For a number of months, the financial crisis in Europe has been explained under the guise of sound versus unsound policy. If this were indeed the case, the fix would be simple; eliminate unsound and unsustainable policy and voila, the problems would just go away. European leaders have shifted blame continuously from one problem to the next. First the issue was speculators, then Greece, then Ireland, then Portugal, then Spain, then Belgium, then Italy, then the need for austerity, then the macro economy, and now the problem has erupted to everywhere. The current set of events will hopefully amount to a positive development as it becomes clear that the problem is the construct of the Eurozone itself. Europe’s misguided attempts to reform its way out of a crisis are pointless. Once the true nature of the crisis is acknowledged, Europe can decide what it should have already decided by now; to put an end to the financial crisis immediately and work out the residual moral hazard issues and structural problems over the next number of years. The alternative is to deal with the consequences of a depression and ultimately abandon the Eurozone project. Unfortunately there probably isn’t a middle ground anymore.
The European financial crisis has been “ring fenced” either explicitly or implicitly up until this point. The first version of the EFSF was enough to obviate a crisis stemming from Greece, Ireland or Portugal. The size and commitment to the original EFSF was sufficient to prevent a crisis on this accord. Assumed, was that over the five month period from July to November, the Eurozone would take the risk of a pervasive crisis off the table. Stunningly, Eurozone leaders have preferred the minimalist approach throughout, focusing on deleveraging, austerity, and reform which can take months if not years to implement. The market action in European sovereign debt markets and the currency itself point to the available timeframe being weeks not years. If the vicious circle of higher debt costs isn’t arrested via Eurobonds or an activist ECB the crisis will grow – other options are too little and too late at this point.
We have approached the endgame of Europe’s financial crisis because the mechanism of a powerful negative feedback loop has become entrenched. This loop will either force the issue to be resolved once and for all through ECB backed subsidization of sovereign borrowing costs or the Eurozone will collapse. The negative reflexivity is simply too much for a collective economy that has some weak links and little to no growth. The automatic stabilizers for the Eurozone economy are broken which brings us closer to the more dire stages of the crisis. To understand clearly, examine the situation in the US when the economy weakens. In the US, an economic slowdown, or fears of a recession lead to a flight to quality of assets and risk reduction which causes strength in the USD and a rally in US bond markets. Lower interest rates help counterbalance a recession by stimulating the economy and easing debt burdens. The reason the US economy has automatic stabilizers are because of the Federal Reserve Board, the Treasury Department, and an independent currency. In Italy, fears of a recession are now causing bond yields to rise which puts more pressure on debt burdens and makes the solvency of the nation worse not better. The higher Italian interest costs go, the worse the budgetary situation, the more need for austerity, the deeper the recession, and the more need to price more credit risk into Italian debt. Italy lacks an independent central bank, treasury, and currency.
The answer for Europe is to temporarily reduce the credit risk component of Eurozone debt through direct purchase by the ECB. European taxpayers end up implicitly being on the hook for all the sovereign debt purchases but if a crisis is averted the taxpayers end up earning a profit and things work out. Of course a strong commitment from the ECB to end the crisis would also lessen the need for the financial system to immediately raise capital at high costs. Moreover, countries like Italy would have time to implement structural reforms which could instill confidence further. The Eurozone is getting questioned as an entire construct and the policy response has been inadequate thus far. Perversely, the more bearish the sovereign debt markets react, the closer the world may be to a real fix to the crisis. If there is no fix, the Eurozone is likely to break apart leading to a depression in Europe and a recession around the world. The outcome is unnecessary because European solvency is collectively fine. German economists and the ECB will need to shift gears from a focus on price stability to a focus on ending the financial crisis and saving the Eurozone. The world is watching and waiting.