Sunday, June 10, 2012

Rescuing the eurozone: What would Isabel Peron do?

There appears to be a widespread assumption (see this week’s Economist) that all would be well in the eurozone if only Angela Merkel would just step up and do the right thing. The right thing is defined as agreeing to co-guarantee joint eurozone bonds and to allow the ECB to make unlimited credit available to eurozone governments and their banks. Her refusal to do so is attributed to German stubbornness and selfishness.

Frankly, it is pointless to attempt to discuss the eurozone crisis in moral terms. Morality is irrelevant under such circumstances. All is fair in financial crises.

Let us accept the promise that it is in Germany’s interest to rescue Europe. Let’s not debate that, we’ll just take it as a premise. Germany agrees to sign up to lend its credit to the entire eurozone, and the Bundesbank allows the ECB to buy the bonds of troubled governments.

First, let’s look at the eurobond piece. While it is possible that an announcement such as this would reopen the debt markets to allow the PIIGS to to issue their own debt, that is quite doubtful. The bond market is not charitable. Therefore, the future source of credit for troubled eurozone governments will be eurobonds, co-signed by Germany, forever.

The outstanding government debt of the eurozone is ~$14 trillion. The debt of the PIIGS is ~$4.0 trillion. Germany’s GDP is ~$3.0 trillion, and its debt is ~$1.5 trillion. Germany’s credit is not strong enough to shoulder the burden of the PIIGS debt, let alone the rest of the zone.

Were eurobonds to become a German contingent liability, Germany would no longer be AAA. Would there be a ready market for trillions in such bonds? Perhaps, but not at AA yields. That would be real “story paper”.

Ok, let’s stipulate that it would be difficult to get fiduciaries to buy trillions of eurobonds at risk-free yields. What about the ECB? Certainly the ECB could be the buyer of last resort for eurobonds, the European equivalent of Treasuries. At present, the ECB’s balance sheet is EUR 2.7 trillion. Can it sterilize a few trillion of new eurobond purchases? No, it can’t, because it is already stuffed to the gills with unsellable peripheral bonds and TARGET2 exposures to peripheral banks. The ECB has only a limited ability to buy eurobonds unless it permits the monetary aggregates to increase in a manner unrelated to the conduct of monetary policy. (There is a strong case to be made that the ECB has been too tight and that a dose of inflation would be very helpful. An involuntary growth of the ECB’s balance sheet would be a good thing, but we are getting into a rather fanciful realm. The Bundesbank is still in charge.)

So we appear to be at an impasse: eurobonds will be a hard sell in the debt markets, and the ECB can’t buy them all. Does that mean that Europe is out of tools to rescue the euro? We need to take off our OECD hats, and put  on our faded old Latin American hats (remember the LDC crisis of thirty years ago?).  Instead of asking “What would Angela Merkel do?”, we need to ask instead “What would Isabel Peron do?”

The eurozone will be facing a Latin American crisis. No one wants its currency, and no one wants its bonds. Every Latin American country has been in this position many times. How do you finance yourself when your obligations are distrusted?

The answer is simple, but a bit drastic: impose capital controls. There is plenty of money within the eurozone to allow it to finance itself, so long as banks and investors have no other options. If zonians are prohibited from buying “foreign” bonds and other instruments, the zone’s savings can be mobilized to invest in eurobonds.

I might add that this would not be a completely novel experience for Europe. During the postwar era, most zonal countries had capital and exchange controls. Free capital movement is a relatively recent phenomenon. Even today, China maintains both exchange and capital controls, and it certainly hasn’t hurt them.

My argument here is that the euro can be saved, but only by taking very drastic action. European exchange controls would represent a major shock to global markets; exchange controls would violate WTO and the implicit architecture of the eurozone. (Remember that the euro was supposed to supplant the dollar as the world’s reserve currency?)

The foregoing is intended to throw cold water on the rescue of the euro. We are talking about uncharted territory and the land of unintended consequences. Europe is not Latin America, and this is not 1954. My point is that the steps required to save the euro are extreme and unfamiliar (as well as illegal).

My expectation is that, in the end, the euro will fail and Europe will enter a deep depression.

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