I haven’t written much on the crisis in the Eurozone recently, others have been covering much better than I could – the best coverage is to be found at the FT’s Alphaville and with the BBC’s Paul Mason.
But given the most recent downgrade of Portugal yesterday, and the warnings that it might require a second ‘bail out’ to, I thought now might be a good time to post a few thoughts.
What Portugal reminds us is that this isn’t just a question about Greece. Portugal and Ireland have both been ‘bailed out’ but may require more support in the future – big question marks remain over Spain, too an extent Italy and also Belgium. And banks across the Eurozone (and UK) are exposed to these economies.
What the afflicted economies have in common is the lack of policy flexibility that comes in common with Euro membership, the ‘hard money’ attitude of the ECB and (generally) real interest rates that were too low for a decade. The exact problems though wary from public debt in Greece to a private sector banking problem in Spain (and problems with regional governments).
As Mark Blyth has written there are four ways out of a debt crisis – inflate, deflate, devalue or default.
Devaluation is impossible whilst a Euro member and although these countries may be forced to eave to the Eurozone, the practical problems with this are immense. How would a new currency be introduced? Surely it would cause a run on the banks? If you were a Greek citizen and held your savings in Euros in a Greek bank, surely you’d move them to a German bank and keep them in Euros rather than passively wait for them to be converted into devalued New Drachma? Devaluation then is not a short term option.
Inflating your way out a of a debt problem, if government borrowing is heavily constrained by an unwillingness of markets to lend and you don’t control your own currency or central bank is not possible.
Default (which I will come back to) isn’t quite the neat solution that many seem to think it is – although it may be the only viable medium term solution.
Deflating your way out a debt problem though is equally problematic – the 1930s-esque embrace of liquidationist policies of austerity has become the policy of choice in the European periphery. In effect what is being attempted is an ‘internal devaluation’, an attempt to lower costs in the economy to such a point that exports become competitive. Whilst this might be possible (and some claim Latvia has achieved this – although at the costs of a depression, with a 20%+ fall in GDP) in economic terms, I doubt it is politically possible – electorates will only bare so much pain. And austerity is killing economic growth inGreece – making the existing debt burden even harder to handle.
Which takes us back to default.
The problems with default is that no one quite knows how it will play out – what second round effects would it trigger? Are European banks well capitalised enough to take the hit? If a European bank runs into trouble – who is exposed to that bank? If Greece defaults, what happens to Portuguese and Irish bond prices? Could the Greek domestic banks survive a sovereign default? If not, who would bail them out to stop a catastrophic collapse old the domestic Greek banking system?
I’ve long favoured some form of managed default – but the sequencing of events here matters. It has to be agreed in advance and it has to come after proper stress tests of European banks and the necessary re-capitalisation of any found wanting and it has to be accompanied by huge ECB liquidity support for inter-bank markets.
We’re in a place where there are no good answers – only tradeoffs.