The Choice: Save Europe Now Or Later?

In major every crisis you have a choice.  You cannot choose between inaction and action, because ultimately you will be forced to act.  You do not really choose between bailout and no bailout, because very soon you find that all the reasonable options involve some sort of bailout for some people (and not for others).  And, try as you might, there is no way to choose to let your neighbors fail completely – because that failure has such awful consequences for their citizens and, in all likelihood, for your banks, that you finally come across with the money.

But you do have a choice on when to come to help your neighbors and your friends, and you can definitely choose the form of this assistance.  if you come in earlier and in a more systematic fashion, the cost for everyone is lower and the chances of a fast recovery are stronger.

The sensible decision might seems obvious from a distance or in retrospect, but it’s this exact choice that the richer and more stable countries in Western Europe are now struggling with.

Back in October, we argued for a eurozone stabilization fund, as a means of mutual support and – most importantly – as a way to provide liquidity and buy time for euro sovereigns who need to make fiscal adjustments.  Circumstances have changed, of course, but I would like to reiterate the following proposal,

Create a European Stability Fund with at least €2tn of credit lines guaranteed by all Eurozone member nations and potentially other European countries with large financial systems such as Switzerland, Sweden and the UK. This fund should provide alternative financing to member countries in case market rates on their government debt become too high. This will prevent a self-fulfilling cycle of rising interest rates. The fund should be large enough to have credibility; countries could access the fund automatically, but should then adopt a 5-year program for ensuring financial stability, subject to peer review within the Eurozone.

I should also clarify that we are not suggesting that countries leave the eurozone (this would be bad for everyone) or that this is likely (the adverse consequences are sufficiently obvious on all sides).  In fact, my presentation in early January – which has circulated to some effect – very much emphasizes that eurozone fiscal austerity is our baseline expectation.

The German Minister of Finance this week suggested that financial support within Western Europe is on the cards for the first – presumably, his mind is being concentrated by potential developments for Austrian banks.  At the same time, there are strong voices opposed to any kind of bailout, e.g., represented by Charles Wyplosz writing yesterday on  Europe should really have had the full moral hazard theology debate back in the fall; better than late than never, but it’s awfully late.

Remember this.  Eventually, you will go to help your neighbors (again, see Iceland for details).  And the longer you delay, the more it will cost, in both monetary and human terms.  And, for those of you still hung up on moral hazard, I can assure you that support provided today will not prevent middle class and poorer people from being hammered hard by the crisis – and I would suggest that they will sort out their rulers at a time and place of their choosing. 

Provide generous support, come in early, and insist on a sensible macroeconomic framework – some fiscal adjustment is almost always needed.  Do not require eurozone countries to go to the IMF.

26 thoughts on “The Choice: Save Europe Now Or Later?

  1. The problem with this is that several of these countries (and I don’t think Iceland was in this category) have been for years positioning themselves quite deliberately to become permanent beneficiaries of a cross-country EU welfare system.

    In other words, if you write them a check they are just going to do it again.

    Voters in the richer EU countries know this perfectly well, and so expect their leaders to either refuse or impose truly punitive terms. This is where the IMF has been useful in the past and may have a key role to play now, as the ‘bad guy’.

    Your post seems to miss this factor, which is critical to both the politics and the EU’s long term financial stability.

  2. There is already a cross-country EU welfare system. And the countries that are now in the greatest danger have been the biggest beneficiaries of the welfare system. You can not enforce a “sensible macroeconomic framework” without a loss of sovereignty; and as soon as one member of the EU has a loss of sovereignty, the precedent has been set for all members to lose control over their own country to some EU bureaucracy. The recent attempt to install a European Constitution shows that the people of Europe are not ready for that step yet.

  3. @Neville

    It seems to me that Mr. Johnson is proposing a line of credit and not a bailout check. It sounds similar in some ways to the domestic auto plan in that they get access to loans based on actions taken to restructure. I don’t think governments in need will be eager to tap the line of credit unless it is their only option, but I don’t have much in-depth knowledge of Eurozone political or economic policies. What is your take?

  4. Instead of retreating to the convenience of protestant ethics, surplus countries should realise that God Economicus makes no distinction between hedonist spenders and prudent savers. Both large surpluses and deficits constitute an imbalance of equal degree since one sustains the other. The latest figures regarding growth rates for export addicts will eventually drive the message home.

  5. @Nathan

    If somebody expects a deal not available on commercial terms, then they are to that extent expecting a subsidy. In this sense the subsidies implicit in the bailouts starting to fly back and forth are very large.

    This is all the more true if the political nature of a bailout leads to the recipients, in addition to getting sub-market rates, being able to evade making concessions which even a commercial lender would have required.

    The commercial terms that would have been required of countries like Greece would have been at penal rates reflecting both the way they have quite deliberately piloted their credit into the ground and the high degree of likelihood that they will do so again in the future as soon as someone hands them the opportunity.

    In political terms the IMF’s involvement is often used to deflect the blame for all this from the politicians, with the recipient governments blaming the IMF for imposing policy measures that would have been required in any case to get loans commercially or from other governments. At the same time donor governments get to shelter from charges that they are taking advantage of the recipient countries or imposing hostile conditions, by providing support either through or alongside the IMF, which gets the blame instead. It happened for instance when the UK went through an equally self-inflicted debacle in the 1970’s.

  6. *Sigh*

    A 2 trillion Euro credit line? Roughly 2.6 trillion dollars? With the expectation that the member countries really will repay it? Really, this time… when their economies are crumbling and they (like Weimar Germany) realize they have nothing to gain from paying it back and everything to lose?

    Germany knows full well they won’t get it back…

    Currently, there is an excess of stored wealth in some Euro countries, and a paucity in others. Simon’s rescue involves extending more credit to the countries that lack wealth, to sustain consumption that cannot be sustained because wages/local asset values/entitlements are too high…

    The elegant solution (and the market’s inherent natural response) would be a local currency devaluation. Then the countries with stored wealth can use it to buy cheap goods from the poorer countries.

    Oops. Should have thought of that before Maastricht.

    The second best solution is a Euro devaluation (e.g. print some money – am I sounding repetitive yet?), then disburse it proportionately to member states (according to GDP size). Indebted countries are required to use these funds to pay back loans. Wealthy countries save it and invest it, or buy up assets in the indebted countries. Unemployment does not skyrocket, exports are stabilized, and net tax revenues do not plummet.

    This will need to be accompanied by systemic regulation to minimize future recurrence, and perhaps by some degree of global economic decoupling (e.g. “localization” vs. globalization). Maybe even some _real investment_.

    Yet public officials are terrified to entertain a discussion of seignorage, having been conditioned to fear the inflation boogeyman by 30 years of anti-Keynesian neo-liberal economics.

    So let me offer this alternate view on the discussion:

    In the perfect world of Ronald Coase (costless bargaining, no transaction costs – we wouldn’t need to devalue because wages/land value/debt obligations would instantly reconfigure themselves – but in the real world it’s expensive and time consuming to adjust wages/asset values/debt.

    Inflation and currency adjustment are supposed to provide that relief valve. Without it, the relief valve needs another mechanism. In the US, that mechanism is federal spending (including military bases, highways, etc.), individual relocation for jobs, and company relocation to lower costs. Europe doesn’t have these outlets to the same degree.

    I fully concur that Europe has a tough bargaining problem ahead. The US has an easier challenge, but we still are not having the right debate – we’re talking about which of five dozen plans is the best way to have the US taxpayer absorb massive bank losses.

    How is it that we’re all OK discussing the option of mortgage principal reduction for homeowners (at taxpayer expense), but we can’t even _discuss_ the option of principal reduction for US taxpayer debt? (Either through outright debt cancellation, or through a fully legal and historically effective mechanism that is built precisely for these situations – create money.)

    Now really, the ideal way to handle this situation would be a single-instance creation of cash (rather than a continuing flow of inflation which can get embedded in contracts and such). Wham! US creates 5 trillion dollars, pays back all the debt that comes due in the next year or so, stops sucking cash out of the economy in t-bill auctions, absorbs some portion of bank losses (pick the fanciest rescue plan you want), declares a 3 month tax holiday. Assets appreciate, debt devalues.

    Make no mistake – this would end the recession/depression virtually overnight. It would also restore the debt/GDP ratio to a rational level.

    However, the owners of currency would howl bloody murder and pull out their dog-eared copies of Adam Smith and threaten interest rate revenge!

    Good. Maybe China should have let the Yuan appreciate 10 years ago instead of holding 2 trillion dollars in currency to prop up the dollar to support a mercantilist expansion.

    And frankly, even the holders of dollar-denominated assets would be better in the long run by avoiding financial armageddon.

    So why are we terrified to talk about inflation?

  7. @Neville

    That really helped me get a better picture of the function of the IMF, and I now understand the point you are making. Thanks!

  8. @StatsGuy

    You are right to question the logic of rigid anti-inflationary dogma in the current climate.

    Inflation can be thought of as a means of regulating the relationship between current money and future consumption. At present, I think we are in a situation in which massive asset bubbles are being propped up by a raft of policies, even as the prospects for future production (and hence consumption) look limited.

    This suggests two basic approaches to restoring this equilibrium: 1) Deflate the asset bubbles (this will happen as banks fail) 2) Allow prices and wages to rise up to a new level relative to the ‘old money’

    In practice both things will happen at the same time, but we are currently fighting them both with every policy instrument at our disposal: The logic of recapitalisation of failed banks to is defend the asset value on their balance sheets. The same is true of plans to stall mortgage foreclosures.

    At the same time, an unwillingness to monetise public debt is tantamount to a defence of current wealth against the threat of rising future prices (and wages)

  9. It goes something like this: do not create any European Stability Fund. Get rid of Trichet pronto (because he did not) Stop the swap with Fed. Do not lower the interest rate any further under no circumstances. Create a good bank and let the dead drop (or their debt holders voluntarily become the new equity). Ban the deposit insurance over 200.00 EUR within the EU. Stop the governmental insurance of banks debt pronto. Ban any further governmental guarantee (to any bank or insurance co) in the EU (as illegal). Then peg the Swiss franc to Euro without any objection possible by the Swiss, swap Euros to Russia – unlimited / probably with Chinese-like strings attached. Swap them also to every EU country except the UK. UK can go Darling itself. If France re-enters Nato, make sure Europe seizes the (decision making) control. No Afganistan engagement enlargement without consent of Russia China and India. They should pay for this with their troops at least and with some financing to go with. Do not pay any one cent to any one US debt due (US bank) due to fraud – go to courts if needed. Do not recognize any one CDS as legally binding / it is not. And that’s just an outline.

  10. We’re doing this experiment already in the US with California. The stimulus bill is going to borrow huge amounts of money and give a lot of it to California. The end result will be that a year from now, California will come right back to the trough, begging for more because they will nt have made any cuts. Remember, that under the new budget, any new income (read: cash from Uncle Sam) will be used to eliminate budget cuts.

    As for inflation not being a boogieman, what you’re really saying is let’s stick it to the people who saved and invested and planned for the future. That’s fine if you want less of that. Why save money if the stuff is going to be inflated away?

    Finally, you’re missing a much bigger picture here. Europe is quickly aging and will have no chance to pay this back. Their birth rates are well below replacement levels. Unless you expect a pack of Eurogeezers to get back to work in the factories and mines, your $2.6T or whatever number you want to pull out of the air is just going to end up being printed.

    In the end, wages and standards of living will fall and there’s nothing you can do about it. You can either do it through inflation and discourage prudent behavior or you can do it through deflation and economic wreckage and watch the profligate people get creamed.

  11. Moral hazard is an inescapable law of economics; there’s no “hang-up” per se, only a trade off. For some, it’s worth it to suffer more in the near term if your neighbor learns his lesson and doesn’t come begging every time he stumbles.

  12. One more thought. This solution assumes everyone will stay where they are and work as hard as they can. If there is a significant movement of people, earnings or cash, the whole thing falls apart.

    If you’re an EE, say, in Germany or France and you speak passable English, are you going to stick around as the bill comes due for $2.6T, the working population shrinks, the country ages and your savings are destroyed by inflation?

    When you attack the productive people, they either stop producing or they leave.

  13. The Chinese concept of wu wei(do nothing) works well when watching tomatoes ripen on the vine but I wouldn’t recommend it when doing a turnarounds or workout. But, this situation is much bigger than even turning around the behemoths of Wall Street and helping them maintain their hegemony. The inter-bank lending system is an outgrowth of the industrial economic age and has outlived its usefulness. My experience is that you can’t expect something on the order of The MERC to emerge from the minds of a guy who has lived his life in government service and goes to tennis camp with the other players. Nor can it come from the do-dahs who have been leading the big banks.

    There’s a wonderful tv commercial where this guy Rodger, who has the old analogue telephone service is calling his tatoo artist,complaining that he wanted a tiger on his body, not tiger stripes all over it. He thinks that merely by having new digital phone service he can explain the mistake and by virtue of communicating the problem will be resolved. The tatoo artist tries to tell him that tattoos are permanent. Just before exhausting himself the artist says, “Roger, you tiger now”.

    Anyone who expects a bunch of R.E.M.F.s’ to suddenly turn on a light bulb in their head and create the 21st century global financial system is nuts. This endeavor will be the lengthened shadow of a single man leading a team. I would suggest that a convention be held, not in Washington, DC or New York, but someplace like Denver. Have the top 25 guys who know what they are talking about convene and begin to draft a declaration and constitution–that is, a framework document for what is necessary. Keep the ass-holes away. I believe that if pulled together the best minds and got it down on a website energy would develop behind it faster than Obama’s campaign. Maybe BaseLine Scenario can be the catalyst for something pragmatic.

  14. My preliminary nominations for the Financial and Economic Manifesto Convention to be held in Denver, Colorado.

    Nominations are now being taken for the Nominating Committee.

    Preliminary nominations for the Core Group, are as follows:
    1. Jim Grant
    2. Mohammed El Ehrian
    3. Bill Gross
    4. Charles Morris
    5. Niall Ferguson
    6. Peter L. Bernstein
    7. Lawrence Lessig
    8. E. O. Wilson
    9. John Steele Gordon
    10. Amity Shlaes
    11. Robert Prechter
    12. George Soros
    13. LiaQuat Ahamed
    14. Joseph E. Stiglitz
    15. Robert Shiller
    16. Martin Feldstein
    17. Charles Morris

    Rules of the Road
    1. Core Group is nominated and each C.G. participant allowed to bring in 2-3 additional players.
    2. Group meets and uses open outcry method to hammer out consensus.
    3. First Report-Day 1
    a. What got us into this mess.
    b. Tragic flaws in current approach
    c. Requirements for new system
    d. Recommendations on where to bury the dead dinosaurs and elephants.
    4. Lunch

    Gentlemen and/or Ladies: Imagine you are Davy Crockett and his Kentucky indian fighters arriving at the Alamo. Col. Travis and Jim Bowie give you an assessment of the situation. You look over the walls and see the campfires of 5,000 Mexicans assembled to deal with the Gringo situation. There is a line drawn in the sand. You must decide what to do.

  15. Simon,

    Love your blog. Has any of this crisis and it’s causes led you to question the value of central banking and consider the Austrian position of eliminating it? How can any of us trust government with discretionary money creation after this 20 year double-bubble-double-trouble disaster? Even if the arsonists are able to put out the fire, shouldn’t we still put them in jail and throw away the key for starting it in the first place?

  16. I have the following issues for you to consider:

    I am relying partially upon numbers as presented by Susan Wachter in the Yale seminars entitled “Subprime Lending and the Procyclical Production of Risk” shown in two of her graphs at the end of 2006. I also looked in Eurostat statistics to look at the same categories for Europe. The results are shown below:

    Gross Debt as % GDP USA 2006 EU 2006

    Financial Institutions 118% Not found
    Households 100 66
    Non Financial Companies 75 266
    Government 52 66
    Total 345% 398%

    1. Can anyone confirm these numbers?
    2. Greenspan, in his latest speech to the Economic Club in New York, says that debts of the financial sector on a global basis, cancels out. That is debts owed by financial institutions have been utilised to provide loans to the other sectors, i.e. Households, Non-Financial Institutions and Government – and so we need to eliminate double counting. Is this a valid assumption/approach? In any case, following this approach, Gross Debt as % of GDP – excluding Financial Institutions – is 227% in the US while it is 398% in Europe. Do we agree that Europe has the bigger problem? Europe also has a lower long term economic growth potential than the US – caused by many factors including demographics.
    3. Everyone seems to agree that we are entering a period of deleveraging. Households, Financial Institutions and Non-financial companies – everyone, except of course for Governments, is trying to reduce their debt. I am trying to figure out what this means for the cost of capital. What will this mean for the expected return on equity? What will this mean for interest rates – government and corporate? Strictly speaking, all things being equal, if non-financial companies deleverage, the return on equity will decline, unless of course borrowing costs drop commensurately. (A long term reduction in expected equity returns is probably being priced into the stock market now, as is expected growth.)
    4. However, equity capital will still require a risk premium over and above the expected return on government and corporate debt. So what will happen with interest rates on a long term basis? In the short term the US government will continue to try to keep down US bond yields through interest rate policy and also by buying longer term treasuries. This, they hope, will bring down mortgage rates and of course other consumer and corporate lending rates. Longer term we can expect more inflation. Presently the differential between 10 year US Treasuries versus AAA corporate is about 3%.

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