Arnold Kling  

The State of the European Crisis

Sociology and Signaling... Tools and Objectives...

Tyler Cowen writes,

In a nutshell, we're watching the most pitched, highest-stakes, most determined battle between politics and finance which has been staged. I am expecting finance to win.

The question is whether the Eurocrats can beat back the speculators. I find the whole situation much too complex. I can only come up with a list of things that I wish I knew.

1. What is the true state of the large European banks? In particular, if, they had to write down the principal on the debt of the PIGS by, say, 15 percent, which banks would still be solvent?

2. What does the option for inflating away European debt look like? How would the cost of that inflation be distributed? Can the inflation take place within the context of the euro, or does it require that some countries leave the euro?

3. Does a crisis create an opportunity for governments to make radical changes to the welfare state, or is that still not possible?

4. Suppose that governments have to choose between preserving their banks and preserving high levels of spending on public employees and retirees. Which choice is better for the economy? For political survival?

COMMENTS (7 to date)
PacRim Jim writes:

The very thought that Soros is profiting from Europe's profligacy warms the cockles of my heart, wherever those may be.

Noah Yetter writes:

We know the answer to #1: zero. ALL fractional reserve banks are ALWAYS insolvent.

Joemama writes:

Well I'll try my hand at answering these questions:

1. I think they might be in pretty bad shape from what I have seen. Ireland has said they have enough capital to last until next year without having to float new bonds. They were forced to take the bailout at proverbial gunpoint.

You have to figure they were forced to take this money so Irish bonds don't drop any further and make the balance sheets at the banks look like swiss-cheese.

Also you have to remember that their are billions of PIGS debt on the books of the EU from the last QE they did. They don't want to do nothing and make themselves insolvent as that PIGS debt starts to deteriorate.

2. I have not idea if they would be able to inflate their way out of debt. However, kicking countries out of the euro would probably work but at the cost of the credibility and future of the EU itself. I bet Germany would love this option if they were presented with it. A EU breakup would go a long way toward permanently fixing the problem.

3. They can make radical changes but not without blood in the streets. There were major riots and strikes in France over raising the retirement age by a few years. Think of what would happen if Spain dropped something expensive like universal health care. Europeans are used to their welfare state and will fight like mad to keep it.

4. They will spend German money to prop up their banks as long as they can. They will cut pensions and public worker jobs only as a very last resort. The social unrest caused by this unwinding of Eurozone debt might get far worse before it gets better.

David Taylor writes:

This question is even more interesting in the context of Reinhart and Rogoff's THIS TIME IS DIFFERENT, as it is the cusp event of default that they point to as indicating the recovery path/time. At this point, I think default in some of the PIIGS seems probable and that will make the scenery on our path going forward rather ugly.

I also suspect that casting the finance v politics as either/or is wrongheaded. I think that the financial reality will have to be faced soon. (At best it can be delayed as the problems seem built into the present structure.) Once the politicians cannot avoid the problem, they will use it as crisis to improve their power base and consolidate the Euro. My guess is the opposite of an EU breakup, (even though I agree that an EU breakup would go a long way toward fixing the structural problem).

Yngvar writes:

It's the most pitched, highest-stakes, most determined battle between bond-insurers and bond buyers. Credit Default Swaps must be banned immediately. They create a moral hazard.

Hyena writes:

I really don't see why PIGS can't default and I think they would if there weren't politics and sentiment involved.

To me it looks like the EU is wasting a vast amount of resources trying to shift around the consequences. They should let this go the path of least resistance, they're not likely to craft a system which will cost less than that.

Tom Grey writes:

Printing 0% coupon 1-yr bearer bonds, and paying off salaries with bonds, not cash.

Accepting such bonds at 100% immediately for taxes.

Ireland could do this, to buy time for their austerity to work, and for the economy to grow.

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