What are the alternatives to austerity for the Eurozone?

by on May 3, 2012 at 2:26 am in Economics, Political Science | Permalink

Paul Krugman’s post on the topic was revealing, compared especially to the analytic and rhetorical flourish which he applies to criticizing austerity.  You can’t fault his IQ or his knowledge of the situation, there simply isn’t much convincing to put forward.  Here is Ryan Avent, in a good post but I think it also fails to put forward a workable solution:

What, then, are the alternatives to austerity? Well, first up would be an integration that would help break the diabolical loop now gutting the periphery. Creating a euro-zone-wide safe asset and a euro-zone-wide set of institutions to stand behind damaged banks would help accomplish that. America doesn’t expect Delaware to shoulder the costs of failures of banks headquartered in Delaware. That’s an important contributor to the stability of the American federal system. The euro-zone must recognise that it is the failure to build appropriate euro-zone-wide institutions—equal in scope to the considerations and resources of the central bank—that is contributing to soaring yields around the periphery and creating the illusion of the need for dramatic austerity in places that could do without it.

I call this the “Germany pays for everything and accepts all the risk of moral hazard” approach.  Potential German liabilities could run in the trillions of euros and the “ball and chain” lasts forever.  I know all about Connecticut and Mississippi, but without a common electorate, not to mention a common national identity, I don’t see how this is possible.  Keep in mind that Eurozone-wide deposit insurance in essence serves as an implicit guarantee to the parent national governments as well, for Modigliani-Miller-like reasons.

It is like doing African development policy by suggesting that America send one-third of its gross national product to Mozambique.  Maybe it is moral to do so (though I doubt that), but in any case it is not really a policy proposal.  Lack of a common identity is a constraint, not a policy choice, except at fairly small margins or at moments of extraordinary cultural transformation (hint: this is not one of them , especially when there are seventeen nations involved).

Just to (imperfectly) integrate the relatively small unit of East Germany cost West Germany almost $2 trillion dollars.

By the way, will the periphery nations give much (any?) control over their finances to Germany?  Clearly not, and thus we are back to the idea being dead as a doornail.

There is no common fiscal policy without a common electorate, not for long at least.

Ryan Avent also supports looser monetary policy for the eurozone, as do I.  It’s worth trying.  But keep in mind, the further along is a financial crisis, the more emergency monetary policy takes on a more purely redistributive element.  You end up having to stick the money somewhere quite specific and forget about ever getting it back.  Nominal reflation helps with some problems when done well in advance of crunch time, but right now it is a question of solvency for many of the parties involved.  It’s already ineffective for the ECB to be doing three-year loans to rotten banks at one percent, against very low value collateral, how much more of a boost are we to expect?

Just how much monetary policy needs to be done?  At this point, we’re not talking about a move from price stability to say four percent eurozone inflation (which I would nonetheless favor, and favored all the more a year or two ago), rather much more would be required.  We’re running up against the same constraints which prevent the de facto Eurobonds from taking off.  Revisit the well-known point that in a financial crisis fiscal and monetary policy blur together, and we return to the notion that solutions are based on massive cross-border redistribution.  On top of all that, arguably the deflationary pressures in Greece, and possibly Spain, are already past the point of control from the ECB side, given the ongoing collapse in private lending.

Here is my earlier post, Austerity as a substitute for trust.  Kevin Drum adds related comment.

Adrian Ratnapala May 3, 2012 at 3:15 am


I call this the “Germany pays for everything and accepts all the risk of moral hazard” approach. Potential German liabilities could run in the trillions of euros and the “ball and chain” lasts forever. I know all about Connecticut and Mississippi, but without a common electorate, not to mention a common national identity, I don’t see how this is possible.

I have a question about economic history. What were the financial conditions leading to the ratification of the US constitution? I know in some vague sense that it involved consolidating national debt. But what does that really mean? Did it involve the US agreeing to pay the debts of particular states? (I thought that even today, the US does not do this.) Did the early US do anything resembling deposit insurance or bank-bailouts? Was it expected that the US would be able to print enough money to cause inflation? Or did the gold standard prevent that?

My suspicion here is that if voters in rich states had a crystal ball to tell them about the financial institutions that would later evolve, they might never have agreed to federate – or else they would have written much stronger no-bailout, no-transfer terms explicitly into the constitution. Even without a crystal ball, there was serious resistance. Today, Germans are being asked to jump directly into that later stage with eyes open; they don’t need a crystal ball to know that they don’t like it.

Doc Merlin May 3, 2012 at 3:20 am

Europe is not democratic (it merely has the veneer of democracy)… thus its quite possible, if the political elites will it.

The Germans also rejected the Lisbon treaty (in a referendum non-the-less), but somehow it still became german law.

Adrian Ratnapala May 3, 2012 at 3:33 am

“Europe is not democratic” might be taking it a bit fair, but yes, I am fairly sure that the German (and Dutch etc.) taxpayers will get screwed on this one. “EU leaders bumbling through”, basically amounts to dodging and darting to find a way to make these voters pay without them noticing until it is too late.

BTW: I don’t think Germany had a referendum on it. They seem to think that referenda are a Hitler thing.

david May 3, 2012 at 3:42 am

Hamilton pushed for central taxation power, which permitted the US and state governments to raise the debts required to fund the revolution. Prices of debt changed to reflect this – suddenly it became a lot cheaper for the states to raise debts. Implicitly they were being underwritten. There was never any explicit statement as such, but the change in bond prices suggests that understanding.

However, after the revolution, Georgia tried to default on obligations. SCOTUS stopped it (Chisholm v. Georgia), as bondholders presumably expected. The governments pushed back using the 11th Amendment, which prevented the states from being obliged by the federal government to repay debts, and nobody can force the federal government to do so, of course. Effectively the states gave themselves the option to default on bondholders after-the-fact and the federal government likewise cheerfully gave up the previously-implied guarantee of the state debt. Very convenient for the young nation – states borrow for the federal cause (war of revolution) under implied federal guarantee, then the states default but the federal government keeps its own borrowing ability unaffected. It’s a trick you can only pull once, though.

The comparison to the EU is actually remarkably salient, given that there seems to have been a presumption amongst bondholders that the EU was implicitly guaranteeing member debt – that’s why yields were moving together. That the EU explicitly disavowed any desire to do so seems to have not mattered.

Adrian Ratnapala May 3, 2012 at 3:55 am

The comparison to the EU is actually remarkably salient, given that there seems to have been a presumption amongst bondholders that the EU was implicitly guaranteeing member debt – that’s why yields were moving together. That the EU explicitly disavowed any desire to do so seems to have not mattered.

I was thinking the same thing, but perhaps with a twist. In Europe, whatever bond prices did, voters initially believed in the no-bailout guarantee. If they knew anything about bond prices at all, they might have just thought the “magical Europe fairly” will take care of things.

I wouldn’t be surprised if something similar was true for the US. So although the “change in bond prices suggests that understanding” it is possible, even likely, that that understanding didn’t permeate into political decision making. Essentially, residents of some states (New York>) got diddled, and the debate defaults vs. federal guarantees is all about whether it is the bankers or the taxpayers who bare the brunt. Very much like Europe.

david May 3, 2012 at 4:09 am

By the 1837 panic the federal government told the states to go burn when the states wanted a bailout for their own non-federal-cause debts in the face of a financial crisis. So there you go.

(Its doing so caused a massive monetary contraction, not neutralized (gold standard!) that caused record unemployment, etc. etc.)

mark May 3, 2012 at 12:34 pm

I think it’s less salient. The difference is the US federal government had a giant undeveloped asset to its west. So it could grow its way out of the debt. The Eurozone doesn’t have any such asset outside of its member states. I mean, they could invade Russia or something like that but otherwise, they can’t grow out of their debt either.

msgkings May 3, 2012 at 12:44 pm

Also, for all their differences, the colonies shared a heck of a lot more culturally than the EU member states.

david May 3, 2012 at 12:51 pm

At the end of revolution the “giant undeveloped asset” was still British or Spanish. The US had to fight another two wars to take it from them.

And, just to nitpick, the colonies had this major dispute amongst themselves that they, too, had to fight a massive total war to settle, as you may recall…?

iya May 4, 2012 at 11:26 am

Exactly. How many nations were build without war? Even the USA needed it and Europe has seen its fair share.
I’m glad that no politician is currently willing to “play the role of visionary leader who brings the utopia to fruition.”
Taking a step back to what worked for 50 years, is much less risky and thus more sensible.

Yancey Ward May 3, 2012 at 12:02 pm

I think you are right about that crystal ball. One of the more amusing things I hear out of US liberals from blue states is their great resentment at the net federal transfers from Connecticut (my home state) to Mississippi despite their assertions about the duty to help out the poor.

msgkings May 3, 2012 at 12:46 pm

To be fair, that meme crops up when politicians and others from those redder than red states that get the federal transfers start railing against the federal government.

Nyongesa May 4, 2012 at 1:17 am

Exactly, farm, defense and other government welfare programs are the primary irritant.

TallDave May 5, 2012 at 12:36 am

That seems to be largely a function of the fact retirees tend to move to lower COL rural areas, i.e. red states, and it’s not really that consistent — Texas, by far the largest red state, is a net payer, in some years so much so it cancels out all the rest.

Of course, the transfer from wealthier red voters to poorer blue is much larger anyway.

Very Serious Sam May 3, 2012 at 3:58 am

“Creating a euro-zone-wide safe asset and a euro-zone-wide set of institutions to stand behind damaged banks would help accomplish that” …the spiral into the abyss can continue. When will you understand that damaged banks must be dismantled as soon as possible? Not suppported with taxpayer’s money even further. So far, the Eurozone countries injected close to two trillion Euro into the finance industry to keep even zombie banks afloat.

This a) achieved nothing sustainable on the receiving end, because the profits were immediately privatised, the risks transfered to ECB et al and b) inflated the debts of the nations, which pose by now -of course- an even higher risk. How comes that pundits don’t understand that you can’t end the series of crisis with more and more and more borrowed money?

And yes, with this proposal, Ryan Avent made just another one in his long list of “Germany pays for everything and accepts all the risk of moral hazard” approaches. And he is not alone, almost all proposals by almost all economists and other pundits push in this direction.

CMK May 3, 2012 at 3:58 am

Common European identity that makes open ended inter-country fiscal transfers politically possible is the sticking point in the whole saga. Economists are doing a valiant job trying to engineer a solution, but the discipline best positioned to save the Euro is Social Psychology.

P.S: When I link this article on Facebook, the thumbnail that appears is of Hitler and other Nazi staff; it’s a little disconcerting

J May 3, 2012 at 5:44 am

but the discipline best positioned to save the Euro is Social Psychology.

LOL. When have social psychologists ever saved anything?

Richard Fazzone May 3, 2012 at 6:01 am

“There is no common fiscal policy without a common electorate, not for long at least.”

There is no common fiscal policy with a common electorate, not so far at least in 21st Century America.

Curt Doolittle May 4, 2012 at 2:55 am

i’m not sure that any measure available to us suggests that we have a common electorate. Just the opposite.

Paul Seabright May 3, 2012 at 6:12 am

Tyler, I really don’t understand how you can call this a ““Germany pays for everything and accepts all the risk of moral hazard”” view. If 50% youth unemployment among Spaniards is not “sharing in the payment” I don’t know what is. Citizens of Spain, Greece, Portugal and Ireland are already paying a lot – far more than the citizens of Germany. Likewise, the moral hazard that caused the crisis was a moral hazard of reckless lenders as well as foolish borrowers (mainly in the private sector for Spain and Ireland, mainly in the public sector for Greece). Yes, between 2000 and 2010 Greece was the world’s fourth largest arms importer (source: SIPRI), importing nearly twice as much as Israel over that period. But who sold the arms to Greece? Take a look at the destination of Germany’s arms over that period – and look at the way in which the exposure of German banks to Greek debt increased at the same time, even though the main ratings agencies had downgraded Greek debt as early as 2004. Do you think German politicians were trying soberly to restrain their banks from funding arms sales? The recklessness of Germany’s banks, aided at least passively by the complacency of Germany’s politicians, is part of what has created the fragility of the eurozone. And don’t get me started on French banks…

The current crisis is worsened, not helped, by German failure to see that moral hazard is a probem for lenders as well as borrowers, and the persistent desire among German politicians, as well as many journalistic commentators, to turn this into a morality tale of spendthrift southerners ripping off innocent northerners.

Substantial debt write-downs are inevitable – it would be much better if they came about through coordinated policy rather than through economic collapse. Everyone (Greeks, Germans, Spaniards…. citizens, bankers, politicians….) will find that easier if the narrative of the crisis can be turned into a narrative of shared responsibility rather than one-sided blame.

Uninformed Observer May 3, 2012 at 7:37 am

Moral hazard to lenders, you say? What moral hazard? Europe has committed the same error we did with Fannie Mae / Freddie Mac, in allowing (forcing?) lenders to make bad loans in pursuit of some policy goal, feigning astonishment when the loans fell through, then “bailing out” the lenders so they didn’t have to pay for their bad lending decisions. If lenders make loans (and price loans) with the understanding from the beginning that there will be no (easy) bailouts, credit will tighten, sure, but then we’ll avoid real moral hazard, allow for creative destruction, and keep credit open for those who can plausibly make good on their debts.

Too late now, of course. Now there’s nothing for it but austerity, or stimulus, and hope it all somehow works out in the end.

Geoff Olynyk May 3, 2012 at 10:01 am

Very good, well-thought-out post. I agree with you.

andy May 3, 2012 at 10:30 am

“If 50% youth unemployment among Spaniards is not “sharing in the payment” I don’t know what is.”

The unemployed are on the receiving side of the payments, aren’t they?

mark May 3, 2012 at 2:24 pm

Exactly. That assertion is passionate but confused. happen to agree with the final paragraph but the path to get there ought to be a rational one.

wiki May 3, 2012 at 1:25 pm

I don’t get the logic of the argument. Spanish unemployment is there whether or not the Germans bail them out. But in order to reduce unemployment and raise NGDP, Germany is being asked to foot the bill for benefits that will disproportionately go to countries they don’t think highly of. Unless you have a story where the Germans will benefit more by giving than doing nothing, Tyler’s claim is mostly correct.

Curt Doolittle May 4, 2012 at 3:03 am

Paul, thats an equivalency that isn’t born out. The behaviors of individuals within the cultures are different, and those behaviors have a cost to the individuals in them. The german education, work and discipline ethic makes them successful at producing goods and services. Money may equilibrate through lending as you suggest but costs do not. The PIIGS pay lower costs and have higher unemployment because they pay lower behavioral costs.

Jim May 3, 2012 at 8:30 am

“It is like doing African development policy by suggesting that America send one-third of its gross national product to Mozambique”.

No, it’s nothing like that. Mozambique isn’t in trouble because of over-zealous lending by the US. Mozambique’s economic troubles are not a threat to the US economy.

Such hysteria is not conducive to a rational debate. Your mood affiliation is showing.

Cliff May 3, 2012 at 1:16 pm

It is in the sense that it’s a political non-starter

Woj May 3, 2012 at 9:31 am

“Just how much monetary policy needs to be done? At this point, we’re not talking about a move from price stability to say four percent eurozone inflation (which I would nonetheless favor, and favored all the more a year or two ago), rather much more would be required.”

At the recent INET conference, I believe it was Paul Martin (former Prime Minister of Canada) who said that policy measures must be implemented the first time with enough backing to meet goals otherwise the ability to gain support for future rounds becomes increasingly difficult. Both in the US and Europe, central banks have already greatly expanded balance sheets in several rounds. My concern with attempting to promote high enough inflation through monetary policy is that both central bank balance sheets could require expansion to or above 100% of GDP. If a willingness to go that far is not credible (likely politically), then further attempts may actually increase risks with very little reward. This seems especially true in Europe, where if countries ultimately leave the Euro, the ECB may end up with sizable losses that are not backed by any central Treasury (but could fall largely on Germany).

Anon. May 3, 2012 at 9:59 am

I don’t see how anyone can blame the lenders when Greece was lying so thoroughly about its statistics. Is it even possible to do due diligence on a sovereign when even the sovereign itself is not aware of its finances?

clayton May 3, 2012 at 12:08 pm

Should have asked for collateral

Ano May 3, 2012 at 10:43 am

Another possible long-term solution to keep the Euro together: a permanently higher inflation target (to allow rapid unwinding of wage imbalances), plus massive “pre-austerity” for countries experiencing Spain- or Ireland-like expansions.

Spain was indeed running a surplus on the eve of the collapse (as Krugman constantly points out), but they would have avoided the crisis if they had run a much bigger one.

So: a 5% inflation target and the likes of Spain in 2007 running a 7% of GDP surplus.

Woj May 3, 2012 at 12:10 pm

If Spain had been running a larger surplus, with their current account deficit, the private sector would have been forced to go even more massively into debt. As a recent post on the New York Fed blog pointed out, much of the private foreign borrowing went to support investment in nontradable sectors, specifically housing. This dynamic could not last and is a far bigger problem for Spain than sovereign debt. I discussed this issue a bit more here: http://bubblesandbusts.blogspot.com/2012/05/private-debt-continues-to-drag-down.html

mark May 3, 2012 at 2:27 pm

That is a good link:

“Foreign borrowing to finance productive investment projects raises national income and should result in a surplus over debt service costs. Foreign borrowing undertaken because of lower levels of saving, in contrast, supports current consumption while building up a debt burden on future income. The composition of investment can also matter. For example, foreign borrowing to support investment in nontradable sectors such as housing generates no foreign income stream to support repayment.”

Spot on. No one, no organization, no nation, no continent, can borrow to fund consumption on a persistent basis.

TallDave May 5, 2012 at 12:40 am

Good points, but why would you assume the current account deficit would stay the same?

It’s an odd trend lately — people act as though deficit spending is a response to trade conditions, rather than a decision that affects them.

theakinet May 3, 2012 at 12:28 pm

“but without a common electorate, not to mention a common national identity”

[comment about tyler’s support for mass immigration into america, and how that would mean it would be harder to get things done, but tyler doesn’t care because his desire for cheap (and tasty!) chulupas is more important than everyone else’s desire to live in a non-balkanized nation-state]

@theakinet

CC May 3, 2012 at 1:33 pm

“Germany pays for everything and accepts all the risk of moral hazard” approach. Potential German liabilities could run in the trillions of euros and the “ball and chain” lasts forever.

With all due respect to the germans, THAT IS THE COST OF A CURRENCY UNION.

They want to have their cake and eat it too, but it’s just not possible.

Danton May 3, 2012 at 5:21 pm

They didnt want it anyway. They were quite happy with the D-Mark.

TallDave May 5, 2012 at 12:13 am

Currency union as suicide pact?

The Germans feel the cost of a currency pact is that Greece gets its house in order.

And that’s why this currency union may not last much longer.

Manoel Galdino May 5, 2012 at 11:18 am

+1 to CC.

Allen May 3, 2012 at 2:14 pm

Greece should pay their creditors in some sort of scrip psuedo-currency, and then require that at least 20% of all taxes owed be paid with that scrip. Once collected, the scrip is destroyed and that part of the debt is officially retired.

Problem solved.

Jens Fiederer May 4, 2012 at 1:36 pm

With “Germany pays for everything and accepts all the risk of moral hazard”, what happens after the German money runs out? Or is this not considered a finite resource?

TallDave May 5, 2012 at 12:11 am

The ECB prints more.

You can have solvency, or moneyprinting/devaluation.

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