Magazine | June 11, 2012, Issue

Four Kinds of Dreadful

On the possible outcomes of the Greek debt crisis

One day before the G8 summit, there was a “leak” from the office of German chancellor Angela Merkel that revealed some of the thinking behind how Germany wants to resolve the long-running euro crisis. The leak was that Chancellor Merkel would ask the Greek prime minister to hold a referendum on Greece’s membership in the euro zone at the same time as the June 17 Greek election. But because it was immediately and embarrassingly denied, it also revealed that the German government was increasingly desperate as it juggled solutions to the euro/Greek crisis. You could follow the thought processes that led to the leak and later to its retraction.

Before the leak:

Chancellor, what we want is for the Greeks to stay within the euro and also to meet their obligations to repay debt and reform their economy. The Greeks hope to avoid meeting their obligations, natürlich, but polls show that 80 percent of them, more than ever, would choose to remain in the euro. So let us tell them to hold a referendum on the euro. If it passes, any new government, however Greek, will not be able to use the threat of exiting from the euro in order to blackmail us into giving it more money. We will have tied their hands. And we will have kept the euro zone virgo intacta. A master stroke, nein? 

After the leak:

Unfortunately, Chancellor, there are some unforeseen difficulties with our brilliant plan to hold a Greek referendum on the euro. First, you may recall that we actually dismissed the last-but-two Greek prime ministers for suggesting exactly the same referendum. Second, our colleagues in Brussels remind us that we dislike referendums in general because they have a way of not giving the required answer. And, third, a referendum would tie our hands only slightly less than those of the Greeks. It is, of course, unthinkable that Greece should leave the euro. At the present moment. But the costs of keeping them in might ultimately become so high that a “Grexit” — that is what the frivolous Anglo-Saxons call the Greeks’ returning to the drachma — might well become thinkable.

Fortunately, Chancellor, all of these difficulties can be easily resolved by one single action: deny the leak. A master stroke, nein?

These monologues are, of course, a fancy; but they are not fanciful. They reflect the real and increasingly divided thinking of German political elites since the construction of the euro — especially since Greece was admitted into the single currency despite elite nervousness and popular opposition, and more especially since Greece’s finances began to resemble a black hole sucking the wealth of Europe, including Germany’s, into itself and nothingness.

Germany is not the only begetter of the euro; the French were always keener on it, and Germany was never united behind it. Ordinary Germans never wanted to lose their beloved D-mark, the symbol of their postwar recovery and respect; German economists and bankers always had a healthy complement that was skeptical of a single currency on the technical grounds outlined below; only the politicians — all the politicians — saw its adoption (or, rather, the abandonment of the D-mark) as the decisive sacrifice Germany needed to make to seal its integration into a united, democratic European Union. Their reasons were always more political than economic, more concerned with binding European nations together than with basing the new currency on an “optimal currency area.” As the euro gradually took shape, economic decisions that had been made for political motives gradually undermined the new currency. But because the euro was valued above and beyond economics, its practical difficulties could never be honestly faced by the politicians. It became a fetish for Germany’s political elites. It had to be defended at all costs — and the costs keep on mounting.

#page#The history of the euro, if it were a horror movie, would be called something like “The Revenge of the Fetish.” Its original design was flawed because it sought to include too many countries, with too-diverse economic characters and histories, too-different levels of unemployment, and so on. It was impossible to set a single interest rate that would be suitable for all these countries at the same time. Above all, the euro zone did not include the three things needed to reconcile these differences in a practical way: downward flexibility of nominal wages; transnational labor mobility; and transnational monetary transfers. Union-heavy societies such as France would not tolerate wage reductions. Labor mobility between, say, Portugal and Poland was obstructed by the kind of cultural and linguistic differences that do not exist between Texas and Massachusetts. And Germany, as the EU’s banker of last resort, was strongly opposed to the ramping up of monetary transfers from rich to poor nations and regions. Unfortunately for the German argument, monetary transfers are the omission most easily repaired.

Such gaping holes in the currency’s defensive structure were likely to produce crises sooner rather than later. Indeed, one theory going the rounds was that the currency’s strongest advocates wanted a crisis. A former Brussels official who resigned in protest, Bernard Connolly, wrote in National Review as early as 1997 that his senior colleagues knew a single currency required a single budget, a single treasury, and a single fiscal policy in order to work efficiently. Only in a crisis, however, would governments be prepared to surrender the sovereignty needed to establish such central controlling mechanisms. Certainly one curiosity of the early history of the euro is the relative ease with which the Stability and Growth Pact — intended to enforce fiscal responsibility at the national level — was sidelined and eventually abandoned by France and Germany as well as smaller countries with little or no protest from Brussels. That removed one roadblock on the way to a euro crisis — a roadblock that, as it happens, explains why some classical-liberal economists supported a single currency. They saw it as potentially a necessary restraint on the spending proclivities of Europe’s social-democratic governments. Yet when it was wanted, it suddenly wasn’t there.

Now we come to a further absurdity. Having constructed a new international currency covering 17 nations in the knowledge (and arguably with the intention) that it would eventually fail, provoke a massive crisis, and require the establishment of a full-blown European political union with a single treasury, central bank, and common budgetary system, the governments and officials responsible made no preparations for the time when that happened. They acted on the logic advanced by Amanda, and immediately demolished by Elyot, in Noël Coward’s Private Lives:

AMANDA: We should have to trust to the inspiration of the moment.

ELYOT: It would be a moment completely devoid of inspiration.

And so it has proved. Faced with the intended result of their handiwork — albeit a far more severe and intractable crisis than they had bargained for — Europe’s politicians and central bankers have embarked on a series of rescue packages designed to prop up banks, keep vulnerable southern-European countries inside the euro, and help them begin the long process of paying off their mountainous debts. None of the packages has been large enough to solve the problem. The markets have been appeased but not defeated. What began as a Greek crisis has since spread to Portugal, Ireland, Spain, and . . . well, the heat could be felt in France. A few months after every settlement, the crisis has resumed at a faster pace and with higher stakes. And despite an escalating rhetoric of crisis, European governments and central banks seem in the grip of a curious passivity. They meet, discuss, reiterate previous assurances, and, after an EU summit or G8 meeting ends, resume their drift towards disaster, because every single one of the practical solutions to the crisis has dreadful consequences, and some have unimaginable ones.

#page#Consider the Greek crisis in isolation. It combines two questions: Should Greece leave or stay in the euro, and should Greece default or pay its debts?

In reality, Greece has already defaulted on its debts in a grand “haircut” of private investors that scalped more than 50 percent of their loans. This was orchestrated by EU finance ministers and the European Central Bank, and justified as a full settlement that would finally resolve the crisis. It manifestly did not resolve the crisis, but it will likely ensure that any vulnerable European economies will be able to borrow money only at punitive rates for some time ahead. That was the reason the ECB initially resisted this robbery. When it finally gave way, it felt guilty about surrendering to anti-banker populism and pressure from governments, and disguised the default as a civilized restructuring. But a default had occurred all the same. References below to defaults should therefore be read as meaning additional or future defaults by Greece.

That said, there are four possible options to choose from.

First, Greece could both leave the euro and repudiate its international debts on some such grounds as that the loans were “predatory” or that democracy must wrest back power from the markets. If the rhetoric of the radical European Left is taken seriously, something like that is what they favor. Their Greek representative is Alexis Tsipras, leader of the Radical Left Coalition, whom many expect to be prime minister after the June 17 election. Other parties are uniting against him, however, and he should not be difficult to defeat if the Greeks are guided by anything close to rational self-interest. A policy of leaving the euro and repudiating debt would mean cutting Greece off simultaneously from private-sector investment and from such loans, subsidies, and grants as are available from international agencies and European governments. Argentina is sometimes cited as a successful example of this strategy. But Argentina was initially the undeserving beneficiary of a raw-material boom. It is now seeking additional resources by expropriating foreign companies. Lacking Argentina’s raw materials, Greece would hit the buffers far earlier — and therefore both its public and its private sectors would face austerity on a far greater scale than at present. It might be prudent, however, to blunt Mr. Tsipras’s complaints preemptively by pointing out that markets enjoy no power over countries that don’t want to borrow their money or that pay investors a reasonable rate of return. Their sole power — that of refusal to lend — is effective only against those seeking to rob them.

The second option is for Greece to default while remaining inside the euro. That seems possible in principle — just as California could default within the “dollar zone.” But what benefit would anyone gain from it? As under Option 1, neither markets nor official European bodies would then lend Greece money. Yet the country would be committed to repaying its debts in expensive euros. Again as under Option 1, it would have to impose a still more savage austerity than the current one in order to finance quite crushing debt repayments. Unless Greeks suddenly become Prussians, this is simply an impractical solution. Worse is that if the Greeks were to be bailed out yet again, it would encourage the other vulnerable countries to allow their public finances to run riot.

#page#The third option is that Greece would leave the euro but credibly promise to pay its debts. Those debts would have to be redenominated, admittedly. The whole point of Greece’s leaving the euro would be to adopt a new Greek drachma at a value of, say, half that of the euro. In theory (and in the immediate term) switching to a cheaper currency would both devalue the total of Greek indebtedness and increase the country’s ability to pay by stimulating exports and tourism. It would not be that simple, of course. Very likely the euro-zone countries and the ECB would scale greatly back any financial assistance to Greece, for the bank’s main purpose so far has been to keep Greece within the euro. But everyone has an interest in solving the Greek problem with as little instability as possible. So Europe might well find it useful to grease the “Grexit” with a little short-term assistance. And if the economy began an early recovery — some economists suggest that it might happen in 18 months — the drachma would presumably rise accordingly, so that the bondholders would get back more of their money than now seems likely. There are horrendous transitional difficulties attached to this solution. Many West European banks have huge Greek loans on their books that would have to be sharply devalued. But this option does offer at least hope of recovery long term. Its advocates tend to stress the rapid recovery of the British pound and economy after Britain’s exit from the Exchange Rate Mechanism.

The fourth and final option is the status quo: Greece would remain inside the euro and commit to full repayment of its loans, which would naturally be in euros. The status quo is always an option; just as there is always a Plan B. As it has developed over the last two years, however, the fourth option seems to rest on an indefinite transfer of resources from northern Europe (Germany, Holland, Belgium, the Baltic states) to southern Europe (Greece, Portugal, Spain, and Italy). This resource transfer is necessary to enable the latter to overcome the crucial obstacle that within the euro they are at an effective exchange-rate disadvantage of about one-third to northern Europe. Germany can therefore sell cheaply in their countries (and, not coincidentally, in third-country markets) while their own goods are overpriced once they travel north. How can southern-European countries raise the export surpluses necessary to pay their outstanding debts? The answer is that they can’t; they therefore face an endless struggle through the valley of the shadow of austerity.

In the real world the choice seems to lie between Options 3 and 4. Most free-market economists and the private sector would probably choose Option 3, because it seems to offer a greater and quicker prospect of economic recovery. Most governments favor Option 4 because it seems to include a greater chance of persuading the Germans to continue sending money — and indeed to send more money — to them and their neighbors.

It is this distinction that explains why the French president, Greek political parties, and left-wing organizations throughout Europe have suddenly begun discussing an end to “austerity” and a beginning of “growth.” It is starting to look as if the high-water mark of euro austerity was reached in December 2011 when Angela Merkel persuaded 24 other European countries to support the Treaty on Stability, Coordination, and Governance, which amounts, in effect, to a rerun of the Stability and Growth Pact with the implied codicil “And this time we really mean it.” Europe now seems to be moving away from that and towards a more indulgent “growth” policy. But since most euro countries have no money, a question arises as to who will pay for the return to growth and stimulus. The implied benefactor of last resort is Germany again.

Since the G8 meeting European leaders such as Italian premier Mario Monti and European Commission president José Manuel Barroso have been talking up the prospect of something called “project bonds” to replace the proposal for “euro bonds” that Germany had made clear it would resist. “Project bonds” differ from euro bonds in some particulars, but they are the same in two important ways: They are a mechanism for moving towards the mutualization (collectivization) of national debt obligations, and an attempt to lure the Germans into dipping their toes into this concept. And as Mrs. Merkel looks at the way the euro debate is developing, she must be wondering how best to restrain the demands upon Germany’s purse strings and restore some kind of punishment for those who continue to use the euro as a way of getting more money from Berlin.

Maybe it is to throw someone out of the euro pour encourager les autres.

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