Towards an Imperfect Union

The Economist newspaper has come to the conclusion that European monetary union is in trouble; hoist on its own internal contradictions. They see the stark choices for Europe as either full on federalism with an accompanying loss of national sovereignty or dissolution of the euro, with attendant chaos. They then attempt to offer a third way that will not work because it fails to solve the key contradictions. This matters to America because chaos in Europe will deeply affect our economy and some of the lessons have direct applicability to our situation. From the leader:

One road leads to the full break-up of the euro, with all its economic and political repercussions. The other involves an unprecedented transfer of wealth across Europe’s borders and, in return, a corresponding surrender of sovereignty. Separate or superstate: those seem to be the alternatives now.

Why is this so? The currency union presupposes a single market; with one currency and goods and services flowing freely in response to the signals of the free market; just like in the United States. But this has not been achieved in Europe. Labor markets in Europe do not function like those in America. First, labor is not really free to flow across borders in Europe. Language creates barriers, as do habits of peoples used to living in their native land. More importantly, in many countries, and especially Greece, large sections of the economy are under state control. Employees are state workers, further restricting labor flows. Finally, national labor unions in Europe have lobbied national governments for restrictions on labor, in the way of required benefits, minimum wages and rules about firing employees and these rules differ significantly by nation.

Beyond the lack of an integrated labor market, some sovereign governments, by dint of their huge share of the economy, form a barrier to economic integration. The solution was supposed to be that member countries had limits on debt as a share of GDP. The Greeks cheated on this, but it was never realistic to believe that politicians could keep this promise over the objections of disgruntled electorates during a severe recession.

The Economist's proposal doesn't really address the core issues. It admits to a purely technocratic solution. They propose European central regulation of banking, to prevent banks from being pressured by national governments to by sovereign debt and to institute a European wide system of deposit insurance. Second, they argue for a limited effort to mutualise deb of all euro-zone economies above 60% of GDP. I don't really understand this latter plan, but I don't have to, because it won't be implemented. It is a sop to the reckless that the Germans will never accept, IMHO. They argue that this is not a step to full scale federalism. That's not the point anyway.

The move to European regulation of the banks is actually the move to federalism. As the banks are regulated by centrally, but lend locally, the local conditions will become the next target for central European regulators. If union demands make it unprofitable for banks to do any lending in Greece, for example; the logical next step is for central regulators to step in and change those conditions. Banking is so central to capitalism that central control leads inevitably to federalism. To the extent that countries continue on the path to socialism in Europe, their economies will be not be viable.

What would work? The only way that European monetary union would work would be to limit national sovereignty by preventing socialist and Peronist-style intervention in free markets. It is the size of the state sector, and uneven workplace flexibility, including restrictions on wages, that prevents a single market. Unless the EU is willing to guarantee a minimum level of market freedom, including a ban on state participation in the economy, then monetary union won't work.

For the U.S., I foresee a rocky road ahead, because European turmoil will affect our economy directly through the banking system and indirectly through trade. The U.S. already has a federalism with a largely flexible labor market, so most of the issues in the EU lack direct relevance to our situation. The biggest question is what happens if California or Illinois can't run their governments with the revenues they take in. Short of the employees taking serious pay cuts, I don't see any way out of the messes for those states. Greek state workers have already suffered this fate.

To paraphrase Abraham Lincoln, I believe this union cannot endure, permanently half socialist and half free.

In the Unlikely Event of a Water Landing

I work in IT management, and preparing for contingencies and product launch failures and delays is a prudent part of my daily routine. We always joke about the process, because unlike airlines, where water landings are very rare, apparently, disasters are more routine in IT. Which brings me to the euro. Here is a little tidbit that is an indicator of the euro's long term health.

At least one—the Central Bank of Ireland—is evaluating whether it needs to secure additional access to printing presses in case it has to churn out new bank notes to support a reborn national currency, according to people familiar with the matter.

So, in the unlikely event of a water landing. Just a friendly warning. I cashed out an international fund six weeks ago and put the funds in U.S. corporate bonds. The more I study the problem the more I am convinced that the euro can't survive. More than one prominent economist points to the huge productivity growth disparity between Germany and the rest of the euro zone, which is not compensated for by wage disparity, as the reason the euro can't survive. Alan Blinder has a very readable explanation here.

Bracing for Stormy Economic Weather - UPDATE

Update at bottom.

The leader in the most recent issue of the Economist questions Europe's collective will to defend the euro.  The result of failure would be catastrophic, in that august publication's opinion.  I am not so sure, but it would be bad in the short term.  They recommend a number of steps in the unsigned editorial, most notably, printing more euros, although that's not how it is phrased of course.

That is because much looser monetary policy is necessary to stave off recession and deflation in the euro zone. If the ECB is to fulfil its mandate of price stability, it must prevent prices falling. That means cutting short-term rates and embarking on “quantitative easing” (buying government bonds) on a large scale. And since conditions are tightest in the peripheral economies, the ECB will have to buy their bonds disproportionately.

It is an open question whether the euro will survive in its present form, but regardless of the outcome, we can expect turbulence ahead.  Even if the euro is saved by the aforementioned actions, it will set in motion long term inflationary pressures as the euro loses value against the dollar.  This will have a negative impact on U.S. exports, putting more pressure on our tepid recovery.  However, if the euro zone can't be saved, and widespread defaults on government bonds outside of Greece get started, then a real liquidity crisis could trigger a second global recession.  America would not be immune to this outcome either.

Either way, we are going to see real pressure on our own government's deficit situation, as economic headwinds deprive governments at all levels of revenue.  At the same time another recession increases outlays due to unemployment payments and increased use of food stamps, medicaid and other parts of the social safety net. 

The silver lining is that Obama is unlikely to be re-elected in such a climate.  But many Americans and people all over the world are going to suffer.  The root cause of our troubles is clear; all over the western world, politicians have made promises that were going to be impossible to fulfill.  This is the central appeal of Chris Christie; he is the politician who has best articulated this truth.  The end result is that those dependent on the government, whether retired employees, social security recipients, or others, will not have the standard of living they thought.  Governments will not keep their promises, either through bankruptcy, inflation or abrogation, because the collective promises can't be met. This will lead to lowered consumption as the reality of reduced lifetime income sets in and long term re-adjustment in the economy.  We are not going to have a full recovery for a decade, in my humble opinion.  But the tea party movement is correct in focusing on getting the spending under control now, because the sooner we come to grips with the spending problem, the sooner the economy will recover.

UPDATE

Over at Zero Hedge, Phoenix Capital Research has this to say:

Indeed, with Europe’s entire banking system insolvent (even German banks need to be recapitalized to the tune of over $171 billion) the outcome for Europe is only one of two options:

1) Massive debt restructuring.

2) Monetization of everything/ hyperinflation These are the realities facing Europe today (and eventually Japan and the US).

Either way we are talking about the destruction of tens of trillions of Euros in wealth. The issue is which poison the European powers that be choose.

Personally, I believe we are going to see a combination of the two with deflation hitting all EU countries first and then serious inflation or hyperinflation hitting peripheral players and the PIIGS.

Plan B - Screw the Germans

The Economist is plumping for a brilliant new plan to save the PIGS (Portugal, Ireland, Greece and Spain), well to be fair, just the PIG. The article, titled The euro area: Time for Plan B is filled with euphemisms like restructuring (aka default), insolvent (bankrupt) and euro zone's core (Germany). To be fair, the article admitted to the last euphemism, but used it anyway. What's the point? The point is that everyone who lent these countries money is going to lose, because they won't, can't or shouldn't pay their just debts, even though they are sovereign nations.

At the same time the costs of buying time with loans have become painfully clear. The burden on the countries that have been rescued is enormous. Despite the toughest fiscal adjustment by any rich country since 1945, Greece’s debt burden will, on plausible assumptions, peak at 165% of GDP by 2014. The Irish will toil for years to service rescue loans that, at Europe’s insistence, pay off the bondholders of its defunct banks. At some point it will become politically impossible to demand more austerity to pay off foreigners.
. . .
If Europe’s leaders stick to plan A, the debt crisis will continue to deepen. If they get on with restructurings that are eventually inevitable, they have a fighting chance of putting the crisis behind them. Plan B will require deft technical management and political courage. Thanks to its emerging-market expertise, the IMF has some of the former. It is up to Europe’s politicians to find the latter.

So, the Germans, whose voters worried about the impact to their own economy of lending to countries that seemed destined for default, will reap the exact reward their voters feared. Are there any lessons for the United States? Perhaps it might not be a good idea for the American taxpayers to bail out California and Illinois. And does anyone really believe that Europe's heretofore spineless politicians will suddenly find the political courage to make this work? Stand by for some interesting lessons to be learned.

Greek Update and a California Question

And no, I don't mean a frat party at UCSD. KT has been keeping up with the Greek debt situation and alerted us to the fact that the interest on Greek two year debt has shot up to 26%, "...26% is what you would pay on your credit cards if you missed a payment." My question is to what extent is California going to go the way of Greece? California can't print its own money, just as Greece can't print euros. California apparently lacks the political will to tackle its structural deficit, a la Greece. California will inevitably ask the feds for a bailout, much as the Greeks have done with the EU. And the promise of a bailout may come too little, too late to help. Bottom line, I wouldn't be holding California debt if I could help it, and that includes waiting on an income tax refund check, like I'm doing right now. There's a name for chumps like me that paid too much in taxes to the state and are now waiting for that check, Unsecured Creditors. Last in line for you, pal.