Sunday, May 5, 2013

Southern Europe: Revolt Now Or Default Later

“The policy is being set by the AAA core. The Commission bends to power, and will not move unless the rest of EMU mobilises superior counter-power. All else has become irrelevant in the euro snake pit.”
---Ambrose Evans-Pritchard, Daily Telegraph, April 24th, 2013

There are two schools of thought emerging among the non-delusional community with respect to the future of the eurozone. One view is that the ECB can still, by heroic action, save the eurozone. The other view is that it is now too late for the ECB to save the eurozone, and that the Club Med bloc will need to resume monetary sovereignty.

I cling to the former view because the alternative is pretty awful. I find it hard to grapple with the idea of some of the world’s largest debt issuers defaulting on their debts. It’s a horrific prospect. Euro exit by Italy or Spain would eviscerate the European banking system and cause a Lehman-squared.

But is the ECB rescue scenario possible? First, we will need to dispense with current ECB politics. This scenario only works if the ECB comes to Jesus and executes a total policy reversal as a consequence of the imminent default of Spain or Italy. So it is a given in this scenario that either the ECB sees the light on its own, or the Club Med bloc somehow forces the ECB to reverse course.

So now we have Mario Draghi and his entire board including the Bundesbank on the side of the angels, willing to whatever it takes to save the euro. What should the ECB do? For starters, it should implement the plan outlined by Lars Christiansen:
  • Target the level of NGDP that would have resulted had the eurozone been growing at a reasonable pace since 2007. That is a level maybe 10-15% above the eurozone's current NGDP.
  • Commit to engage in asset purchases such that M3 growth will average 10% p.a. until the output gap has been closed.
  • Suspend the 2% inflation cap until the target is met.
  • The policy instrument would be a GDP-weighted basket of eurozone government bonds.

In addition to the Christiansen plan, I would add the following:
  • Active use of the OMT to backstop Club Med bond issuance, so as to limit yield spreads and restore market-access.
  • A eurozone-wide bank support scheme guaranteed by the ESM and funded by the ECB.
  • A statement that no bank in the eurozone will be allowed to default on its deposits for the next five years.
Such a program would: (1) restore market access; (2) restore depositor confidence; and (3) ensure that all eurozone banks have full access to ECB liquidity. Both the sovereign and banking crises would be solved.

It is true that this plan would not fully address the real effective exchange rate appreciation which has made the Club Med countries uncompetitive. But it would help in that inflation would permit real wages to decline over time (if nominal wages were constrained, a big if). Not ideal, but better than the current deflation and better than catastrophic default.

If this scenario proves impossible (see: Bundestag), the next question is whether a “managed exit” scenario is possible, by which one or more Club Med countries would be allowed to exit in the least disruptive way. Here, the answer is no. That is because euro exit at a minimum will be accompanied by redenomination of all debts, which is a form of default. There is no way that the troika (EU, ECB, IMF) is going to countenance a massive debt default. Indeed, it is likely that the troika will want to wreak its vengeance on the first escapee, to scare the others from trying to leave.

Thus, Spain and Italy face a stark choice: force the ECB to relent, or exit unilaterally. For Spain and Italy to be in a posture of revolt will require conditions to get much worse, and will require new governments. As Ambrose Evans-Pritchard wrote recently, a successful revolt by the south will require Churchillian leadership, which means different leaders.

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