October 20, 2011

Can the Euro Crisis Be Solved? Not in Greece

After the American Century

The Euro Crisis has not gone away. Several times there have been meetings and pledges of more money. The Greek Governemtn keeps making cutbacks, and the Greeks themselves keep protesting. The EU keeps up the pressure with one hand and gives the Greeks money with the other. Nothing seems to change for the better, and the financial fallout continues.
Who would have thought that all European consumers would be nervous because the Greeks profligately overspent? Why should this matter to other countries? Because the banks are all inter-related, and in Greece they are over-exposed. What is now possible is a kind of gigantic domino effect, in which the fall of Greece will topple some banks abroad, which will in turn have a knock on effect right across Europe and across the globe. 

Once upon a time the world was less connected, and some countries made a regular practice of overspending and then devaluting their currency. Take Mexico as an example. Starting in the 1950s for two decades the exchange rate was 12.5 pesos to one American dollar. But in 1976 this rate became impossible to maintain, and Mexico lowered the value of its currency to 20.4 pesos to the dollar. By June, 1982 the rate was 25 to the dollar, but things rapidly got much worse reaching 150 to the dollar by the end of the year. This was a serious crisis for Mexico. It got worse in the following decade, but it did not drag other larger economies to ruin.

By comparison, Greece has a smaller economy than Mexico, but it is much more tied into the economies of its neighbors. Mexico's peso fell pretty much on its own, but Greece has the same currency as much of Europe. 

So how bad is it in Greece? Worse than it was a year ago. The yearly deficit is getting bigger, not smaller, despite passage of austerity measures. It reached 19.2 billion euroes ($26.1 billion) for the first three quarters of 2011 compared to 16.65 billion euros for the same period last year. That is considerably worse than the EU Commission predicted in 2009, as can be seen in the chart above. The EU thought the deficit would be "only" about 12.3 billion for all of this year, but it looks to be about twice that once we have all four quarters. The cumulative deficit is growing even faster than the annual deficit, because it includes interest payments. The Greek rat hole is getting much larger, not smaller, as the size of the debt is exploding. Worse still, the cutbacks now being feverishly passed in Greece will reduce economic activity, in turn reducing revenues from taxation. It is a vicious circle, and nothing suggests that the Greeks are going to be able to avoid catastrophe. 

It may be time to give up on saving them and instead bail out the banks outside Greece, so that the European economy can continue to function. The banks should not be allowed to make a profit on their incompetence, of course, but it looks as though we must save them from ruin. I suggest this not for any love of banks, but because it seems the only plausible course of action to protect the rest of the EU. 

I said the European banks have been irresponsible. How so? Consider a chart from the Financial Times.

Far more than any other EU nation Greece has relied on foreign banks to buy its debt. This was smart of Greece, perhaps, but just plain stupid on the part of the banks. I would suggest an EU regulation that created a sliding scale for the amount of debt any member country could sell to outsiders. In other words, the worse the deficit, the less debt could be externally financed. A nation with almost no deficit would be able to borrow more and far more easily. Frugal virtue would be rewarded, profligacy punished, and punished much sooner than has happened in the present crisis.

Going off the cliff with Greece could ruin the EU economy for some years, and the Europe that might emerge after such a collapse will have fallen well behind Asia and the United States. Decoupling the banks from Greece will not be pretty, and the Euro will fall, but it will fall less and fall for a shorter time.In such a scenario, any Christmas bonuses for bankers would be obscene.