Who killed the euro zone?
THERE are many facets to the crisis in the euro zone, but at heart the problem is fairly straightforward. The euro zone developed a balance-of-payments problem; some of the countries in the single currency accumulated large external debts. To service those debts, the deficit countries need to become surplus countries, which is difficult to do without the flexibility of a floating currency. The difficulty of adjustment has led markets to doubt the solvency of some institutions, and these doubts have, in the absence of a lender-of-last-resort, metastasised into a contagion that threatens to leave banks and sovereigns bankrupt.
When you frame the crisis like that, it begins to look inevitable, and perhaps it was. It is worth pointing out, however, that perceptions of solvency are very much state-contingent. It was never a given that a country like Italy would flip from one equilibrium to another. Prior to the crisis, Italy's government was running a primary surplus and bringing down its debt-to-GDP ratio. So long as markets were prepared to finance Italy's old debt at low rates, it was in good shape. Now, of course, markets aren't prepared to do that. One interesting question is why.
One possible reason is simple contagion. The euro zone failed to contain market worries as they spread from Greece to Portugal and Ireland. Cautious investors began to shed exposure to banks and sovereigns that might potentially be affected, contributing to rising yields in places like Italy. That, in turn, worsened the outlook for Italian solvency and contributed to a feedback loop of doom. Others argue, however, that the market's souring take on Italy was attributable to doubts about the country's growth outlook. That's certainly possible, though it's difficult to prove. After all, Italy's economy has been dreadful for years. In the first 5 years of the 2000s, real Italian growth was scarcely positive and the economy ran a persistent current account deficit. It nonetheless managed to reduce its debt load, and markets were happy to fund it cheaply. Maybe markets were overoptimistic then and are now readjusting their outlook. The timing of that reevaluation nonetheless looks suspiciously like what one would expect given a contagion-driven increase in yields.
There's another way to look at the situation, however—one which partially reconciles the two views above. Solvency is state-contingent and depends in no small part on expected growth. And over the past year, euro-zone economic officials have worked together to move growth expectations sharply downward. Governments around the single currency area have pursued a substantial, coordinated fiscal tightening; the opposite of what governments attempted to draw up in 2008 and 2009. Perhaps more importantly, the European Central Bank—the one truly powerful, supra-national economic institution in the European Union—has coordinated a sharp decline in expectations for nominal growth.
The ECB raised its benchmark interest rate in April of this year. It raised that rate yet again in July. Each move was just 25 basis points, but the signaling power of those moves was significant: the ECB, markets were informed, would not let dormant core inflation, a fragile economy, high unemployment, and an intensifying financial crisis stand in the way of its commitment to low headline inflation. As Paul Krugman and David Beckworth point out, the market impact of the ECB's actions was dramatic. Inflation expectations tumbled. Nominal output across most of the euro zone switched from expansion to contraction. And as the OECD pointed out today, euro economies are now in recession.
The ECB successfully engineered a collapse in demand (not without assistance from governments, of course). It would be shocking if this didn't feed into a move from a solvency to an insolvency equilibrium in economies relatively close to the threshold.
Now, if the ECB were hellbent on deflating the euro zone economy in order to tamp down prices, then it at least ought to have had the good sense to prevent its actions from being the factor that moved critical euro-zone economies from a good to a bad debt equilibrium. It should have recognised the risk of contagion and acted from the beginning to prevent any rise in bond yields outside of a firewall erected around Greece, Portugal, and Ireland. Instead, the ECB seemed to decide that it was not enough to focus on price stability to the exclusion of any and all other economic goals. Rather, it saw fit to use the rising yields generated by its heedless monetary policy to extract a pound of flesh from economies deemed to be poorly governed or insufficiently flexible.
The ECB, perhaps worried that it may find itself standing over the corpse of the euro zone with the bloody murder weapon still in hand, is now reversing course. In his first monetary policy action, new ECB President Mario Draghi announced a 25-basis-point reduction in the euro zone's benchmark interest rate. That rate remains higher now than it was at the beginning of the year, however. And the ECB's earlier actions may have so broken bond markets as to render the interest rate monetary policy transmission channel inoperative.
Maybe the single currency will survive. It will certainly be disastrous if it doesn't. But if the ECB manages to rescue the euro zone with a life-saving infusion of cash delivered via massive bond purchases, we shouldn't forget that it was the ECB that nearly killed it in the first place.
This diagnosis obviously lets individual governments off the hook to some extent. There is clearly some information contained in the fact that Italy now faces 10-year bond yields over 7% while the Netherlands does not. By the same token, there is clearly some information contained in the fact that Germany's 10-year bond yield is over 2.3% and rising while Britain's is below 2.3% and falling. Amid contagion, fiscal probity is no protection, and the indistinct line between solvency and insolvency vanishes altogether.
Some might argue that responsibility for the crisis must nonetheless sit with the debtors. The Italian economy is a mess, Tyler Cowen says, and though Italy could make a substantial dent in its debts through a large tax on wealth it opts not to. It is broken Italian governance that dooms the euro. Neither Germany or the ECB can be expected to save an Italian economy that won't take reasonable steps to meet its obligations. But as Mr Cowen is fond of saying in other contexts, the central bank moves last. If the ECB is willing to permit contagion, then no Italian action is a sufficient defence. If the ECB is willing to engineer a recession to wring out inflation, then no Italian reform will generate strong growth.
No one disputes that Italians are responsible for the long-run potential of their economy and for their country's fiscal decisions. But the ECB alone regulates euro-zone demand. By engineering a contraction in demand to fight inflation, it likely coordinated a shift in market expectations concerning the solvency of several threshold economies. It's dangerous to walk alone at night in dodgy neighbourhoods, and it's dangerous to carry large debts within a system of fixed exchange rates. But just because a victim lived dangerously doesn't exonerate the fellow, or the central bank, that stuck in the knife.
http://www.economist.com/blogs/freeexch ... -crisis-21 
