The Next Big Crisis

Even though the market meltdown in the aftermath of Lehman's collapse came after about a year of slow boiling in financial markets (beginning with BNP Paribas suspending redemptions on its subprime-invested hedge funds in 2007 and continuing with Bear Stearns's acquisition by JPMorgan and the government's placement of Fannie Mae and Freddie Mac into conservatorship), relatively few people expected the housing crisis to have as profound an effect on the global economy as it did.  But now, barely 4 years after Lehman, we're seeing the same kind of build-up coming in slow motion.  Except this time, the problem isn't just housing in the US and parts of Europe-- it's European sovereigns.

Now, there's a conventional story people (read: American conservatives, and, on some issues, the Germans) like to tell about why Europe's in trouble, and it's important to know that, for the most part, that story is BS.  It's not "massive welfare states" and "irresponsible government spending" that have Europe on the edge of collapse-- that's a major part of the story for Greece, but if that were the story, Spain and Ireland would be fine (they had little debt and budget surpluses in 2007), and Italy would be humming along (it's got a heavy debt burden, but the budget is more or less balanced).  The problem, really, is that the Eurozone is fundamentally a problem-- there's a massive mismatch between what the Germans want (low inflation) and what the peripheral countries need (monetary easing combined with fiscal stimulus).  To be able to pay off their debt loads, what the peripheral countries need is devaluation-- they need their wages and prices to fall relative to Germany and France's.  That would allow them to export more goods to the Germans, boost their employment, and begin to pay off their debts.  But the Germans won't play along.  While the press focuses on the subsidy the Euro provided to countries like Greece and Ireland (which borrowed at German rates until they didn't), there's a subsidy that Germany gets that is overlooked by the financial press.  A huge chunk of Germany's economic success has come from the strength of its export sector.  And that export sector has been fueled in large part by the fact that the Euro is (and has long been) valued lower than the Deutschemark would be were it still in existence.  That is, while German workers are substantially more productive than Greek or Italian workers on balance, their labor is valued in the same currency units, which allows Germany to export a ton of goods and keeps its economy buzzing along.  And the Germans won't readily accept higher inflation that would allow the peripheral countries to revalue because it would mean giving up some of their export advantages in the process.  And internal deflation by the peripheral economies without German inflation won't work either because that would boost the real value of those countries' debts and make repayment even harder than it already is.

So Europe is stuck between a rock and a hard place-- its solution so far has been to kick the can down the road, providing loan subsidies tied to austerity demands in hopes that somehow the Greek, Spanish, Irish, Italian and Portuguese economies will magically start growing and will allow them to start making progress on repaying their debts.  But that's a fool's hope.  It might happen someday, but for now, there's no light at the end of the tunnel-- it looks like Europe is looking at the comatose patient and hoping the feeding tube will be enough to pull him out of his coma.

What Europe actually needs is systemic rebalancing-- it needs substantiallly higher (maybe 4%) inflation in the core countries that will make it relatively less painful for the peripheral countries to devalue compared to the core.  It needs significant fiscal transfers from the core to the periphery to jump-start demand, and a Eurobond program that makes individual countries' obligations collective "European" obligations.  It also needs looser monetary policy from the ECB-- hyperinflation is bad and all, but worrying about it in the current climate is absurd-- it's like agonizing over heatstroke on the North Pole.  Collectively, those steps might make Europe less likely to blow up fast.  But even then, it would take quite a bit of luck to diffuse the ticking time bomb on the continent.

While Europe might spend the next few months kicking the can down the road, the reality is that the continent is under speculative attack.  And the attackers know that, economically, the rebalancing they're betting on needs to happen, so they'll press their advantage.  That means half-measures won't go far: there are two ways to halt a speculative attack-- by definitively resolving the problem, or by caving in.  In 1992, when the British pound's peg to the deutschemark was under speculative attack from George Soros and a bunch of other hedge fund giants, the attack ended when Britain had to abandon the peg and leave the exchange-rate mechanism (almost certainly for its own good).  In 2008, when the stocks of the stand-alone investment banks came under speculative attack after Lehman collapsed and Merrill Lynch was acquired by Bank of America, Morgan Stanley and Goldman halted the attack by becoming bank holding companies and getting permanent access to the Fed's discount window, instantly allaying concerns about their liquidity.  To resolve the issue in Europe, half-measures won't do: to avoid defaults and a rapid, disorderly blowup of the Eurozone,  similarly decisive steps are essential.  But right now, it doesn't look like we'll get them.