The Endgame In Europe

Tyler Cowen commenting on the failed German bond auction offered perhaps the most succinct analysis of the dilemma facing Europe:

Maybe these markets simply will shut down soon. There is so much talk about what the Germans should do, but I don’t see the viable options. With Germany’s own credit status now in doubt, eighty percent debt to gdp ratio, massive welfare state, and unfavorable demographics, are they supposed to endorse — going to endorse — ten or fifteen percent price inflation for a few years’ time, all with no guarantee of reforms in the economically weaker countries? And is that inflation then followed by a subsequent deflation? Or does it continue forever? And would Germany have to move to a regime of wage flexibility for the professions too? How politically feasible is that? I don’t see how the Germans benefit from going down this road, even if you think, as I do, that the alternatives are quite dire.

And amid all the talk among politicians, technocrats and the media about what should or not should be done, he properly notes that there are questions of democracy which should be considered.

The motto “no monetary union without a fiscal union” isn’t wrong, but more to the point is “no fiscal union without a common electorate.”

Even assuming, however, that Europe could expeditiously merge in such a fashion as to allow for continent wide referendums on solutions, it is not all that clear to me that would be in the best interests of the German citizens or for that matter those of their northern neighbors. The collective voting power of the failing countries might well be able to dictate the terms of any new regime. Certainly the antipathy to fiscal reforms so far demonstrated doesn’t argue for any sort of outcome which would not negatively impact the more responsible countries.

Now along comes Holman Jenkins in the WSJ who alludes to a potential way out of the dilemma:

A month ago, as far as the eye could see, Germany was to be the last good credit in Europe, able to bail out all the others. Well, that illusion has liquidated itself in a hurry. Investors sent a message at Berlin’s Wednesday bond sale, sitting on their hands for $3 billion being offered. The message: Markets are getting ready to punish Germany for the sin of its neighbors’ overborrowing, unless Germany allows the sin of money-printing to paper over those sins in the short term.

Then what? Despite the overheated reaction, a six-page German memo that surfaced last week is a most promising document. It describes, if you look between the lines, a Europe that becomes safe for sovereign default. No bank runs. No precipitous withdrawals from the euro. Instead a generous, pro-reform receivership for bankrupt governments at the hands of fellow European governments.

The deadbeats would get debt relief at the expense of Europe’s banks, which hold much of their debt. The deadbeat governments would get new funding from somebody (likely the European Central Bank), in return for welfare and labor-market reforms that would be democratically practical because they would be coupled with debt relief.

Herein resides the best possible solution to the European impasse: an outcome that restores growth, avoids self-defeating austerity, and allows the best possible recovery for bondholders, who would collect more pennies on the dollar than they would if debtor countries were pushed into depression in a futile effort to pay every centime. The only downside would be a modest appearance of subservience to Berlin.

Now Jenkins does readily admit that it takes a certain bit of optimism to believe that this would truly work as smoothly as outlined, but it does seem to address some of the issues that Cowen raised.

Extinguishing the existing debt and funding ongoing needs by the ECB would certainly be much less inflationary than flooding the market with Euros in order to maintain the status quo. While any imposed solution is going to be an affront to the concept of democracy, the tone of this one would at least probably be grudgingly accepted by most of the parties’ electorates. The fiscally conservative countries could at least hope that the ECB printing presses don’t send inflation running and the aid recipients’ populace would hopefully see that their diminished living standards are preferable to the depression they were staring down.

What becomes of the banks that are forced to eat the losses is another matter. Germany, France and a few other countries are going to have to cope with massive recapitalisation to the detriment of their economies. It remains to be seen if bank creditors will finally pay a price, but at least the plan would provide time for an orderly reorganization as opposed to the hysteria that would most likely result from a collapse of the EU.

I suspect that something along the lines of what Jenkins has outlined will come to pass. In some respects this all seems creepily like the period leading up to the passage of TARP. All sorts of plans floating about, predictions of the end of at least banking as we knew it in the US, hard positions and politicians taking everything up to the brink. And then we muddled through.

Expect the EU to do so as well. The careers of too many politicians and technocrats depend on it and, while I don’t think it would be Armageddon the alternative would in Cowen’s words be “dire.”