even senior ones, must accept losses on their claims when a financial institution is severely financially distressed. This is needed to prevent even more private debt being put on government balance sheets. If orderly treatment of unsecured senior creditors requires a new, Europe-wide regime to close down insolvent European banks, such a regime should be implemented soon.
It is hard to understand Roubini's sound medicine recommendations here of restructuring government debt, i.e., sovereign bankruptcy and the call for banks to face losses, with his unsound Keynesian/mercantilist advice. The medicine in itself would solve the EU crisis, while the other policy advice would simply suffocate the region.

In his book, Crisis Economics, Roubini writes that economists should learn more about what the Austrian school economists have to say. One hopes that Roubini takes his own advice soon and starts reading up on Austrian business cycle theory, so that he can understand the disastrous flaws in Keynesian/mercantilist policy theory.

1 comment:

  1. Remember, the leading policy that will emerge out of Davos to solve the EU debt crisis will be an EU-version of the US' TARP (Troubled Asset Relief Program) which is the socialization of EU regional debt across the entire region.

    In any case, while Roubini says this will weaken the euro, I say ANY solution that comes out of Davos will lead to a weakening of the euro. The euro will become a political instrument to lasso the EU states closer together both politically and economically.

    Just like the rally cries here in the States about carbon taxes "leveling the playing field" between developed and developing economies, an EU-bond, euro printing (i.e. QE) or an EU-"TARP" which drag the leading economies of Europe (Germany and France) down to "fix" Portugal, Spain, Italy, Greece and Ireland. In reality, its Germany and France (especially Germany) that are being "fixed" like pets to bring their comparably overachieving economies under control.

    I wonder where private equity will go though. Maybe we'll see the rise of massive government/private funds (i.e. sovereign wealth funds) that will be the future of barons of capital inflows.