Arnold Kling  

Eurozone Crisis: what is the solution?

Real Subjects Have No Arbiter... I Flunk Horwitz's Doonesbury C...

Friends sometimes ask me this question. My answer is rather harsh.

The problem is that some governments and some banks are insolvent. When a financial institution is insolvent, its liabilities must be taken over by a solvent institution. The solvent institution gets to set the price, which typically is a discount.

So, if your solution is for Germany to "step up," the question has to be, at what price? Should the German government take over the liabilities of the Spanish banks and/or the Spanish government at 100 cents on the euro? That would not be terribly rational on the Germans' part.

The crisis will end only when the liabilities of the insolvent governments and banks have been properly discounted. Maybe Spanish bonds will be worth only 70 percent of their face value. Maybe creditors of some large banks will receive new notes worth, on average, 80 percent of their existing notes. (But will small depositors get 100 percent, and large creditors get much less than 80 percent?).

Another important issue arises from the nature of sovereign debt. For private debt issued within a country, creditors have recourse to the court system to try to recover their money. But there is no court with the power to force the government of Spain to pay anything to its creditors. So, even if the German government, in order to "save the European union," agrees as an agent for its citizens to buy existing Spanish debt at par in exchange for new debt worth 70 cents on the euro, how can we be sure that Spain will pay off the new debt?

In any case, the important point is that resolution of the crisis requires large markdowns in the value of the liabilities of some governments and banks. The crisis continues because the parties involved are unwilling to undertake this step. The crisis will end when they have exhausted the alternatives.

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CATEGORIES: Eurozone crisis

COMMENTS (7 to date)
OneEyedMan writes:

Is it even true that if their debts are written down to zero that that alone would restore their economies. Many of them don't even have a primary (excluding interest payments) surplus, so I don't see how reducing their debt burden would be enough.

But for those pitching exit from the Euro and currency devaluation, why is the money illusion as powerful this claim would suggest? Why will Greek workers agree to 50% or more wage cuts in the form of Neo-Drachmas but not 50% wage cuts in Euros? Wouldn't 70% cuts in government employee wages and government transfers (across the board) do much more to address nominal rigidities and restore fiscal balance then any amount of default. Even in massively indebted countries debt payments are small relative to other government expenditures.

As you have argued, let them quit. They won't because unemployment is much too high for them to have other choices. By lowering the need for cash to pay workers and transfers this will free up money to service debt and more importantly reduce the need for further borrowing.

Grant Gould writes:

OneEyedMan: Anecdotally, many Greeks aren't getting their paychecks right now anyway, so the internal devaluation is arguably already in progress (albeit in a grey-market kind of way).

But this can hardly reassure Dr. Kling, as if we take "PSST" seriously we are obliged to admit that at the moment no pattern of trade involving anyone under Greek jursidiction can be regarded as sustainable -- the level of regime uncertainty is such that there is no reason to believe that the ground rules tomorrow will be one thing or another, and the notion of a sustainable pattern is under such circumstances a joke.

The only circumstance under which regime certainty can be restored is if the government is on sustainable footing. But there is no sustainable source of funds available -- taxes are famously evaded, bailout money is even less predictable than the tax take, even the accounts are not in order and haven't been in a decade -- and so any particular government is unlikely to last. Thus if we accept Kling's PSST hypothesis, we must admit that Greece will not have anything resembling a modern economy for a decade or more.

Under those circumstances, the question of who ends up holding the bonds is a peripheral detail. Greece will remain in the Euro only if internal devaluation can keep pace with economic collapse; if it exits, things will likely get worse (as monetary uncertainty is added to regime uncertainty).

Perhaps the one good thing to say about Greece remaining in the Euro is that it would be a step toward accepting the necessary lesson: That sovereign default must be allowed to take its course, even in a currency union, and that the central bank must account for more and less risky sovereign debt with eyes open.

Joe Cushing writes:

In other words, the markets have to clear. That's what we have been waiting for in the US for some time. We seem to be getting closer though.

IVV writes:

And Cyprus joins the breadline.

Vadim writes:

Marking down liabilities is a really obtuse way of saying that losses must be realized.

The real question is who will bear the losses? Taxpayers? Bondholders? The filthy rich?

The euro problem is that outside of politics there doesn't exist an institution or process to allocate losses on such a marco scale. Add no politician is going impose massive losses on any large constituency (pensioners, gov't worksers, taxpayers, bondholders, or savers/deposit holders) and survive.

Philo writes:

Euro-inflation would make the situation much less dire.

Tom E. Snyder writes:

If the Spanish government cannot pay its debt the creditors should foreclose (an economic coup). Or, the creditors can sell their bonds to Germany, and Spain becomes a territory of Germany.

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