"Why, Sometimes I’ve Believed as Many as Six Impossible Things Before Breakfast."
The legal tender law of 1862, which established a new inconvertible paper legal tender currency, was effectively a bank bailout. By creating a new, depreciated numeraire (the greenback), and by allowing dollar claims (including deposits) to be denominated in this depreciated version of the dollar, rather than in gold or silver, the government offset the negative shock to bank assets from government bond depreciation with a similar negative shock to the value of deposits. Later, in the 1870s, the legal basis for legal tender notes was challenged, but since it had been employed during wartime as an expedient to ensure the survival of the government and the banks, and since it would have been very difficult to unwind the sequence of payments that had been made on a depreciated currency basis over several years, its constitutionality was upheld. To ensure that it was upheld, President Ulysses S. Grant added two justices to the Supreme Court (another outcome that many would have dismissed as far-fetched in 1860). The force majeure of fiscal necessity can be a source of great legal innovation.
Nor was this U.S. experience exceptional. In 1933, the U.S. government prohibited the enforcement of gold clauses in private debt contracts. It did so to assist debtors who were suffering the double blow of a weak economy and a depreciated dollar (which increased the burden of paying gold-denominated debt). In a five-to-four Supreme Court decision, that action was upheld in 1935. That Supreme Court decision was widely regarded as permitting the government to orchestrate illegal takings from creditors and was decried as such in an apocalyptic minority dissent.
As recently as 2002, the Argentine Republic put aside its constitutionally mandated adherence to a dollar-linked currency board. It left the dollar standard and redenominated dollar-denominated and dollar-indexed contracts into the newly depreciated peso. The precipitating event that led the Argentine government to recognize the need to resolve its longstanding fiscal crisis—which had been going on for over two years—was the run on Argentine banks that occurred in December 2001, which precipitated a suspension of the convertibility of deposits.
The Divergent Realities of the Euro Zone
I will not repeat here in detail my prior analyses published elsewhere of the currently unsustainable paths of Greece, Portugal, Ireland, Italy, and (depending on its bank bailout policies) Spain. I would, however, emphasize that these countries are not all facing the same problems. Their strategies for dealing with their problems should differ, as should the EU strategies for agreeing to loss-sharing arrangements to address those problems.
There are three distinct problems related to euro zone membership that confront this group of countries: (1) over-indebtedness, (2) high deficits in combination with over-indebtedness, and (3) non-competitiveness. These problems are distinct and pose different challenges for policy. The relative weight to attach to each problem also differs across the euro zone countries that are currently under the greatest pressure. First, debt sustainability refers to an excessive amount of debt relative to GDP, which must be addressed through some form of default and restructuring.
High deficits add another dimension to that problem. A country that defaults on its debt will find it difficult to fund its continuing deficits through new issues of sovereign debt into the market. Thus, a high-deficit country that is also in need of restructuring either must leave the euro zone to print money to finance its continuing deficits, or obtain public-sector support for deficit borrowing "in arrears" in the wake of its default (presumably with the hope of quickly ending its deficits, so that public sector support does not result in a second debt default).
Also, countries with over-valued exchange rates (which resulted from their slow productivity growth in tradable goods and their rigid labor markets) face the difficult choice between a protracted period of recession as their wages and prices decline to restore competitiveness, or departing from the euro zone, depreciating their currency, re-denominating their wages, prices, and bank deposits in the newly depreciated currency, and immediately beginning their recovery. Under either of those scenarios, long-term reforms of labor markets and other policies to address competitiveness are desirable. But those long-term reforms will not resolve the short-term problem; in the short term, over-valuation implies a clear trade-off between continuing recession and devaluation.
Countries that leave the euro zone could and should re-join it in a matter of a few years, after undertaking significant reforms to their fiscal affairs.
In my view, all three of the fundamental problems listed above are severe for Greece. It is a matter of simple arithmetic that Greece’s debt is not sustainable. Greece’s deficits are also large, and it would be challenging for it to succeed in credibly promising to shrink those deficits to obtain sufficient short-term financing in arrears to avoid leaving the euro zone as it restructures its debts.
Even if financing in arrears were possible, the economic costs of remaining in the euro zone would be large because continuing over-valuation would deepen Greece’s recession. It is hard to see how—absent a massive transfer (not a loan) to Greece of roughly two hundred billion euros—Greece can avoid both debt default and exiting the euro zone. Portugal’s situation is not as dire, but a similar logic applies to its case. A restructuring and an exit from the euro would seem to make sense as a means of resolving all three of its problems.
Countries that leave the euro zone could and should re-join it in a matter of a few years, after undertaking significant reforms to their fiscal affairs, labor markets, and pension systems. It makes no sense to prohibit them from re-joining, and that prospect could be a useful source of encouragement for reforms.
Ireland and Spain are in a somewhat different position than Greece and Portugal. If they can avoid domestic government assumption of their local banks’ debts held abroad (e.g., by German, UK, Belgian, and Danish banks), then they are not clearly in unsustainable fiscal positions (although Ireland’s absorption of bank debt already has placed it at substantial risk in that regard). And if Spain and Ireland can avoid the debt sustainability trap that would result from absorbing their banks’ debt problems, then there is the possibility of improving their economic competitiveness and performance. But if they absorb their failed banks’ debts, they will make their sovereign debt problems much worse, and probably unsustainable. Although the right policy choice is clear, Ireland and Spain have come under enormous pressure from European counterparts (and from domestic political friends of insolvent cajas in the case of Spain) to absorb those debts. They must find the political will to say no.
Italy’s situation is also unique. Its debt sustainability problem could be solved with quick, significant, but not crippling, cuts in fiscal expenditures, combined with significant reforms in tax collection and corruption. But Italy is deeply broken politically. There is little prospect that timely and necessary policy changes will be implemented.
What Should Happen vs. What Will Happen
The best path forward for the euro zone would be to encourage the policy adjustments for Greece, Portugal, Ireland, Spain, and Italy discussed above, and to agree to loss-sharing arrangements to absorb, in an orderly way, the losses that would result to German, UK, French, Belgian, Danish, and other countries’ banks from sovereign defaults and failed Irish and Spanish banks’ and cajas’ defaults.
If history is a guide, however, this is not the way the euro crisis will be resolved. Governments likely will try to postpone taking unpopular measures, and thus will not resolve the problems at hand. The most likely outcome will be a chaotic sequence of ad hoc and poorly coordinated emergency measures, taken in response to bank runs that will begin in Greece or somewhere else as depositors become increasingly wary of continuing euro convertibility of their deposits. The time to act is now, as the possibility of undertaking an orderly and sensible resolution of the crisis is slipping away.
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