Squaring the Euro Circle?

Although markets faltered today, Mario Draghi (‘super Mario’) laid out the basis for the deal he believes will save the Euro.  This deal has three steps, modeled on the deal that saved (?!) — so far — Greece.

First, countries that are facing excessive interest rates have to apply to the European Financial Stability Fund  and the European Stability Mechanism for help.  This means political leaders have to fall on their sword, admitting to their citizens that they have failed to manage national accounts and are willing to subordinate national fiscal policy to the terms laid down by the EFSF and ESM.

Second, the political leaders and the EFSF/ESM need to work out a deal that will involve severe austerity measures to protect the investment of the EFSF.  The belief is that by agreeing to austerity measures, the countries will avoid again falling into the kind of debt trouble that forced them to come to the EFSF in the first place. This is supposed to ensure that the bailout has an end, and that (like TARP) the money put up is eventually repaid and does not threaten the financial standing of Europe’s stronger economies.

Third, once an agreement is in place, the ECB will undertake unlimited bond purchases (by printing Euros) from the countries that have worked out their deal, in order to drive down their borrowing costs to managable levels.  The ECB will also NOT subordinate existing soverieign bond holders, avoiding the problems that arose in Greece with regard to private bond-holders having to take all the burden of the write-down of Greek debts.

That is the plan.  Unfortunately, that plan has already been tried with Greece and failed.  Even though the Greek leaders have capitulated (most recently this week) and undertaken austerity measures that have ground the Greek economy into the dust and unleashed social unrest and mass suffering, Greece’s borrowing costs are STILL unsustainable and its debts are STILL rising because the austerity measures have had far more costly effects on Greece’s economy than was anticipated.

So — the same plan that failed to effectively rescue Greece and put it on track to solvency and recovery is being applied to the much larger and more critical economies of Spain and Italy.  Is this insanity (in Einstein’s sense of doing the same thing repeatedly and expecting a different result)?

Of course, Super Mario may have one more trick up his sleeve.  It may be that the 3-part plan was developed to win over the reluctant northern countries who are still manaically insisting on austerity as the price of bailouts.  But there could be a part 4 waiting in the wings, in which the ECB writes down its share of the sovereign bonds it acquires, marking them ‘to market’ (i.e. cutting their value to a realistically reduced level).  That will likely weaken the Euro and impose inflation on Germany and other northern countries, which they cannot explicitly agree to.  But it is the only path forward that makes any sense.  Otherwise, imposing austerity on Spain and Italy as was done with Greece will only devasate their economies and drag all of Europe into depression.

We shall have to see what lies ahead.  At best, the Draghi plan may offer a way to gain European agreement to measures that will centralize and then reduce the debts that are staggering European banks and mediterranean countries.  But at worst, it will drag Europe into deeper austerity and depression (putting the ‘drag’ in ‘Draghi’).  Greece was a little can that could be kicked down the road.  Spain and Italy are massive stones that, if kicked too far, will roll out of control.  Let us hope that is NOT what lies ahead.

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About jackgoldstone

Hazel Professor of Public Policy at George Mason University
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