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CAMBRIDGE "“ When Greece was bailed out by a joint eurozone-IMF rescue package back in May, it was clear that the deal had bought only a temporary respite. Now the other shoe has dropped. With Ireland's troubles threatening to spill over to Portugal, Spain, and even Italy, it is time to rethink the viability of Europe's currency union.
These words do not come easily, as I am no Euroskeptic. Unlike others, such as my Harvard colleague Martin Feldstein, who argue that Europe is not a natural monetary area, I believed that monetary union made perfect sense in the context of a broader European project that emphasized "“ as it still does "“ political institution-building alongside economic integration.
Europe's bad luck was to be hit with the worst financial crisis since the 1930's while still only halfway through its integration process. The eurozone was too integrated for cross-border spillovers not to cause mayhem in national economies, but not integrated enough to have the institutional capacity needed to manage the crisis.
Consider what happens when banks in Texas, Florida, or California make bad lending decisions that threaten their survival. If the banks are merely illiquid, the Federal Reserve in Washington is ready to act as a lender of last resort. If they are judged to be insolvent, they are allowed to fail or are taken over by federal authorities, while depositors are made whole by the Federal Deposit Insurance Corporation.
Similarly, in case of bankruptcy, federal laws and courts readily adjudicate claims among creditors, and do so without regard to state borders. Regardless of the outcome, private debt is not socialized by state governments (but by the federal government, if at all), and does not threaten public finances at the state level.
State governments in turn have no legal power to abrogate debt contracts vis-à-vis out-of-state creditors, and no incentive to do so (given the help they get from the federal government). So, even in the throes of a financial crisis, banks and non-financial firms can continue to borrow if their balance sheets are sound, uncontaminated by the "sovereign risk" of their state government.
Meanwhile, the federal government makes up for a good chunk of the drop in state incomes by transfers or reduced taxes. Workers who nonetheless have it bad can move easily to better-performing states without worries about language differences or culture shock. Almost all of this happens automatically, without long, contentious negotiations among state governors and federal officials, assistance from the IMF, or calling into question the existence of the United States as a unified political-economic entity.
So the real problem in Europe is not that Spain or Ireland has borrowed a lot, or that too much Spanish and Irish debt sits on banks balance sheets elsewhere in Europe. After all, who cares about Florida's current-account deficit "“ or even knows what it amounts to? No, the real problem is that Europe has not created the union-wide institutions that an integrated financial market requires.
This reflects the absence of adequate political institutions at the center. The European Union has taught us valuable lessons over the last few decades: first, that financial integration requires eliminating volatility among national currencies; next, that eradicating exchange-rate risk requires doing away with national currencies altogether; and now, that monetary union is impossible, among democracies, without political union.
It should have been expected that the political side of the equation would take time to fall into place. It is easy to blame European politicians for lack of leadership. But let us not underestimate the magnitude of the task that European governments took on.
In fact, the closest analogue to it is America's own historical experience with building a federal republic. As the long American struggle for "states' rights" "“ and indeed the Civil War "“ shows, creating a political union out of a collection of self-governing entities is hardly a smooth or speedy process.
States naturally cherish their sovereignty. Worse still, economic union itself can fan the fires of nationalism and endanger political integration. It places strains on each country's institutions (seen in the pressure on Europe's welfare states), breeds resentment against foreigners (witness the recent success of anti-immigration parties), and renders financial crises originating from abroad both likelier and costlier (as the current situation makes all too clear).
Alas, it may now be too late for the eurozone. Ireland and the southern European countries must reduce their debt burden and sharply enhance their economies' competitiveness. It is hard to see how they can achieve both aims while remaining in the eurozone.
The Greek and Irish bailouts are only temporary palliatives: they do nothing to curtail indebtedness, and they have not stopped contagion. Moreover, the fiscal austerity they prescribe delays economic recovery. The idea that structural and labor-market reforms can deliver quick growth is nothing but a mirage. So the need for debt restructuring is an unavoidable reality.
Even if the Germans and other creditors acquiesce in a restructuring "“ not from 2013 on, as German Chancellor Angel Merkel has asked for, but now "“ there is the further problem of restoring competitiveness. This problem is shared by all deficit countries, but is acute in Southern Europe. Membership in the same monetary zone as Germany will condemn these countries to years of deflation, high unemployment, and domestic political turmoil. An exit from the eurozone may be at this point the only realistic option for recovery.
A breakup of the eurozone may not doom it forever. Countries can rejoin, and do so credibly, when the fiscal, regulatory, and political prerequisites are in place. For the moment, the eurozone may well have reached the point where an amicable divorce is a better option than years of economic decline and political acrimony.
Dani Rodrik is Professor of Political Economy at Harvard University's John F. Kennedy School of Government and the author of One Economics, Many Recipes: Globalization, Institutions, and Economic Growth.
Copyright: Project Syndicate, 2010. www.project-syndicate.org For a podcast of this commentary in English, please use this link:http://media.blubrry.com/ps/media.libsyn.com/media/ps/rodrik51.mp3
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Username Password New registration Forgotten password mattus 03:41 10 Dec 10This analysis is not very helpful. To compare a sovereign European country in the eurozone to a state in the USA is just pointless, and all the arguments flowing from it equally so. Europe is not even a nascent United States of Europe, and will never be one.
Also, the argument that financial markets need union-wide institutions is far off the mark. Financial markets work worldwide without any world-wide institutions. Individual regulators oversee them in their individual countries, central banks work as lenders of last resort, and governments legislate. All different in all countries, still, the financial markets worked for hundreds of years like that. Why a euro currency union now needs to change all that is not clear.
What the euro zone did, however, increased the appetite for risk by credit providers (by believing that current account deficits did not matter), and the appetite for loans by citizens and governments, as real interest rates fell. A potent cocktail, mixed with a dash of real-estate exuberance. Anyone who tried it is now heading for their hang-over period.
If nobody cares about a current account deficit in Florida, that is because transfer payments will automatically adjust it. In Europe people temporarily forgot that this is not the case.
There are no tranfers between rich and poor countries, so the current account deficits matter. Equally it is worthwhile to attempt to control real-estate markets from over-heating, as well as the enforcement of government deficit rules which each country signed up to.
But if that little paragraph immediately above this sentence is all what is wrong with the design of the currency area, that is easy to fix. Fix current account deficits, property bubbles and government spending: the over-indebtedness of the problem countries would not have happened, and won't happen again in future. Currency area is saved, the Euro survives.
These problems are not solved by further political or economic union. They just need a bit of regulation, with perhaps the European Central Bank (ECB) being the institution most likely to ensure these aims, under its remit to ensure wider financial stability.
Clearly, the crisis feels slightly bigger than that now, even though not any European bail out money has been lost yet.
That is mainly because of the uncertainty of whether or not debtor countries can get out of their mess. It will take some time, will be hard (like it was in Estonia), but it is surely worth having a go for the next few years.
manuelcc 07:49 11 Dec 10It would be too long to tell here, but the costs for the EU of the output of any country in the euro area, especially if an economy as important as that of Spain, are so high that the future existence of the EU itself will depend of good management to be done now to the economic problems that the EU has mainly regarding government debt.It would be convenient to view the details of these problems in the article of December 2, 2010 in The Economist whose link is: http://www.economist.com/node/17629757On the other hand, even the great powers of the EU, especially Germany, are not interested in any country out of the euro area for two important reasons:1. The output of the euro would arise from the collapse of that country. The bankruptcy of this country means to suspend payments abroad. Remember that much of the private and public debt of Spain is in the hands of large banks in Germany. We can understand Germany supported the rescue of Ireland for this serious reason. The suspension of payments of Spain is, among other problems, the bankruptcy of the pension system of the Germans.2. The output of the euro in Spain, for example, would be made only to proceed to the devaluation of the currency to replace the euro for the economy more competitive and create jobs. Although the debt is paid in euros, of course, for the State of Spain, we could increase money to return, although the substitute currency to depreciate. Salaries and taxes do not rise at the same time as the possible devaluation of the currency.As indicated in an excellent article Krugman (http://www.nytimes.com/2010/11/29/opinion/29krugman.html?_r=2&ref=todayspaper): The Spanish Prisoner.Manuel Caraballo CalleroSpanish economisthttp://manuelcaraballo.wordpress.com
pratclif1 05:52 12 Dec 10One piece of news that is being missed by most observers and the general public, is that the financial markets have invented CDS used against sovereign debt... The markets are therefore playing casino against european deficit countries... who is likely to default and who is not. The EU central bank is helpless in acting against this. But this may lead to EU changing the rules... see this link http://2.ly/d7m9 and this one http://2.ly/d7m7
mattus 05:07 13 Dec 10
@pratclif1
An important point. Anybody on this site innocently advocating debt default or haircuts of European country debt as the way out of the crisis will, albeit unintentionally, play into the hands of the hedgefunds who try and destabilize the system. Their biggest pay day would come if a country would actually default.
Hedgefunds have taken a position on expecting interest rates to rise, as investors get more and more nervous. They can make plenty of money on a worsening of the situation without an actual default.
But is the European Central Bank (ECB) really powerless? Ten days ago it effectivley lowered interest rates on Portugese and Irish sovereign debt by buying up the whole market of offered bonds. Although they only bought less than 2% of all outstanding Irish and Greek debt (only about Euro 2 bn ($2.6bn)) interest rates (yields) on these bonds fell by 1.5%. So a highly illiquid market with the ECB effectively setting interest rates.
(It also showed that 98% of investors did not believe that either Portugal or Ireland would default, otherwise they would have tried to sell as well.)
Whoever controls interest rates controls the price of Credit Default Swaps (CDS), the insurance for that debt. The price of CDS for Portugal and Ireland will have fallen in line with yields.
The hedgefunds will have lost a great deal of money through the 1.5% fall in yields and the ECB is now in charge of setting the prices of CDS. The hedgefunds will not be pleased.
(Why are the prices of CDS linked to interest rates? Think about it, the rates for CDS have to be lower than the yield, otherwise nobody would buy this insurance. If you want to buy 100 worth of Portugese bonds which has a yield of 6% you expect 106 in a years time. If CDS costs 7, you are better off not to buy the bonds but to put your money under the mattress.)
Of course, CDS should be banned. They provide a hugely inefficient market with enormous cost externalities.
AUTHOR INFO Dani Rodrik Dani Rodrik is Professor of Political Economy at Harvard University's John F. Kennedy School of Government and the author of One Economics, Many Recipes: Globalization, Institutions, and Economic Growth. MOST READ MOST RECOMMENDED MOST COMMENTED Europe's Monetary Cordon Sanitaire Simon Johnson and Peter Boone The Irrepressible 1930's Robert Skidelsky The Retreat of Macroeconomic Policy J. Bradford DeLong Europe's Inevitable Haircut Barry Eichengreen Alternatives to Austerity Joseph E. Stiglitz A New World Architecture George Soros No Time for a Trade War Joseph E. Stiglitz Let A Hundred Theories Bloom George Akerlof and Joseph E. Stiglitz Avatar and Empire Naomi Wolf The Risky Rich Nouriel Roubini The Retreat of Macroeconomic Policy J. Bradford DeLong Europe's Inevitable Haircut Barry Eichengreen Alternatives to Austerity Joseph E. Stiglitz Land for Peace in Kosovo Charles Tannock The Euro at Mid-Crisis Kenneth Rogoff ADVERTISEMENT PROJECT SYNDICATEProject Syndicate: the world's pre-eminent source of original op-ed commentaries. A unique collaboration of distinguished opinion makers from every corner of the globe, Project Syndicate provides incisive perspectives on our changing world by those who are shaping its politics, economics, science, and culture. Exclusive, trenchant, unparalleled in scope and depth: Project Syndicate is truly A World of Ideas.
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This analysis is not very helpful. To compare a sovereign European country in the eurozone to a state in the USA is just pointless, and all the arguments flowing from it equally so. Europe is not even a nascent United States of Europe, and will never be one.
Also, the argument that financial markets need union-wide institutions is far off the mark. Financial markets work worldwide without any world-wide institutions. Individual regulators oversee them in their individual countries, central banks work as lenders of last resort, and governments legislate. All different in all countries, still, the financial markets worked for hundreds of years like that. Why a euro currency union now needs to change all that is not clear.
What the euro zone did, however, increased the appetite for risk by credit providers (by believing that current account deficits did not matter), and the appetite for loans by citizens and governments, as real interest rates fell. A potent cocktail, mixed with a dash of real-estate exuberance. Anyone who tried it is now heading for their hang-over period.
If nobody cares about a current account deficit in Florida, that is because transfer payments will automatically adjust it. In Europe people temporarily forgot that this is not the case.
There are no tranfers between rich and poor countries, so the current account deficits matter. Equally it is worthwhile to attempt to control real-estate markets from over-heating, as well as the enforcement of government deficit rules which each country signed up to.
But if that little paragraph immediately above this sentence is all what is wrong with the design of the currency area, that is easy to fix. Fix current account deficits, property bubbles and government spending: the over-indebtedness of the problem countries would not have happened, and won't happen again in future. Currency area is saved, the Euro survives.
These problems are not solved by further political or economic union. They just need a bit of regulation, with perhaps the European Central Bank (ECB) being the institution most likely to ensure these aims, under its remit to ensure wider financial stability.
Clearly, the crisis feels slightly bigger than that now, even though not any European bail out money has been lost yet.
That is mainly because of the uncertainty of whether or not debtor countries can get out of their mess. It will take some time, will be hard (like it was in Estonia), but it is surely worth having a go for the next few years.
It would be too long to tell here, but the costs for the EU of the output of any country in the euro area, especially if an economy as important as that of Spain, are so high that the future existence of the EU itself will depend of good management to be done now to the economic problems that the EU has mainly regarding government debt.It would be convenient to view the details of these problems in the article of December 2, 2010 in The Economist whose link is: http://www.economist.com/node/17629757On the other hand, even the great powers of the EU, especially Germany, are not interested in any country out of the euro area for two important reasons:1. The output of the euro would arise from the collapse of that country. The bankruptcy of this country means to suspend payments abroad. Remember that much of the private and public debt of Spain is in the hands of large banks in Germany. We can understand Germany supported the rescue of Ireland for this serious reason. The suspension of payments of Spain is, among other problems, the bankruptcy of the pension system of the Germans.2. The output of the euro in Spain, for example, would be made only to proceed to the devaluation of the currency to replace the euro for the economy more competitive and create jobs. Although the debt is paid in euros, of course, for the State of Spain, we could increase money to return, although the substitute currency to depreciate. Salaries and taxes do not rise at the same time as the possible devaluation of the currency.As indicated in an excellent article Krugman (http://www.nytimes.com/2010/11/29/opinion/29krugman.html?_r=2&ref=todayspaper): The Spanish Prisoner.Manuel Caraballo CalleroSpanish economisthttp://manuelcaraballo.wordpress.com
One piece of news that is being missed by most observers and the general public, is that the financial markets have invented CDS used against sovereign debt... The markets are therefore playing casino against european deficit countries... who is likely to default and who is not. The EU central bank is helpless in acting against this. But this may lead to EU changing the rules... see this link http://2.ly/d7m9 and this one http://2.ly/d7m7
@pratclif1
An important point. Anybody on this site innocently advocating debt default or haircuts of European country debt as the way out of the crisis will, albeit unintentionally, play into the hands of the hedgefunds who try and destabilize the system. Their biggest pay day would come if a country would actually default.
Hedgefunds have taken a position on expecting interest rates to rise, as investors get more and more nervous. They can make plenty of money on a worsening of the situation without an actual default.
But is the European Central Bank (ECB) really powerless? Ten days ago it effectivley lowered interest rates on Portugese and Irish sovereign debt by buying up the whole market of offered bonds. Although they only bought less than 2% of all outstanding Irish and Greek debt (only about Euro 2 bn ($2.6bn)) interest rates (yields) on these bonds fell by 1.5%. So a highly illiquid market with the ECB effectively setting interest rates.
(It also showed that 98% of investors did not believe that either Portugal or Ireland would default, otherwise they would have tried to sell as well.)
Whoever controls interest rates controls the price of Credit Default Swaps (CDS), the insurance for that debt. The price of CDS for Portugal and Ireland will have fallen in line with yields.
The hedgefunds will have lost a great deal of money through the 1.5% fall in yields and the ECB is now in charge of setting the prices of CDS. The hedgefunds will not be pleased.
(Why are the prices of CDS linked to interest rates? Think about it, the rates for CDS have to be lower than the yield, otherwise nobody would buy this insurance. If you want to buy 100 worth of Portugese bonds which has a yield of 6% you expect 106 in a years time. If CDS costs 7, you are better off not to buy the bonds but to put your money under the mattress.)
Of course, CDS should be banned. They provide a hugely inefficient market with enormous cost externalities.
Project Syndicate: the world's pre-eminent source of original op-ed commentaries. A unique collaboration of distinguished opinion makers from every corner of the globe, Project Syndicate provides incisive perspectives on our changing world by those who are shaping its politics, economics, science, and culture. Exclusive, trenchant, unparalleled in scope and depth: Project Syndicate is truly A World of Ideas.
Project Syndicate provides the world's foremost newspapers with exclusive commentaries by prominent leaders and opinion makers. It currently offers 52 monthly series and one weekly series of columns on topics ranging from economics to international affairs to science and philosophy.
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