Tuesday, May 22, 2012

European Economist De Grauwe on EU

My former graduate school colleague, Paul De Grauwe is currently Professor of Economics at the London School of Economics, and he has written a tome, now in the eight edition, Economics of Monetary Union. I saw him today on Bloomberg video talking about some of the same issues in our last post. 

A word he uses quite often in discussing the problems within the European monetary union is "distrust."  He applies this term to bond markets.  He compares the debt ratios of Spain and the U.K., which he says are broadly similar. Yet, Spanish yields are much higher than U.K. yields, and he notes the difference is that the Spanish sovereign issuer is not in control of the currency in which it issues the debt, namely the euro.  In this case, liquidity leaves the Spanish system when markets lose faith, and a liquidity crisis quickly ensues.

He calls for the ECB to become the lender of last resort, to draw a line in the sand and to provide any amount of liquidity to bail the union out of the current crisis, without looking over its shoulder for German support.  This is wishful thinking.  The ECB is constitutionally directed by its board, over which Germany controls only its own vote.  Yet, it will shoulder a disproportionate risk in any such open-ended bailout.  So the German interest in this mechanism is what? 

Paul does admit in his paper that Greece was probably insolvent at the time it was admitted into the eurozone.  Now we start to get to the root of the issues.  The EU never hewed to its own published rules and public rhetoric either in admitting new members or in calling them on the carpet for breaking budget or trade deficit guidelines.  If the EU has behaved like this for decades, then any practitioner knows that the market comes armed with distrust and its own discipline. 

We again reiterate that Spain's problems should all be addressed by cleaning up its own banking system, which would rebuild trust in the credit markets.  De Grauwe also makes the point, in another research paper, that Ireland has already undergone a painful "internal devaluation," in which case it might be at the point where it would be better for it to voluntarily leave the euro and grow with an improved relative competitive position.  Paul's work is interesting reading.

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