It is clear that the current path in euroland is unsustainable. Almost anyone (but the Germans and the 'Austrians' (the latter refers to those of the Austrian economics school) can see that the only credible balance sheet is that of the European Central Bank.
They should come to the rescue. But wait, they already have.
This is until the end of last week, so we're approaching 200 billion euros of bond purchases pretty fast.
Yet this manifestly hasn't worked. Why not? Well, here's Paul de Grauwe:
Imagine an army going to war. It has overwhelming firepower. The generals, however, announce that they actually hate the whole thing and that they will limit the shooting as much as possible. Some of the generals are so upset by the prospect of going to war that they resign from the army. The remaining generals then tell the enemy that the shooting will only be temporary, and that the army will go home as soon as possible. What is the likely outcome of this war? You guessed it. Utter defeat by the enemy.
Less is More
Could the ECB go all in? Yes, for sure. If the ECB would announce unlimited bond buying tomorrow, the crisis would end. This, after all, is what the Swiss central bank recently did to stem the rise of the Swiss franc, and that has been a rousing success.
The funny thing is, in all likelihood, they wouldn't have to buy nearly as much bonds as they're actually buying these days -- the announcement itself would be enough. Sometimes less is more.
Why is the ECB so stubbornly persisting with these silent interventions that making more, not less interventions necessary?
- To keep maximum pressure on Italy to reform.
- An ideological attachment to the hard money doctrine as embedded in the ECB's mandate (with price stability as its only objective).
If Italy manages to get its act together and implement a meaningful budget cutting and structural reform program that increases growth, the ECB might still play ball, but in the high stake poker game they don't want to be the first to blink.
However, even if that happens, there is an other, even more fundamental problem. According to an unpublished IFO study:
According to the study, prices of goods produced in Greece went up by an average of 67 percent between 1995 and 2008, a record increase for the euro zone. The average price of domestically produced goods went up by 56 percent in Spain, 47 percent in Portugal and 41 percent in Italy. By contrast, prices went up in Germany by only 9 percent in the same period.
So these countries have become rather uncompetitive, resulting in:
Taken together, the four most troubled nations (Italy, Spain, Portugal and Greece) have a combined current account deficit of $183 billion. Most of this deficit is accounted for by the public sector deficits of these countries, since their private sectors are now roughly in financial balance. Offsetting these deficits, Germany has a current account surplus of $182 billion, or about 5 per cent of its GDP. [FTalphaville]
The thesis of that article is that the euro crisis is at heart a balance of payments crisis. Without currencies to adjust, this is quite difficult to solve. The present solution is called euphemistically "internal devaluation." This means getting wages and prices in line by means of smashing austerity programs and wage cuts.
Having one's own currency has its advantages. Not only is there a lender of last resort for the government bonds, its far easier to change one price (the exchange rate) than having to change all (or at least most) wages and prices in order to restore competitiveness.
Internal devaluation isn't completely impossible, but it's very costly. Here is Samuel Brittan to explain:
A domestic reduction of costs and prices by a country in difficulties is in principle possible. In Ireland, unit labour costs in manufacturing have fallen a good 30 per cent since 2006: it has experienced an internal devaluation. But Ireland is not Greece. Nor is it Portugal or Italy. And Ireland’s transformation has been achieved at enormous cost. In the past few years its economy has contracted by some 12 per cent. Unemployment has soared to nearly 15 per cent. And the return flow of Irish workers to the homeland which characterised the boom years has given way to the net emigration reminiscent of earlier, sadder years.
Which is why, apparently, Germany and France are considering a smaller euro area. Less is more, once again.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.