Euro crisis not over yet

Paul Krugman reminds us that the euro crisis is still very much with us (Europanic 2.0 10/11/2014):

Not that long ago the austerians who had dictated macro policy in the euro area were strutting around, proclaiming victory on the basis of a modest uptick in growth. Then inflation plunged and the eurozone economy began to sputter — and perhaps more important, everyone looked at the fundamentals again and realized that the situation remains extremely dire.

The panics over interest rates on national bonds of eurozone members culminated in 2012, when the ECB finally stepped in with a promise to backstop the eurozone bond market. This was a creative stretch of its legal authority, but is something central banks are normally able to do with their currency zones, which are mostly individual nations.

It was one of the faults of the euro currency design that the ECB wasn't originally given such authority outright. German Chancellor Angela Merkel opposed the action right up until then, but she finally grudgingly relented, when it became painfully obvious that the speculation was weeks or even days from wrecking the euro.

Merkel's Finance Minister Wolfgang Schäuble is still worrying that ECB chairman Mario Draghi is dangerously stimulus-oriented. (Stefan Riecher et al, Draghi Clashes With Schaeuble Over Steps for Europe Bloomberg News 10/10/25014):

As the International Monetary Fund’s annual meeting in Washington began, Draghi pledged anew to loosen monetary policy more if needed and called on those governments with the room to ease fiscal policy to do so. By contrast, Schaeuble warned against U.S.-style quantitative easing and urged continued budgetary discipline.

The differences demonstrate the lack of a common front in euro-area policy making as its economy continues to deteriorate and the IMF estimates there is as much as a 40 percent risk of a third recession since 2008.

As Krugman puts it, "Once the prospect of a cash shortage [that might force individual country defaults] was taken off the table [by the ECB's 2012 action], the panic quickly subsided, and at this point both Spain and Italy have historically low borrowing costs."

Krugman references a Frontline interview with the late economist Rudi Dornbusch, talking about the 1995 Mexican finance crisis, for the episode Murder, Money and Mexico: The Rise and Fall of the Salinas Brothers (1997).

YOU SAY IT WAS PREDICTABLE AND YOU DID SEE IT COMING. BUT WHY DID WALL STREET NOT SEE IT COMING?

Well, when it happened, it's a wide open question. An overvalued currency isn't tantamount to a crisis. The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought, and that's sort of exactly the Mexican story. It took forever and then it took a night. [my emphasis]

That sentence, "It took forever and then it took a night," is an important observation. Economic crises build up for a while, and then often take a sudden turn for the (much) worse. The eurozone has been visibly in crisis as a currency zone, which has extended and worsening the depression that began in 2008. In mid-2012, it was entering an "it took a night" phase. We're likely to see more of them. At least one more.

That 1995 Mexican crisis also had fixed exchange rates involved, as M. Angeles Villarreal describes in The Mexican Economy After the Global Financial Crisis 09/16/2010:

The Mexican economy suffered a financial crisis in 1995 that resulted from a number of complex financial, economic, and political factors. In response, the government abandoned its previous fixed exchange rate policy and adopted a floating exchange rate regime. Mexico’s currency plunged by around 50% within six months as a result, sending the country into a deep recession.

The gold standard was a type of fixed exchange rate for participating countries, and so is the euro.

Krugman describes the difference of the current situation to 2012, referring to the "zero lower bound." That term refers to very low interest rates. Nominal interest rates can't go below zero. They normally approach zero only in a weak economy, one that has lots of unused capacity, and therefore high unemployment. Neo-Keynesians like Krugman recognize that in such a situation, monetary policy can have only a very limited effect in promoting economic growth. (More orthodox Keynesians and post-Keynesians are more likely to question whether monetary policy can ever do much of anything to promote economic growth.) Krugman:

What’s happening now, however, is very different [from 2012]. It’s a slower-motion crisis, involving the euro area as a whole, which is sliding into a deflationary trap with the ECB already essentially at the zero lower bound. Draghi can try to get traction through quantitative easing, but it’s by no means clear that this could do the trick even under the best of circumstances — and in reality he faces severe political constraints on what he can do.

What strikes me, also, is the extent of intellectual confusion that remains. Germany still seems determined to regard the whole thing as the wages of fiscal irresponsibility, which not only rules out effective fiscal stimulus but hobbles QE, since it’s anathema for them to consider buying government debt.

And it’s remarkable, too, how the logic of the liquidity trap remains elusive even after six years — six years! — at the zero lower bound.

Merkel, whether from conviction or loyalty to German corporate bosses, is committed to her Herbert Hoover/Heinrich Brüning for the eurozone. She's also approaching it in a nationalistic way, pursuing policies from which Germany as a national economy benefits at the expense of most of the rest of the eurozone. Her policies at the same time ensure that German workers benefit very little from the advantages of the national economy. The lion's share of the benefits are going to the German One Percent.

Given her nationalistic focus, the only kind of external pressure that could force a change in her policy would be a country like Greece or Spain being willing to leave the eurozone - and thus provoke its collapse more generally - unless Germany backs off and allows a counter-cyclical, stimulative policy for the eurozone.

Within Germany, if the SPD followed an actual center-left economic policy, they could present a real challenge to it. But that ship has sailed. If they were going to do that in any immediate future, they would have tried to form a government after the 2013 Bundestag election with the Left Party and the Greens instead of rushing to become the junior partner in a Grand Coalition government headed by Angela Merkel.

Krugman doesn't see a happy ending to the euro crisis:

Europe has surprised many people, myself included, with its resilience. And I do think the Draghi-era ECB has become a major source of strength. But I (and others I talk to) are having an ever harder time seeing how this ends — or rather, how it ends non-catastrophically. You may find a story in which Marine Le Pen takes France out of both the euro and the EU implausible; but what’s your scenario?