Two things happened this week that I have not mentioned. First, and at the same time as the Greek rescue package maturity extension, Ireland was “rescued” by the IMF and the EU. Secondly, the ECB took some decisions that seem to have calmed the markets. On the one hand, it decided to prolong its sovereign bond purchase operations, known as the Securities Market Programme (SMP), which is good because it helps stabilise the value of sovereign bonds, at a time when stabilizing is needed. On the other hand it announced that it will continue to provide the banking sector with liquidity through a fresh set of longer-term refinancing operations (LTROs). These will “be allotted on 26 January, 23 February and 30 March 2011 as fixed rate tender procedures with full allotment. The rates in these three-month operations will be fixed at the average rate of the MROs over the life of the respective LTRO”. (To learn more about the instruments used by the ECB click here). This came as good news to the markets who were uncertain about the longevity of the SMP expected the last LTRO to mature at the end of this month (three months after the last operation was conducted on 29 September 2010). I’m not quite sure, but it’s possible that the recent market turmoil and the resulting aforementioned Irish rescue package was also caused by this uncertainty regarding the upcoming choices of the ECB.
Aside from this nothing new has happened, which has allowed commentators and politicians to take stock and write a bit about the longer term view of what our options are in terms of dealing with the ongoing “Euro crisis”. The discussions seem to be concentrating on: (1) the different scenarios for leaving the Euro and the costs and benefits associated with it (here, here and here) and (2) the painful and increasingly inevitable need for fiscal union between Euro-zone member states (here, here and here).
The cost of a Euro breakup
The point of (1) is to observe that the euro arrangement, may be proving to be a painful experience, in its present form. However, the alternative (leaving the Eurozone) would be much more painful, for the fiscally stable (ie Germany, Austria, the Netherlands, etc) and for the fiscally troubled (Greece, Ireland, Portugal and potentially even Italy or Belgium). Although the articles look at the hypothetical situation as two separate scenarios I think it is better to consider both scenarios as one. For the fiscally stable, leaving the euro would allow them to set interest rates more optimally to their economic situation. However, it would create a flood of money from the fiscally unstable, which would probably require nominal interest rates to be set at a particularly high level to combat the ensuing inflation. At the same time, as the fiscally unstable countries would devalue their currencies. This would make their exports more competitive, but it would also impose the above mentioned capital flight. The ensuing result would be a loss for everyone. The articles then posit the fact that capital controls would obviously be needed in order to stop the above capital flight from fiscally troubled countries. This is obviously no solution as this capital flight would surely result in the freezing of trade from and to either of those countries. The conclusion of the articles is thus that leaving the Euro is not a good idea. They warn however that that never stopped anyone from making the wrong decisions.
Fiscal Federalism and Eurobonds
The point of (2) is very elegantly (in my humble opinion) made by the FT’s Munchau. Unholy trinities being a fashionable description since Mundell and Flemming seminal paper, Munchau argues that the EU created the Euro in one impossible trilemma (no default, no exit, no bail-out ) and has reformed to work in yet another one(default risk, internal imbalances and fiscal independence). To get out of the inevitable ensuing mess that commentator argues that the only solution is to create some form of fiscal union, given that nothing seems to stop the internal imbalances and the risk of default from wrecking havoc in the currency union . The latest move (for previous ones read here and here) in this direction was the one made by Juncker and Tremonti in their call for the issuance of Eurobonds. German officials are as it is usual in denial, yet they offer no alternatives.
Finally I have to admit that I very much like this other article by Munchau where he discusses how amazingly overwhelmed by the economic realities, EU leaders are.
By the way, and not to honk my own horn too much, I told you so!