What started as the Subprime Crisis in 2007 and morphed in the Global Credit Crisis in 2008 has become the Euro Crisis in 2009. Sober people are now contemplating whether a euro area member such as Greece might default on its debt. In addition to directly damaging bank balance sheets, this would destroy confidence in its banking and financial system. Unable to borrow and facing horrific bank recapitalisation costs, the country would have to print money. To do so it would have to abandon the euro and reinstate its old national currency.
As not a few critics – from Willem Buiter to Wolfgang Munchau to yours truly – have observed, the previous paragraph is rife with dubious premises and logical non-sequiturs. To start with, that Greece will be allowed to default is questionable. There is an alternative, namely fiscal retrenchment, wage reductions, and assistance from the EU and the IMF for the cash-strapped government.
To be sure, this alternative will be excruciatingly painful. No one will like it except possibly the IMF, which will relish the opportunity of reasserting its role as lender to developed countries. There will be demonstrations against the fiscal cuts and wage reductions. Politicians will lose support and governments will fall. The EU will resist providing financial assistance for its more troublesome members.
But, ultimately, everyone will swallow hard and proceed, much as the US Congress, having played rejectionist once, swallowed hard and passed the $700 billion bank bailout bill when disaster loomed.
Admittedly, if the current crisis has taught us one thing, it is that we should not underestimate the ability of politicians to get it wrong. But even the most blinkered politicians will see what is at stake here. Investors would flee en masse from the banks and markets of a country that contemplated abandoning the euro (Eichengreen 2007). No matter how serious the crisis, politicians will realise that attempting to jettison the euro will only make it worse.
Another lesson of the crisis is that financial shocks can spread unpredictably. No one knows whether or not a Greek default would cause Irish and Italian bond prices to collapse, precipitating full-fledged debt and banking crises there. But no one wants to find out. In the end, the EU will overcome its bailout aversion.
The euro area will hang together, in other words, because the decision to enter is essentially irreversible. Getting out is impossible without precipitating the most serious imaginable financial crisis – something that no government is prepared to risk.
But then was the mistake getting in the first place? Opponents of monetary union founded their arguments on asymmetric shocks. They argued that adverse shocks affecting some members but not others were so prevalent that locking them into a single monetary policy was reckless. If those asymmetric shocks hit heavily-indebted countries, then the latter would also have no capacity to deploy fiscal policy in stabilising ways. Absent coping mechanisms like a system of inter-state transfers, the only option would be a grinding deflation and years of double-digit unemployment. More prudent would have been to allow such countries to retain the option of pushing down the exchange rate instead of pushing down wages. Desperately needed improvements in competitiveness would then be more easily engineered. This is the “daylight-savings-time argument” for exchange rate flexibility.
Part of what we have seen is clearly an asymmetric financial shock. Countries like Greece with debt and deficit problems have been singled out by investors who are now fleeing everything that emits the slightest whiff of risk. Similarly, the countries with the biggest housing bubbles, such as Ireland and Spain, are now suffering the most serious slumps as their bubbles deflate and problems ramify through their financial systems. It is their bond spreads that have shot up. It is there where output has slumped most sharply and where the need for wage reductions is most dramatic. The only mystery is why it took investors so long to focus on their problems – why were they not singled out six months or a year ago?
But the more days pass, the more it becomes evident that the truly big event is the negative economic shock affecting the entire euro area. Different euro area members may have felt financial disturbances to a different extent, but they are all now experiencing the economic disturbance in the same way – they are all seeing growth collapse. Germany, which thought itself immune from the economic crisis, is now seeing its exports slump and unemployment rise. The rise in unemployment may be small so far, but it is the tip of the iceberg. And there is no longer any doubt about how much ice lies just below the surface.
This shock is symmetric – it is affecting all euro area members. In turn this means that a common monetary policy response is appropriate. There will now be mounting pressure for the ECB to cut interest rates to zero, move to quantitative easing, and allow the euro exchange rate to weaken. (This last part of the adjustment is already beginning to happen without the ECB having to do anything about it.) Now that recession and deflation loom across the euro area, this is a response on which all members should be able to agree. It can be complemented by fiscal stimulus. If countries in a relatively strong budgetary position, like Germany, are in the best position to apply it, all the better; the result will be help from outside for their more heavily indebted, cash-strapped neighbours who need it most.
Of course, this assumes – to return to an earlier theme – that policy makers do the right thing. The ECB will have to abandon its fixation with inflation, cut rates to zero, and proceed with quantitative easing. Germany will have to abandon its deficit phobia and apply the fiscal stimulus that it and the larger euro area so desperately need. After wallowing in denial, both are now moving in the requisite direction. But there is no time to waste.
If 2008 was the year of the asymmetric financial shock, then 2009 is the year of the symmetric economic shock. In the same way that the former should have been the year of the euro’s greatest jeopardy, the latter can be the year of its salvation. But for this to be true, policy makers must act.
Eichengreen (2007). “Eurozone break-up would trigger the mother of all financial crises”, VoxEU.org, 19 November 2007.