The Countdown Has Begun for the Eurozone Breakup

The Countdown Has Begun for the Eurozone Breakup

After the widely expected official bailout for Portugal, today's ECB hike is like the Fed hiking on the day they bailed out AIG. Can you imagine that?... All of this would would make more sense if the German economy were overheating, but it isn't (not by a long shot)... The countdown has begun alright, but it's not just for Eurozone breakup--it's for perpetual German stagdeflation.

April 7, 2011

Macro and Other Market Musings - The ECB decided to raise interest rates today, despite the strain it is going to put on the Eurozone. Michael T. Darda explains in the WSJ what this could mean for the currency union:

If the ECB starts to tighten policy as expected, it could be a "lights out" situation for the beleaguered European periphery and a potential threat to the euro zone itself.

In more blunt terms, this move may have begun the countdown to the Eurozone breakup. It is hard to see how else this can turn out. The Germans--the folks who really call the shots in Europe--are reluctant to see the needed debt restructuring in the periphery and are equally reluctant to provide bailouts large enough to fix the problem. So far the Germans have been kicking the can down the road on these issues. With ECB monetary policy now tightening they will soon run out of road to kick the can down.

Maybe the breakup was inevitable from the start and this is just hastening that outcome. After all, the Eurozone is not an optimal currency area (OCA). But if Europeans do want to save their currency union, the ECB should be easing monetary policy not tightening it. Doing so would make it far easier to make the structural adjustments necessary to bring the Eurozone closer to an OCA. How so? Here is Darby again:

To understand why, we need to recognize the depth of the hole from which the euro-zone economy is trying to emerge. Nominal GDP, a proxy for nominal income and the tax base, is a staggering 10% below its pre-bubble, post-bust trendline. If anything, this would call for more support, not less, from the ECB... Europe's fiscal bailouts, which began last spring, have transferred resources from stronger countries in the core of Europe to weaker ones in the periphery. They have bought some time, but they are not a substitute for nominal demand in aggregate, which is why debt stresses persist.

Another reason why ECB easing would help is that it would lead to a real appreciation in Germany and and a real depreciation in the periphery. This would increase the periphery's external competitiveness relative to the core's and thus allow them to run current account surpluses. Such surpluses would make it easier for them to manage their debt. But apparently ECB leaders don't see things this way. And sadly, they probably don't care what some blogger from Texas thinks about their monetary policy.

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