The Euro on the Brink

I try to avoid commenting on economic events, and hopefully my pessimism means that the nadir has already been passed.--ES

In september 2008 as the liquidity crisis that followed the fall of Lehman unfolded, the US Federal Reserve and the Treasure extended insurance and guarantees to Certificates of Deposit and Money Market funds--relatively, uncomplicated financial products used as (slightly higher yielding) bank deposits by professional and the investing middle-classes alike. Essentially this extended deposit insurance to instruments that were sold, marketed, and used as the new kind of bank-deposits. These decisions prevented a classic (yet modern-day) system-wide bank-run. I view this as the key decision that prevented financial collapse and 1930s style depression and the one most able to withstand scrutiny from the most skeptical enquirers of later generations. It is really a stroke of luck (or providence) that Ben Bernanke, arguably one of the foremost living authorities on monetary policy in the 20s and 30s, is at the helm of the Fed. (It is extremely rare to find a top economist of his generation with a deep interest in economic history; for obvious reasons that is changing rapidly.)

As I pointed out a few days ago, the Eurocrats forgot all the lessons of history:  in order to bail-out Cypriot banks, all of Cyprus's bank-depositors are being asked to contribute to the bail-out. Not just the rich Russians who treat Cyprus, which is partially inside the EU (long disgraceful story--nobody comes out looking good) and where the Euro is official currency, as a money haven (say, individuals and businesses with more than €100,0009, but also local depositors. The proposed act is not just immoral (steal from the poor to protect the rich), but one of the most insipid, self-inflicted, world historical blunders, on par with, say, Austria-Hungary declaring war on Serbia to start WWI (fill in your favorite example, you know, Eve eating the apple, etc.).

For, if this goes into effect, depositors in all other Euro countries have no reasonable expectation anymore that their deposits are safe--and this kind of lack of trust will trigger and cascade into system-wide bank-runs. This is not a philosopher's thought-experiment; it's a genuine possibility in Greece, Portugal, Spain, Italy, Ireland, the Netherlands, and a few others that are dealing with the aftermath of real estate bubbles. During the last half decade, Europe has studiously avoided serious reform of the troubled banking sector; balanced sheets are still bloated and in many countries mortgages on real estate are still carried on the books against Bubble values. With government austerity programs choking off growth, there is no reason to expect that Europe will grow its way out of this balance-sheet recession (as Vernon Smith coined it).

The parliament of Cyprus has rejected the plan, setting off more negotiations. In Europe these things end up being decided at the very last possible moment, and then we muddle through in ordinary times. (See here for options. [HT Tyler Cowen]) But we are in the midst of a financial crisis with government and bank balance sheets in deplorable state everywhere (except perhaps Germany). While American growth will eventually (as it usually does) translate into higher European exports, we have reached the point where the current policy-options are getting worse and worse, yet the Eurocrats and their political task-masters are still trying to save Northern European bank-balance-sheets (and their overpaid bank executives), and, thus, their own taxpayers, at the expense of sanity. The price we pay for this folly is getting higher and higher.