naked capitalism

Ambrose Evans-Pritchard today has his usual type of offering: extreme, but nevertheless based on a valid observation, on his favorite hobbyhorse, the EMU. His key observation comes at the end:

EMU architects were warned in the early 1990s that monetary union would prove unworkable as constructed. They scoffed, sure that any crisis could be exploited to force the pace of economic union. Commission chief Romano Prodi later admitted as much. “The euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible now. But some day there will be a crisis and new instruments will be created.”

We will soon learn if this gamble will pay off, or prove catastrophically wrong.

The interesting conundrum is that Greece does not appear prepared to accept the austerity measures demanded of it, particularly since unemployment is projected to reach 20% by the end of 2010 before budget cuts have an impact. But if Greece fails to come to heel, not only will its bond rates rise further, but the other PIGS will come under more pressure.

Membership in the Eurozone keeps Greece from adopting the usual emergency measure for debt-burdened countries: depreciating the currency (more accurately, letting it fall, which usually means overshoot on the downside. But rather than having Greece exit the EU to achieve this end, Evans-Pritchard suggests that Germany leave instead:

A German exit would allow Club Med to uphold contracts in euros and devalue with least havoc to internal debt markets. The German bloc would enjoy a windfall gain. The D-Mark II would be stronger. Borrowing costs would fall. The North-South gap in competitiveness could be bridged with less disruption for both sides.

To be sure, Germany is happily placed in the current EMU system. By compressing wages for a decade it has stolen a march on EMU. Critics unfairly call this a beggar-thy-neighbour policy. It is simply the way Lutheran society operates, in deep contrast to the way Latin society operates – a cultural clash that should have given pause for thought before Europe’s elites launched headlong into their adventure.
German goods are flooding the South. In the 12 months to November, Germany-Benelux had a current account surplus of $211bn: Spain had a deficit of $82bn, Italy $74bn, France $57bn, and Greece $37bn. German industry will not give up this edge lightly. However, the matter will in the end be decided by democracy. German citizens were given a pledge by their leaders in the 1990s that loss of the D-Mark would not lead to monetary disorder, or leave them liable for Club Med debt. That is the sacred contract of EMU.

“Politically,” said Bundesbank chief Axel Weber, “it’s not possible to tell voters that they are bailing out another country so that it can avoid painful austerity measures that they themselves have gone through. Such aid, whether conditional, or – even worse – unconditional, is counterproductive.”

Germany is in a similar position to China: a manufacturing powerhouse that sees it as to its advantage to have its currency “peg” result in its labor being underpriced. But the result, that its economy saves, means another economy much consume more than it produces. Keep that up for long enough, and the underproducing country starts to look like a deadbeat. So the surplus country needs to be prepared to accept either a revaluation or deadweight losses. But neither China nor Germany seem ready to hear that.

One of the side effects, as long as this drama is in play, at minimum, is that the Euro does not look like a new reserve currency contender. As has become increasingly common with Bloomberg, a tantilizing headline, “Euro Proving No Reserve Asset as Central Banks Shift (Update1)” had no accompanying story. I assume that will be rectified in the next couple of hours.

Most people expect the Greece drama to be contained…my, that has a familiar ring, now doesn’t it?

Update: Evans-Pritchard is guaranteed to annoy a fair number readers (but I think that is still useful, it gets people to think). A less apocalyptic set of recommendations comes via Wolfgang Munchau in the Financial Times:

The first of the essential conditions is a robust and transparent system of crisis management. Maybe the Greek bail-out will provide a blueprint for such a system. But in any case, it would need to be worked out formally and approved by national parliaments to achieve a maximum degree of legitimacy. This should not be imposed by diktat.

A good crisis-resolution system must also minimise moral hazard. Countries that benefit from help will have to accept a partial loss of sovereignty, and for this reason it is important that any such regime has wide political backing in all the member states. While eurozone members lack the political will for unconditional bail-outs, they accept that they need to help each other during a crisis. But this help is attached to the condition that the recipient takes corrective action.

The second essential prerequisite for survival is a reduction in internal imbalances, which lie at the core of the current crisis. This is an issue that requires action both in countries with large current account deficits, such as Greece and Spain, and in those with large surpluses such as Germany. While Spain, for example, would need to reform its labour market to bring about adjustments in real wages, Germany should implement policies to stimulate consumption, including a long-overdue income tax reform. The build-up of these imbalances is the underlying reason why the Greek problem got out of hand.

The place to handle this co-ordination is the eurogroup of the finance ministers of the eurozone, which now constitutes an official European Union institution under the Lisbon treaty. Jean-Claude Juncker, the prime minister of Luxembourg and chairman of the eurogroup, should make imbalances the defining issue of his agenda and propose binding policies.

Third, the EU should at some point revisit the now almost totally decaffeinated proposals for financial supervision. What started off as a deeply unimpressive set of recommendations by the De Larosière committee ended up further diluted as it proceeded through the EU’s legislative mills. The financial system remains the single biggest threat to the long-term stability of the eurozone economy. Fragmented financial regulation makes no sense in a monetary union and is potentially lethal.