Saturday, 4 August 2012

Whatever it takes (3)

At last, I find the time to define what the political 'whatever it takes' to save the Euro should mean.   I use the conditional purposely, as I am not sure that when Merkel and Hollande issue a joint statement stating the Germany and France will do whatever it takes to save the Euro, they actually mean the same thing.

Actually I think they do not mean the same thing and Merkel could very well be meaning that through austerity we will make all the irresponsible Med countries to start working hard like the Germans whereas France could be meaning that Germans ought to let go a bit and start enjoying life a bit more.

I will try to avoid technicalities and speak more in figurative terms hoping that it would be easier for my readers to follow.   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.

what does her
Whatever-it takes mean?

Things did not work out that way however.   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. To complicate matters this runner called Greece is tied through cultural linkages to another runner who has stopped running with the group (Cyprus) in order to help Greece.   The remaining fourteen are running in the middle a bit disjointed but with prospects that with some effort the Group of 14 can continue running together.

So if one were to say that whatever it takes will be done to keep the Group of seventeen together, what exactly needs to be done?

The more obvious solution could be that the fourteen still reasonably packed together will turn on the remaining three and ask them to leave the group so the fourteen will continue the race together.    But the rules will not allow this so the fourteen 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 fourteen to catch up.    And then the fifteen as reformed will have to do whatever it takes to help poor Greece and Cyprus learn how to run better so that they can keep the pace with the Group.

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

To get into shape so that it can run with rest Greece will have to fire half of the public sector workforce through privatisation or redundancy, and make further cuts in entitlements which would typically hurt the most poor and vulnerable.   Democracy can't live with this.   Democracy can take adjustment pain either in one big shot so that green shoots can be seen before the electoral test needs to be faced again or in serial small doses which at worst will alternate parties in government without actually ditching the democratic framework.   Sharp pain in continuous doses will risk throwing the baby away with the bath water.

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, and possibly Cyprus, 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 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, based on real earnings not borrowed funds for excess consumption, then they will follow the successful Icelandic recovery model.  Iceland has just gone through a similar bitter experience and is coming out of it with considerable success.

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 when its per capita GDP falls well below the EU average.

Cyprus would have to take its own decision whether its wants to keep Greece company in this mis-adventure and accompany it out of the Euro, or else move along on its own and restore their economy within the Euro given that Cyprus has a flexible economy and can use its strategic geographic location to get help from outside the EU structures, including Russia and China.

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 their faces turn blue.  If all countries run a surplus like Germany where will the counter-value deficits be?   Or does Germany think that the EU can run an eternal structural surplus with the rest of the world?  Some hope!

So as Greece has to undergo a devaluation, which as explained above can in democratic terms only happen if they leave the Euro as internal devaluation within the Euro will break the democratic system, Germany has to undergo a revaluation.   Here again they have a choice of whether they 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 substantial revalue against all major currencies including the Euro and Germany will thus loose 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 adopt 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 can't go on like this.  Germany has to choose.

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 you 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.  Leaving the Euro at the original rate of 1.95 and then let the DM float will be the most practical and effective solution and would require no changes to the German constitution or any reference to German courts.  Germany could then work its way back to rejoin at a more realistic rate, probably between 1.30 and 1.60, but only after the Euro rules are changed to enforce fiscal integration of the constituents members, common borrowing through a central debt agency and a clear process leading to converting the EU into a political federation respecting the rules of democracy possibly on the US constitutional model.

If this is too much for Germany they must immediately fast track the internal revaluation route, reversing their atrocious decision for legislatively enforced surplus or 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.

Believe me, there is no time to lose and something must be done soon.

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