I’m currently in Vienna. I’ve spent a lot of time here enjoying cups of coffee in peaceful cafes, and I think I understand the success of the Austrian Economists better now; Vienna is a great place to think. Not everyone is in such a restful mood though. Yesterday evening I met a man who had just bought a gas-mask on the internet. He’d been watching the events in Greece and he thought they would spread to Austria. I’m not sure if he was planning to protect himself in a riot or join in. I gave him my opinion on the likely future of the EU and the euro.
The immediate problem for the EU is the three countries with the worst finances: Greece, Ireland and Portugal. In my opinion all three of these countries are as bankrupt as sovereign nations can be: they can’t possibly raise the taxes to service their debts. This view is hardly unique these days. Keynesian commentators have lamented the austerity measures put in place by the governments, which they fear will lead to a fall in aggregate demand and exacerbate recession. This is based on the idea that paying off debts (along with other forms of saving) doesn’t lead to an increase in investment spending. I could say a lot about this theory, but I won’t. Whether this Keynesian analysis is wrong isn’t important here since it’s unnecessary. The problem is much simpler: few investors will want to invest in these three countries right now. So if they were pay off some of their debts that will lead mainly to greater investment spending somewhere else in the eurozone.
The governments of these three countries should default as soon as possible, but politics and emotions prevent that. No national government wishes to be associated with default, each governing politician know it will likely lead to subsequent electoral defeat. It’s likely those politicians will feel like personal failures if default occurs. It will also lead to disrespect within the EU, which is concerning for established, older politicians who look towards the EU government to provide a lucrative job after leaving national politics. This leads to three strategies for managing the situation. The first is to try to negotiate lower interest payments on loans from the core eurozone countries. In my opinion it’s unlikely that France and Germany will agree to reduce interest rates on these loans far enough to make a difference. The second is to perform mini-defaults on small groups of creditors. Ireland has already done this on some of the bond-holders of nationalized Irish banks. The third strategy is to wait and hope another nation falls first. This is the main strategy.
The governments of Portugal and Ireland are waiting for Greece to default. If that happens then it will likely trigger the bankruptcy of several European banks*. This is the “Second Lehmann Brothers” the UK press have been discussing that could cause another financial crisis. I think such a crisis is likely to happen, but for political reasons more than economic ones. If one of the three countries I mention were to default then the ensuing crisis would give the others permission to do so. It would allow them to blame default on outside events. The politicians in the remaining two countries involved would then become heroes rather than villains. It’s quite likely that in this situation default could be popular since it could reduce taxes.
The cost of default is whatever conditions the core eurozone countries demand. If the first country to default is punished severely by the EU in the form of removed subsidies or exclusion from certain programs then that will make the others more cautious. On the other hand, if there is little punishment then the others will default quickly. The structure of the EU isn’t conducive to quick decision making, which makes it likely that there will be little punishment for defaulting states. This dynamic is also likely to affect whether countries choose to default or to leave the euro. The advantage of defaulting within the euro are obvious: it allows a country to stay within that currency bloc. The advantage of leaving though is that it allows the country to devalue. This would happen automatically during the flotation; were any of the Portugal, Ireland or Greece to float their own currency, it wouldn’t be worth much.
Such a flotation-and-devaluation is unlikely to make a country richer in the long run, but may well increase GDP and employment in the short-run. That could prevent further social unrest. If a state or two were to leave the euro that would cause political problems for the EU, but it would be a one-off problem for the ECB. The ECB would only have to deal with the transition with the countries involved. In our modern would where most money holdings are current account balances this would not be impossible. Changing the form of a current account balance would be quite technically simple (regardless of the legal and moral issues associated with a government doing that). Circulating paper euros and coins could remain euros but become a foreign currency on a specific changeover date. The government could arrange for future cash withdrawals from bank to be in the new currency from that changeover date. By passing laws for the banks to enact, a government could replace one currency with another even if large sections of the population were not too happy about that. However, I don’t think this is so likely to happen. It requires a level of organization that the government of Greece (and probably Portugal) would be stretched to reach. It also requires a willingness to ride rough-shod over the legal problems of converting all existing contracts in euros into another currency. Ireland, for example, may be able to organize a currency change-over in practice, but its high-court is likely to challenge the legality of some aspect of it.
The consequences of default are different. The EU project itself would be harmed much less by default than it would be by nations leaving the euro, but the ECB would be placed in a difficult situation. As things are the ECB acts like a central bank within a nation state. The only main difference is that the member states issue bonds themselves. Once a default occurs, all this changes. In a modern central banking system open market operations are used to change the interest rate and money supply, and these are performed by the buying and selling of government bonds. At present, the ECB can buy the government bonds of any member state. That will no longer be possible if a state were to default, as the possibility of that happening again would be clear and the ECB would be forced to be more careful. There are several new structures the EU and ECB could adopt. Most would increase the power of the EU and ECB.
I expect readers understand I’m not condoning any of the things that I’ve described here. I’m just giving my opinion on what the future is likely to hold. I doubt anyone will reintroduce a gold standard. It doesn’t seem likely even that central banking practices will improve. But, these events in Europe help the case for monetary reform in the long run.
* Some have said that the ECB itself may go bankrupt if Greece defaults. This is technically possible, but it it were to happen the core eurozone countries would certainly bail it out.