Streetwise Professor

August 11, 2011

Amputation or Gangrene

Filed under: Economics,Politics — The Professor @ 8:12 pm

The recent volatility in the market has been linked with last Friday’s S&P downgrade, but the real epicenter is Europe.  The shock waves that commenced in Greece and then Portugal and Ireland have spread to Italy and Spain, and tremors are being felt in France as well.

Europe has two choices: amputation or gangrene.

The amputation option is to jettison the Euro project by lopping off the weak Med countries, and letting them respond to fiscal crisis in the old fashioned way, through a currency devaluation that would permit these countries to become more competitive, and which would reduce the real burden of their debts.

If Europe eschews amputation, its only real choice is to socialize the debt of the financial zombies on the continent’s southern periphery, and have the Germans and Dutch and French assume responsibility for paying the obligations assumed by the poorer, more spendthrift nations currently in financial distress.

This will not go down well with said Germans, Dutch, and French.  it is often said that such a path will require a fiscal union in Europe, but the details of such a union are crucial.  Fiscal union is not sufficient to ensure fiscal probity.  (Cf., States of America, United.)  Indeed, it is hard to see how any European legislative or executive body  that is remotely representative of the nations currently in the EU could avoid perpetuating transfers between the creditor nations and the debtor ones.  Which means that the Germans and Dutch and even the French are unlikely to sign on.

No, to avoid the moral hazards associated with socialization of debt, the government of the fiscal union would have to resemble the creditor committee of a bankrupt firm, imposing a stringent restructuring plan on the debtors, controlling their expenditures, and requiring them to surrender a substantial amount of autonomy.  But that would not be acceptable to sovereign debtor nations, and it is doubtful that any such creditor committee could enforce austerity, given the nationalist resistance any such attempt would spark.

So the Europeans are likely to try to muddle along, and socialize the debt on the sly via the ECB and the EFSF.  Which will be the worst alternative.  It will not address the moral hazard problem and the debtor nations are likely to scrape along, largely unreformed.  And it will be expensive.  As long as it is clear that the EU/ECB/EFSF will attempt to support the debt of bankrupt nations when their spreads spike, it will be vulnerable to periodic speculative attacks–and these attacks are expensive to fight off.  Very expensive.

The perverse incentives of such a policy, and the cost of implementing it, will doom Europe to a slow demise, as the financial gangrene spreads throughout the system, progressively threatening currently healthy (relatively speaking) nations.  Amputation would be the painful, gruesome, but superior alternative.  There is a chance of saving something that way.  Failing to choose that course threatens the entire body of nations.

But the Euros are so invested psychologically in the Euro, and so many of the elites have their interests tied up in the continuation of the Euro project, that they recoil from making the hard choice.  What’s more, politicians always prefer to let their successors clean up messes, and are therefore loath to admit failures on their watch.  There is also fear that amputation would be very costly to French, German and Dutch banks and insurers, as they would suffer losses on the bonds of the amputated members.

But as I said in March 2010, when the crisis first turned serious, it would be better to bail out the banks directly than bail them out indirectly by supporting the profligates.  That would be a one time expense and the damage would be contained, whereas the current MO will lead to a chronic drain of resources from north to south.  Defending against speculative attack for years will be expensive.  Moreover, the flight to quality and the improved fiscal prospects of Germany et al would lead to gains on the banks’ holdings of non-PIIGS debt that would offset some the losses on the latter.  But it is a cost that would be paid now, and the blame attached to the politicians currently in office–so it’s unlikely to happen.

The implications of this are rather grim.  It means that Europe will continue to be the source of economic tremors, whenever there is a run on the debt of any shaky country–or the countries that are supposedly propping up the shaky countries (France being a candidate).  And as we’ve seen in the last week, these tremors will be felt in the US–which is likely to generate more than its share of shocks in the coming years.

It also means that Europe is likely to die slowly, as the financial gangrene spreads progressively throughout the system.  This will be accompanied by slow growth, and social stresses as the promises of the welfare state become impossible of fulfillment not just in Greece or Portugal, but in France and Germany.  What is happening in London could be the  harbinger of things to come on the continent–and that is a much more combustible situation (literally so, if you recall the balieues in Paris, several years back).

Gangrene kills slowly, but it kills.  It is difficult to see how Europe can survive in the long run as currently constituted, with the rot progressively eating its way from country to country.  Amputation is a shattering experience, but it can be survived, and can increase the odds of long term survival.  But politicians typically choose to avoid pain today even if it is beneficial in the long run.  Which means that Europe’s future is bleak indeed.

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  1. Ah ha! But you ignore the fact the European governments have a trump card that they are finally going to play (this is why you will never make it as a European politician). If we ban short selling in equity markets, the financial markets will stabilize and the crisis will be over. 😉

    Comment by Charles — August 11, 2011 @ 8:34 pm

  2. @Charles–I have a bridge for you! Cheap.

    The ProfessorComment by The Professor — August 11, 2011 @ 8:52 pm

  3. Jettisoning the Med sounds logical, until one considers its effects on C. European banks.

    Rescuing which will be beyond even Germany’s means.

    That is why I do not think the Europeans will try to postpone the day of reckoning for as long as possible.

    Comment by Sublime Oblivion — August 11, 2011 @ 9:42 pm

  4. Re: “a currency devaluation … which would reduce the real burden of their debts”

    How is that going to work if the debts are denominated in Euros?

    Re: “a currency devaluation that would permit these countries to become more competitive”

    How is that going to work if the wages and the contracts governing wages are denominated in Euros?

    What about the old-fashioned alternative: default, leaving Europe and the Euro intact?

    Comment by Dan Grayson — August 12, 2011 @ 6:44 am

  5. Hmmm…but remember Professor, you said the EU states all have to stand together against GasPutin’s Evil Empire and its heinous attempts to play divide and conquer. Not bloody likely while bickering over the shrinking pie, huh?

    Perhaps you should just resort to Plan B, and try to get the Polish consulate in Houston keen on buying some LNG from Sabine Pass while Texans see what they can frac in Poland. So far the results in Central Europe have been disappointing, to say the least, and all of those countries would appear to still have Communist era mineral rights policies (aka just like Pemex south of the border, all belong to the State) hence no individual mineral rights incentive (not even the Catholic Church, though not clear on their land holdings in PL) to drill baby drill.

    Comment by Mr. X — August 12, 2011 @ 7:31 pm

  6. Correction: That is why I do not think the Europeans will try to postpone the day of reckoning for as long as possible.

    Comment by Sublime Oblivion — August 12, 2011 @ 10:05 pm

  7. “but remember Professor, you said the EU states all have to stand together against GasPutin’s Evil Empire and its heinous attempts to play divide and conquer.”

    Indeed, most irritating. What needs to happen is for Our unreliable servants Angela and Sarko to end their unbecoming flirtation with Our rebellious servant Vladimir. Those French have the nerve to sell warships to Russia, and the Germans have the nerve to sell a fully instrumented training facility to the Russian Army, the very force that pounded Berlin flat and caused our faithful, if somewhat confused servant Adolpf and his lovely bride Ava to kill themselves! If only that traitor Roosevelt (spits) and that glory-hog Churchill had kept their noses out of things that were none of their business! Those irritating Russians would now be far less numerous, and pushed back to Asia where they belong!

    Alas, the situation appears irretrievable. Although things were looking good while Our faithful servant Boris was running things, the Russian birth rate is now 50% greater than the German. Where will we get an Army that can push those scum back where they belong.

    Comment by a — August 13, 2011 @ 3:05 pm

  8. The fecundity of straw people (I forego the sexist straw man) seems to be extremely high here. So much Russia centric BS, so few letters in the alphabet.

    Comment by pahoben — August 14, 2011 @ 9:54 pm

  9. If you people believe the globalists have no influence on the current regime in Russia you are laughably naive. Who do you think controls the lucre secreted in accounts outside of Russia?

    Comment by pahoben — August 14, 2011 @ 10:25 pm

  10. “If you people believe the globalists have no influence on the current regime in Russia you are laughably naive. Who do you think controls the lucre secreted in accounts outside of Russia?”

    Our rebellious servant Vladimir wastes money that should be Ours on increasing pensions and wages, unlike Our assiduous servant Barack who has ensured that practically all of the economic gains of productivity growth over the past two years, which have been very large, has gone to corporate profits and capital gains.

    Our rebellious servant Vladimir is a thieving scoundrel!

    Comment by a — August 15, 2011 @ 2:03 am

  11. Regardless of solving the current problems of the insolvency in the Mediterranean, the root cause is that some countries using the Euro had a sufficiently different economy that it made no sense for them to be using the same currency as the EU core. If those countries are to do well, they either need to drastically change their economy (and perhaps national culture) and keep the Euro, or switch to a new currency – either a national currency or perhaps a second Euro-Mediterranean currency that could be used for countries similar to each other, but different from the EU core.

    A common currency for Germany, France, Benelux, and some other countries that have a strong economy based on manufacturing, a similar business cycle, and fiscally responsibie government makes sense. Italy may or may not fit into that. Greece obviously does not. There was a price to Greece for the prestige of using the Euro. Greece is now paying that price. Ireland was potentially a future member of the Euro zone, but its business cycle was out of sync with the Euro members, and participation in the Euro fueled a boom and bust cycle greater than what they would have had with their own national currency. They are paying the price for the prestige of using the Euro as well.

    Some kind of currency amputation is needed because the economic fundamentals that made it stupid for Greece to share the same currency as the Germans still exists. Either Greece is willing to put up with these economic problems for the prestige of using the Euro, or they don’t.

    Comment by Chris Durnell — August 15, 2011 @ 12:34 pm

  12. “A” you are a moron.

    During his current reign as “Dictator for Life” Putin has massively cut pensions and entitlement for pensioners:

    Russian seniors protest pension cuts

    And the current Russian plans to raise the entitlement age to 65 for men and women mean that most Russian men will die at least 3 years before receiving their (meager) pension.

    Russian state healthcare is in a state of collapse.

    Real Russian wages are steadily dropping in relation to real prices, and corruption is endemic.

    Comment by Andrew — August 16, 2011 @ 2:03 am

  13. Ah, yes, the days of Our good servant Vladimir, of the 13% flat tax. He has since rebelled, and wasted the energy price windfall on pensions and wages.

    here he is, rousing the rabble:

    Interestingly Vladimir Putin, attempting to raise some sinking political capital has weighed in on the side of the workers:

    Amid proposals for increasingly liberal economic reforms, Prime Minister Vladimir Putin was adamant about boosting the pension fund, and insisted on getting whatever funds necessary to provide adequate care for some 40 million veterans and pensioners.

    “Everyone must pay for the pension system,” Putin said in a Monday video-link meeting with pension fund heads from eight federal districts. This came amid a growing debate on the budget deficit and talk from President Dmitry Medvedev’s advisors of easing the burden on businesses in paying social and pension fees.”

    In 2010, pensions rose by over 40 per cent, with people receiving an average of more than 8,800 roubles a month ($312). Putin pointed out that Russia was one of few countries that raised pensions during the economic crisis, and said pension spending would increase by 20 billion roubles ($0.7 billion) this year.

    “There is money in the budget for this,” he said. “I want to stress that this is our top priority, and we must find the funds. We cannot allow a return to a situation of the 1990s, when pensions were not paid out for months.”

    A 40% increase in the average pension in 2010 Andrew! Putin is a thief I tell you! A criminal!

    Comment by a — August 16, 2011 @ 3:41 am

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