The eurozone, as designed, has failed. It was based on a set of principles that have proved unworkable at the first contact with a financial and fiscal crisis. It has only two options: to go forwards towards a closer union or backwards towards at least partial dissolution. This is what is at stake.
Countries in external deficit receive private financing from abroad. If such financing dries up, economic activity shrinks.
Unemployment then drives down wages and prices, causing an “internal devaluation”.
In the long run, this should deliver financeable balances in the external payments and fiscal accounts, though only after many years of pain.
When the crisis comes, liquidity-starved banking sectors start to collapse. Credit-constrained governments can do little, or nothing, to prevent that from happening. This, then, is a gold standard on financial sector steroids.
The role of banks is central. Almost all of the money in a contemporary economy consists of the liabilities of financial institutions. In the eurozone, for example, currency in circulation is just 9 per cent of broad money (M3). If this is a true currency union, a deposit in any eurozone bank must be the equivalent of a deposit in any other bank.
But what happens if the banks in a given country are on the verge of collapse? The answer is that this presumption of equal value no longer holds.
A euro in a Greek bank is today no longer the same as a euro in a German bank.
The latter has acted as lender of last resort to troubled banks. But, because these banks belonged to countries with external deficits, the ESCB has been indirectly financing those deficits, too. Moreover, because national central banks have lent against discounted public debt, they have been financing their governments.
Huge asset and liability positions have now emerged among the national central banks, with the Bundesbank the dominant creditor
Government insolvencies would now also threaten the solvency of debtor country central banks. This would then impose large losses on creditor country central banks, which national taxpayers would have to make good.
This would be a fiscal transfer by the back door.
First, this backdoor way of financing debtor countries cannot continue for very long. By shifting so much of the eurozone’s money creation towards indirect finance of deficit countries, the system has had to withdraw credit from commercial banks in creditor countries.
Governments would surely have to freeze bank accounts and redenominate debt in a new currency.
A run from the public and private debts of every other fragile country would ensue. That would drive these countries towards a similar catastrophe. The eurozone would then unravel. The alternative would be a politically explosive operation to recycle fleeing outflows via public sector inflows.
First, banking systems cannot be allowed to remain national. Banks must be backed by a common treasury or by the treasury of unimpeachably solvent member states.
Second, cross-border crisis finance must be shifted from the ESCB to a sufficiently large public fund. Third, if the perils of sovereign defaults are to be avoided, as the ECB insists, finance of weak countries must be taken out of the market for years, perhaps even a decade.
The eurozone confronts a choice between two intolerable options: either default and partial dissolution or open-ended official support. The existence of this choice proves that an enduring union will at the very least need deeper financial integration and greater fiscal support than was originally envisaged. How will the politics of these choices now play out? I truly have no idea. I wonder whether anybody does.
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