Europe Has Two Choices: Amputation or Gangrene

The recent volatility in the market has been linked with last Friday’s S&P downgrade, but the real epicenter is Europe.  The shock waves that commenced in Greece and then Portugal and Ireland have spread to Italy and Spain, and tremors are being felt in France as well.

Europe has two choices: amputation or gangrene.

The amputation option is to jettison the Euro project by lopping off the weak Med countries, and letting them respond to fiscal crisis in the old fashioned way, through a currency devaluation that would permit these countries to become more competitive, and which would reduce the real burden of their debts.

If Europe eschews amputation, its only real choice is to socialize the debt of the financial zombies on the continent’s southern periphery, and have the Germans and Dutch and French assume responsibility for paying the obligations assumed by the poorer, more spendthrift nations currently in financial distress.

This will not go down well with said Germans, Dutch, and French.  it is often said that such a path will require a fiscal union in Europe, but the details of such a union are crucial.  Fiscal union is not sufficient to ensure fiscal probity.  (Cf., States of America, United.)  Indeed, it is hard to see how any European legislative or executive body  that is remotely representative of the nations currently in the EU could avoid perpetuating transfers between the creditor nations and the debtor ones.  Which means that the Germans and Dutch and even the French are unlikely to sign on.

No, to avoid the moral hazards associated with socialization of debt, the government of the fiscal union would have to resemble the creditor committee of a bankrupt firm, imposing a stringent restructuring plan on the debtors, controlling their expenditures, and requiring them to surrender a substantial amount of autonomy.  But that would not be acceptable to sovereign debtor nations, and it is doubtful that any such creditor committee could enforce austerity, given the nationalist resistance any such attempt would spark.

So the Europeans are likely to try to muddle along, and socialize the debt on the sly via the ECB and the EFSF.  Which will be the worst alternative.  It will not address the moral hazard problem and the debtor nations are likely to scrape along, largely unreformed.  And it will be expensive.  As long as it is clear that the EU/ECB/EFSF will attempt to support the debt of bankrupt nations when their spreads spike, it will be vulnerable to periodic speculative attacks–and these attacks are expensive to fight off.  Very expensive.

The perverse incentives of such a policy, and the cost of implementing it, will doom Europe to a slow demise, as the financial gangrene spreads throughout the system, progressively threatening currently healthy (relatively speaking) nations.  Amputation would be the painful, gruesome, but superior alternative.  There is a chance of saving something that way.  Failing to choose that course threatens the entire body of nations.

But the Euros are so invested psychologically in the Euro, and so many of the elites have their interests tied up in the continuation of the Euro project, that they recoil from making the hard choice.  What’s more, politicians always prefer to let their successors clean up messes, and are therefore loath to admit failures on their watch.  There is also fear that amputation would be very costly to French, German and Dutch banks and insurers, as they would suffer losses on the bonds of the amputated members.

But as I said in March 2010, when the crisis first turned serious, it would be better to bail out the banks directly than bail them out indirectly by supporting the profligates.  That would be a one time expense and the damage would be contained, whereas the current MO will lead to a chronic drain of resources from north to south.  Defending against speculative attack for years will be expensive.  Moreover, the flight to quality and the improved fiscal prospects of Germany et al would lead to gains on the banks’ holdings of non-PIIGS debt that would offset some the losses on the latter.  But it is a cost that would be paid now, and the blame attached to the politicians currently in office–so it’s unlikely to happen.

The implications of this are rather grim.  It means that Europe will continue to be the source of economic tremors, whenever there is a run on the debt of any shaky country–or the countries that are supposedly propping up the shaky countries (France being a candidate).  And as we’ve seen in the last week, these tremors will be felt in the US–which is likely to generate more than its share of shocks in the coming years.

It also means that Europe is likely to die slowly, as the financial gangrene spreads progressively throughout the system.  This will be accompanied by slow growth, and social stresses as the promises of the welfare state become impossible of fulfillment not just in Greece or Portugal, but in France and Germany.  What is happening in London could be the  harbinger of things to come on the continent–and that is a much more combustible situation (literally so, if you recall the balieues in Paris, several years back).

Gangrene kills slowly, but it kills.  It is difficult to see how Europe can survive in the long run as currently constituted, with the rot progressively eating its way from country to country.  Amputation is a shattering experience, but it can be survived, and can increase the odds of long term survival.  But politicians typically choose to incur pain today even if it is beneficial in the long run.  Which means that Europe’s future is bleak indeed.