We’re not in Kansas anymore

The Wizard of Oz is classic book remade into a classic movie. It is believed to be based on the US experience with the gold standard in the late 1890’s (and the political movement led by William Bryan, who was a candidate for President of the United States*). TH reckons we are in for a remake of the classic — recast as Europe under the euro. Instead of the yellow brick road representing the gold standard, it would represent the Euro. The Wizard would be the president of the ECB.

So why has the common currency, like the gold standard, proven so challenging?

In simple terms, it is the lack of a central fiscal agency. There is no European Treasury. Consequently, when a government is facing weak growth and a budgetary short-fall, they cannot rely on a transfer from the central government to smooth the adjustment process (as would be the case in a fiscal union (such as Australia, Canada, or the United States, to name just 3). Instead, European governments face the disciplining pressures of higher market interest rates and must rely on austerity and higher taxes, which tends to weaken growth in the short term. What’s more, unlike countries with their own currencies, a country in a currency union doesn’t experience the growth enhancing effects of a depreciation (like Australia did in the 1990’s). So, in the Euro area, countries like Italy face a tough time if it.

For this reason, TH doesn’t really think of the sovereign debt problems in Europe as one of solvency (e.g. Italy going bankrupt, unable to pay its debts) or liquidity (temporarily unable to rollover existing debts). TH thinks the problems are more to do with what is perceived as “fair” in an economic union such as Europe. For example, Italian taxpayers might legitimately ask why their government must pay higher interest rates than the Greek, Irish or Portuguese governments? Is that fair? If not, do they deserve a bailout if interest rates go above 7%? Indeed, in recent weeks the media has been full of talk that Italian politicians would approach the IMF for a program because its yields were hovering around 7%.

To see why concerns of fairness complicate matters, imagine that you were an investor and Italian bonds were yielding 6%. At 6%, the investor might start worrying that Italy would consider asking the IMF for a loan to ease the adjustment (after all it happened to Greece when yields reached 7%). This really complicates things because if the IMF made a loan to Italy, it would be a senior creditor and crowd out private investors. So as the perception that there could be an IMF loan increases, so does the yield on the Italian bond (as it becomes less desirable in the market). Perceptions such as the market belief that if interest rates go above 7% a country will get an IMF program can become focal points that drive the market to a self fulfilling outcome with higher interest costs for Italy as a result.

But this is not all of Europe’s problems. In case you haven’t noticed, the global financial crisis is evolving in slow motion in Europe. Whereas institutions in the US encourage firms to file for bankruptcy, restructure and lay-off workers quickly (US Chapter 11), European institutions don’t. Layoffs take time, firms fail slowly, households hang on to homes that they can’t afford. The analogy is to taking off a band aid. The US uses the one quick pull approach, Europe prefers to slowly pick.
The slow European approach may be kinder in the short run, but it tends to delay dealing with some of the underlying problems. You have probably figured out that TH worries that some of European lingering problems have wound up in European banks that tried to use the GFC to grow, and in so doing found themselves holding too many risky assets (its just a guess). So, TH reckons that some banks could fail going forward. The reassuring thing is that the authorities have (so far) been able to wind up one important bank (Dexia) without much in the way of market disruption. Hopefully they can do it again.

So Europe really has three problems. First, it is suffering classic gold standard disease. Second, it is suffering from financial instabilities that are peculiar to the political situation that Europe faces. Third, the stresses of the monetary union could possibly affect some of Europe’s banks. The question is what to do about these problems and can it be done soon enough.

* In 1896 William Bryan (three times candidate for President of the United States) delivered the following words at the Democratic National Convention: “Having behind us the producing masses of this nation and the world, supported by the commercial interests, the labouring interests, and the toilers everywhere, we will answer their [i.e. the bankers’] demand for a gold standard by saying to them: ‘You shall not press down upon the brow of labor this crown of thorns; you shall not crucify mankind upon a cross of gold.’” TH reckons he could be speaking today for the people of Greece, Portugal, Spain and Italy.

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