Question the Euro Crisis
HBR.org 2012-05-04
After more than 18 months, a dozen and a half summits, multiple rounds of austerity, a trillion dollars of liquidity, and now elections in Greece and France that threaten to overturn the fragile policy consensus in Europe, the Euro-crisis rumbles on. How it could end, badly, with a bank run through the European bond market or the collapse of confidence around Greece, Spain or Italy, is well understood. What is less well understood is how to resolve it.
Eurobonds, fiscal treaties, more austerity, declarations of commitment and credibility all vie for prominence alongside an increasingly restive populace for whom more of the same bitter medicine is no longer an attractive option — for the simple reason that it isn't working. Countries undergoing austerity programs have more debt today than they did in 2009, for little visible benefit. So, as Lenin once put it, what is to be done?
Europe has a plethora of conflicting answers from which to choose. The problem is that European leaders don't know, like the ancients before the Oracles of Greece, which questions to ask. Five right questions need to be asked before the right answers can be found.
First, was the euro an accident waiting to happen, the victim of a mugging, or a self-inflicted wound? While this question can be applied to every country in the euro zone (Ireland was self-inflicted, Italy was a mugging) the "accident waiting to happen" design flaws of the euro have been well known since its inception. The lack of a real lender-of-last-resort central bank (an accident waiting to happen), a cross-border bank liability resolution regime (a mugging), and the possibility of bond-spread divergence (a self-inflicted wound) were known but ignored. Now that they have been exposed in the crisis, we should ask if the new mechanisms designed to overcome these issues (new fiscal rules and a bigger banking firewall) would in fact do the job. Given that rules didn't work out so well the first time, perhaps we should worry about the new emphasis on more of the same?
Second, we need to ask what is this a crisis of? If you ask financial market participants rather than academics, or academics rather than politicians, you get rather different diagnoses. Debt, growth, inflexibility, and profligate periphery governments all vie for attention, with the latter being the most popular explanation. It's a pity it is wrong. If the core problem is one of profligate periphery states who broke rules and awarded themselves pay increases that they could not afford, one needs to explain where the periphery got all the money to do this, since they certainly didn't raise it domestically. That answer to that question leads us to over-lending by core European banks that are now on life support from the ECB while being choc-full-o-crappy-assets. You can push Greece to cut public expenditure down to Neolithic levels and it will not do much at all for Société Générale's balance sheet.
A third question to be asked is whether there is anything distinctive about this crisis. There is a tendency, following the work of Reinhardt and Rogoff on debt crises, to simply say "same old story" and walk away. But maybe this time it really is different, precisely because it's happening in the core of the global economy, not in some Argentine extremity. Moreover, while all financial crises are, as Schularick and Taylor put it, "credit booms gone bust," the fact that this particular "boom gone bust" is channeled through such a peculiar set of continent-wide institutions makes its resolution anything but standard. Failure to recognize this leads to "off the shelf" thinking (a.k.a. austerity — one size fits all) that is more harmful than helpful.
A fourth question worth asking is: "Could we have done anything differently to avoid this mess?" While no one likes a Monday-morning quarterback, if it is possible that "this time it may actually be different," then how we got here may contain valuable information about how to get out. Not buying and holding Greek debt at the start of the crisis for a mere $50 billion now seems like a bad idea regardless of any concern for future moral hazard. Not allowing the ECB to do "the full Bernanke" (quantitative easing as a full-on asset swap and not just a liquidity pump) seems similarly shortsighted. Not incorporating the information present in your errors is simply going to produce more errors, yet that seems to be what the EU process generates from summit to summit: compounded errors.
Finally, it's probably worth asking if the objective, saving the Euro, is really worth it. First, what if the price of saving the Euro is the end of the wider European project? The European union is based upon trust, building confidence, sharing the wealth, and mutual support. The new institutions designed to save the Euro — even stricter fiscal rules and a financial "cordon sanitaire" around Greece — are based upon seeing every possible interaction with another state as a moral hazard problem where trust should be eliminated. Designing institutions in this way undermines the capacity to generate trust. Trust is not an optional extra. It is a necessity. Try running a banking system without it and see what happens.
Second, back in the 1990s critics of the Euro pointed to the costs of the convergence needed to make it all happen. There was a decade of anemic growth and high unemployment as multiple states simultaneously tried to get their budget deficits and debts down while maintaining very low inflation rates. The response to those critics at the time was "never mind the short term costs, wait for the long term benefits." Those benefits seemed to arrive in the 2000s, before the financial crisis hit, when inflation rates and bond yields in Europe fell together while growth picked up. But those benefits now seem to be as much a result of the mispricing of risk in the bond market, free money to the periphery and asset price bubbles, as they are of fiscal consolidation. Indeed, today the "never mind the short term costs" argument has found a new form in "We can't break it up because the costs will be catastrophic; we must suffer a decade of depression instead as the lesser of two evils," which makes saving the Euro all cost and no benefit.
The Euro was supposed to obviate the twin problems of serial devaluations and currency volatility. But on the balance sheet of misery, how much devaluation and volatility are worth the impoverishment-by-policy of millions of Europeans and the loss of a generation of growth? If this is the price to be paid for saving the Euro, surely that needs to be recognized ahead of time?
Without asking the right questions, and being honest about what questions to ask, you cannot resolve this crisis. Time is running out to ask the right questions. The elections in France and Greece offer European leaders an opportunity to ask them. If they do not, then austerity-strapped European publics will find their own questions, and the designers of the Euro will not like the answers they provide.