Monday, 13 August 2012

Defining 'whatever it takes'

This article was published in the The Malta Independent on Sunday 12th August 2012
Time to really decide whether to save the Euro
No one can be sure that when Merkel  and Hollande issue a joint statement that Germany and France will do whatever it takes to save the Euro, they actually mean the same thing.

Merkel could very well be meaning that through austerity, all the irresponsible Med countries will be forced to start working hard like the Germans. France could be meaning that Germans ought to let go a bit and start enjoying life a bit more.

The European Monetary System can be likened to a group of seventeen runners who have agreed to run together a race that can only be won if they finish it together as a group. So they pledged to train and keep fit so that they could as a group move fast but together.
Things did not work out that way. One particular runner (Germany) worked so hard and gained so much fitness that it is effectively sprinting ahead of the group. Another one (Greece) cheated, over-ate, under-trained, put on weight and simply can't keep up the pace with the rest of the Group, let alone with Germany. The remaining fifteen are running in the middle a bit disjointed but with prospects that with some effort the Group of 15 can continue running together.

What needs to be done to get the 17 running sustainably together again?
The middle fifteen still reasonably packed together can turn on the two at different extreme ends and ask them to leave the group so the fifteen will continue the race together. But the rules will not allow this.  They have to approach it in another way. Firstly they have to ask the fast runner Germany to slow down a bit, to stop running and have a couple of cold beers to give time to the fifteen to catch up. And then the sixteen as reformed will have to do whatever it takes to help poor Greece to learn how to run better so that they can keep the pace with the Group.

Can this be done? It can in theory,  but it will take a long time and with the way democracy works, I doubt if such time can be found before some demagogue of the extreme left or right will rise to power and decides to slow down the rest of the Group by shooting them in the foot. Democracy would not allow serial rounds of austerity to serve so much continuous pain in double doses of austerity and economic contraction.

So the politicians proclaiming they are willing to do whatever it takes to save the Euro had better come to terms with reality and accept that Greece can never reform within the Euro. They should stop the slow grind of putting the most exposed in the Greek population through the sausage machine and accept that it would be in Greece’s and the Euro's mutual interest for Greece to leave the Euro and revert to their Drachma.

This would involve a substantial devaluation of the Drachma, outright default of Greece on its debt denominated in Euro ( default either through non-payment or through forced conversion in a devalued Drachma) and re-instatement of capital and import controls. Basically Greece would have not only to cancel its Euro membership but also to suspend its EU membership as it breaks the basic concepts of free trade and capital movement.

The Greek population will receive a big sharp shock of pain as salaries and pensions would lose the real value but the country's economy would start growing again pretty soon as the external competitiveness would be instantly restored. If the Greek population learns a lesson from this debacle and understands that they have to live within their means, then they will follow the successful Icelandic recovery model.

The EU would then have to stand ready to support Greece to restore itself to health and work its way back to honouring its EU membership obligation by direct aid from its regional funds as Greece becomes increasingly entitled to once its per capita GDP falls well below the EU average.

The story does not end there however. Germany is causing as much instability to the Euro system from the virtuous side as much as Greece from the vicious side. Germany has to accept that Euro countries cannot become all like Germany even if they try until hell freezes. If all countries run a surplus like Germany where will the counter-value deficits be? So as Greece has to undergo a devaluation, Germany has to undergo a revaluation. Here again they have a choice of whether to do it internally or externally.

An external revaluation for Germany would mean their temporary departure from the Euro and reversion to their beloved Deutsche Mark (DM). The DM will revalue robustly against all major currencies including the Euro and Germany will thus lose their excessive competitiveness forcing industry to relocate and consumers to spend at least part of the increased real value of their salaries and pensions ( how about going for a very inexpensive holiday to Greece which will be priced in cheap Drachmas?).

Or they can do an internal revaluation by staying within the Euro but adopting much looser fiscal policy going into structural deficits to boost consumption just as the chronic deficit countries would be shifting into surplus.

Germany has to choose between one or the other if they really mean what they say when their Chancellor proclaims that they will do whatever it takes to save the Euro. Germany knows this and has been avoiding being forced to make a choice and instead has been unfairly using their economic and political power to put all the pain of adjustment on the deficit countries. Meanwhile Germany has been enjoying the crisis by paying zero real interest on their debt and gaining competitiveness on external markets as the crisis weakens the Euro. The crisis is making the strong stronger and the weak weaker.  It is good while it lasts but it cannot last.

What happens if Germany continues to avoid the hard decision? As Italy and Spain will get enfeebled by serial rounds of austerity without light at the end of the tunnel their democratic model will also get broken ( in Italy elections are due in 2013, Monti will disappear and can one imagine Beppe Grillo or Berlusconi again as Prime Minister?) and the Euro will break up irreparably. Germany then will have no choice but to revert to their DM with the difference that the break-up of the Euro will probably lead to the breakup of the EU and God only knows what else. Remember the 1930's?

So at some point in the very near future Germany will have to decide whether they want the Euro to survive and if they really mean it when they say they are prepared to do whatever it takes, then they have to choose what sort of revaluation they prefer.

If external devaluation is too much for Germany they must immediately fast track the internal revaluation route, reversing their atrocious decision for legislatively enforced neutral budgets and give substantial tax rebates to the German consumers so that they can spend Germany's surplus on increased consumption stimulating increased demand for imports from other EU countries.

In the context of all this the ECB has to stand ready with whatever-it-takes programmes to monetise whatever needs to be monetised to avoid the Euro area falling into a depression. The first thing they have to monetise is a substantial fund to recapitalise the EU banks as they write off their bad assets or bad debts and avoid a Japanese style prolonged depression caused by domestic zombie banks.
Defining ‘whatever it takes’ involves measures bordering on the unthinkable but less unthinkable than the consequences of the Euro break-up.  The menu is served: a  selection of unthinkables.

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