Pearlstein: The euro and the E.U.'s roiling debt crisis

May 19, 2010

In the wake of a bailout of Greece, columnist Steven Pearlstein discusses the economic conditions in the E.U.

I have more than a passing interest in the strength of the euro, since I'll be vacationing in France this fall. May I assume my personal finances will be improved, even if exporting US businesses are not?

They have improved. Whether the euro will continue to drop is unclear. There are good reasons for the euro to fall, but there are good reasons for the dollar to fall, so its something of a race downward for the two currencies. What would help is if the Asian currencies that have been held down artificially would rise to reflect the higher productivity and higher growth rates and increased wealth of those countries.

Dear Mr. Pearlstein, Does your analysis lead to the conclusion that the euro zone sooner or later would have entered a crisis of the euro, even if the financial crisis and great recession had not occurred in the United States? If euro zone labor markets were opened, would that change alone resolve the problems in the euro zone? Thank you.

Its an easy answer to say that the euro zone would have hit these bumps sooner or later, but it is true. That said, it usually takes crises or shocks to expose these weaknesses.  And the lack of labor mobility is a big factor in why its difficult to have a single currency, since that would have the effect of forcing down relative wages in places with endemically lower productivity growth (or push them up in places with higher productivity grown). And the lower wages would then shift where the work is done at the margin, much the way floating currencies have the effect of evening out trade flows. These are the mechanisms by which complex economic systems equilibrate and self-regulate themselves in a useful fashion. But its not just free flow of labor that's important, although that's the most important factor. Freer flow of services and more consistent regulation across borders would also be a factor. Banking markets are also  still balkanized.

The rising dollar makes US industry less competitive. US industry already is hampered by tax policies where US products are VAT-taxed when exported while products of VAT-taxing countries are not similarly taxed here. If a VAT were instituted here, possibly with credits for social security, health care, school taxes, etc. (removing these from income tax deductions), would the US benefit or would turmoil in the world markets overcome any advantage to US production?

One of the reasons I suggested a VAT tax last week, in my deficit reduction column, was for just that reason -- that a VAT tax is rebated for exports. Other countries have payroll taxes, in many cases higher than ours. Other countries have corporate profit taxes, although our marginal rate tends to be higher (effective rate, not so much). So its not like there is a huge tax disadvantage to US exporters. But if we need new tax revenue -- and we surely do -- then a VAT is the one that is the most competitiveness friendly.

Sorry to see you're still confusing command-control stimulus with actual wealth. China is about to collapse and is in far worse shape than the US. Good luck with that weak dollar wishful thinking, Fed lover.

Anyone who calls me a Fed lover hasn't been reading my columns.

Hey Mr. Pearlstein, I found your column, like always, very informative and interesting today. What would, in your opinion, be the best solution for the euro nations? Is their approach the right method or is there a better way? And how should the United States act right now in wake of the EU's double dip reality? Thanks, look forward to your response!

Thanks for your note.

    At this point, the Europeans have to do two things. They have to use their bailout money not simply to buy up or refinance sovereign bonds at par -- and in effect bail out private investors -- but rather as pot sweeteners in debt restructuring plans that require private investors to take a haircut. The markets won't like that idea, of course, and it will in the short term raise the borrowing costs of all European countries until the market herd calms down and learns to discern the good risks from the bad risks. But it is important to do this so market discipline is strengthened and moral hazard is avoided. The only other alternative is to have the EU control national spending and taxes, which is politically unacceptable to everyone. The amount of actual subsidy involved in these restructurings need not be anywhere near $1 trillion, but it is probably necessary to get the kind of voluntary participation from the outstanding bondholders necessary to avoid and out-and-out default.

    The second thing that needs to happen is that Europe has to shore up its banks with some form of TARP program -- big capital infusions on semi-onerous terms that require shareholders to be serious dilution in exchange for the government investment. This will be necessary because of the haircuts banks will take on those restructured Greek and Portuguese bonds that will lower their already inadequate capital. So governments need to build a fire line around the banks.

    Finally, there may need to be a mechanism established for a country to leave the euro. Lots of people I have spoken with think that once a country defaults or restructures, this is the logical course, since they would have lost the whole reason for being in the euro which still be saddled with all the downside inflexibility. I'm not sure about that, because there are other benefits as well in terms of the advantages of easier commercial relationships that the euro provides. But it is probably not a bad idea to begin thinking of how such an exit might be structured. 

If something is a good investment, it will be a good investment tomorrow as well as today. So why should there be hyperfast trading, which sometimes goes seriously awry? And why not have different tax rates so that daily investments are taxed at much higher rates than yearly investments? Why not get the gamblers out of the game so investors are more secure?

What the flash traders do has nothing to do with investment, as you and I understand that word. It's about trading, or gambling. Which is why its not that socially or economically useful.

How long do you expect the euro to be down as it is now (or fall further) against the dollar? Like the previous poster, I also have a vacation to France planned, but for July ... can I count on my dollar going further in Europe than it has in recent years past? What are the probable forecasts here? Thanks for the chat!

I wouldn't worry too much about it -- its probably not going to make a big difference at this point either way. But the safe thing would be to buy about half the euros you plan to spend now, and let the other half float up or down.

A lot of economists have said there will be no "W" effect - that the current global recession, which started with the meltdown of a US mortgage underwriting system run a muck, has been turned around. What is the possibility that Europe's sovereign debt problems are going to trigger a "W" effect and send the world economy into another swoon just as it seemed we might be digging out?

There will be another slowdown in the US and global economy that begins in the second half. It won't be as bad as the recession, and it may not even get into negative growth territory. But I've been saying for a long time that a double dip is the likely scenario.

See if you can follow this: On the theory that the stimulus was so big because if the economy had collapsed, there wouldn't have been enough money to restart it, that is, it would have cost more. On that theory, shouldn't Old Europe do whatever it has to do to stop the euro from collapsing to avert real disaster?

By collapse, I presume you mean a precipitous run against the currency, which could be very bad, because once these things get going they really overshoot on the way down. So it is always a good idea for governments to try to avoid that by providing liquidity. My point, however, is that there is still an underlying solvency problem here, as well as a structural problem with the euro market, and those have to be addressed and they will involve unavoidable pain. And while there will always be Keynesians who argue that you can grow your way out of those problems so that they can be solved without anyone really noticing (because they are paid for, in effect, with foregone growth), I disagree. The outstanding tab is now too big for that, both in Europe and in the US.  Or put another way, we went into this one with so much debt already on the books that the usual Keynesian medicine of taking on more debt isn't going to be possible.

From a report this morning: "German Chancellor Angela Merkel laid out proposals to gain control over destructive financial markets..." With that article, it seems Germany is sending signals they are considering an exodus from the euro unless there is increased regulation in the financial sector. Is there any chance that could happen in reality? Would it impact the US? Will we see markets actually parsed into destructive and non-destructive classifications?

I don't think you're reading that right. Germany IS the euro. It will be easier for it to kick the periphery countries out than for Germany to leave the euro.

Why is it that whatever happens to the dollar it's bad for the US Economy? When the dollar was tanking and the Euro was rising, everyone talked about how it spelled doom for the American economy. And now that the dollar is strengthening against the euro, it's all about how bad it is for our exports?  Sometimes I think the people who comment on the economy (not you) don't know what they're talking about.

And sometimes you're right about that. In this case, the question is how fast the adjustment comes and whether things are "good" for the US in the short run or the longer run. As a general rule, if the value of your currency rises, that's a good thing, but it gets complicated if you are running large trade deficits. In the short run, a stronger dollar means that all those things we import will be cheaper. But in the long run, it means it will be even harder to balance the trade flows, which at the moment require us to take on lots of debt because we import more than we export. So you can see why it gets a bit complicated. My view reflects the long-run one -- that we need to get the system back into balance and that will require a lower value for the dollar against most currencies. 

All these short sale restrictions are going to do is create a vacuum. If history is any guide, once shorts are driven out, there will be a brief rally in German banks followed by a collapse of unknown duration. Politicians are not bigger than the markets. And short sellers are not the problem. If anything, short sellers are the cure. They expose problems and failed policies that politicians refuse to address. In this case, a failure to address debt.

The ban is on "naked" short selling, which is selling something short that you don't, in fact, own or control. And since it means that an infinite number of people can speculate in a security for which, in the real world, there is only a limited supply, its a very distortive market and should be banned -- not just temporarily, but permanently. We do that here in the US and have managed to run a pretty good economy without naked short selling of stocks. Unfortunately, we haven't extended that to derivative instruments, which needs to be done.

     And, by the way, naked shorts are exacerbating the situation now. They didn't cause it, I admit. And there is an underlying solvency problem that needs to be dealt with. But that doesn't mean that speculative trading isn't making a bad situation worse than it needs to be. Your logic on that is simply faulty.

Rather than feeling sorry that the hard working German Ants must bailout the profligate Greek grasshoppers, we should consider how much money the imbalance between these two economies made for Germany. I doubt they will spend more than they made.

That's a fair point -- Germany cannot continue to have an economy based on the proposition that it will always export a lot more than it imports. And that has been true not only with countries outside the euro zone, but even more so with countries inside of it.  With the single currency, its export companies have been a big beneficiary of this imbalance, just as Greek consumers have been. It is analogous to the situation with the US and China, where Chinese export companies and American consumers have become reliant on a large and unsustainable trade deficit.

The nationals and supra-nationals (IMF) may be able to bail out Greece, but not a chance they can deliver Portugal + Italy + Ireland + Spain from the throes of sovereign debt default. So, now that we're witnessing the logical and highly anticipated conclusion of socialism, how do you propose Germany avoid a similar fate?

Let's not get ahead of ourselves, shall we?

Shouldn't creating employment still be the focus of our policy discussions? All this deficit hysteria seems to assume employment will go down to five percent on its own. If we can generate sustained job growth the automatic stabilizers that created the deficit will go into reverse. Besides, we have the world's reserve currency as well as a fiat money system we control. We will never formally default.

You have articulated the Keynesian solution -- use borrowed money to grow your way out of the problem. It works in the short run, as we have discovered in the last year. But when you start out already deeply in debt at the height of the good times, you can run out of running room because the ease and cost of that borrowing is not a given, particularly when you are relying on global savings to finance it. 

Hey Steven, did you catch Ezra Klein's interview will James Galbraith? Galbraith seems to arguing from the perspective of Modern Monetary Theory of the post-Keynesian variety. Are you familiar with it? If true, it would seem to have profound implications for macroeconomic policy.

Not yet, but I will now.

You say that lack of free flow of labor is a problem in Europe, but I thought anyone holding a European passport now had the right to live and work in any EU country. Is that not the case? Or rather, is it the case in principle but not in practice? What are the obstacles to European workers moving from one country to another?

In principle, but not in practice. Lots of licensing and work permit red tape. Also, in Europe people just don't do it the way they do in the US, moving from one region to another. People are very rooted, which makes labor markets not very flexible and efficient.

You ignored the comment that China is collapsing and is in far worse shape than the US. Is that not totally inaccurate ? How can the creditor with $ 850 billion in outstanding US loans be worse off than the debtor ?

China has the inverse problems to the US and that has resulted in lots of bubbles in their country -- housing bubble, stock bubble, etc. They are trying to cool it down now, and because theirs is a managed economy, they may be able to pull it off without some sort of crash. But there are certainly systemic risks there that should not be overlooked. That said, they do have running room in two important areas that would allow them to grow their way out of their situation. One is that they still have lots of underemployed workers who could become much more productive and continue to generate very fast economic growth. And second, they have lots of savings built up and not much debt, net, as a country.

I totally agree with you on naked short selling. But isn't short selling just as bad when it is covered by something borrowed? Why would anyone lend stock to a short seller? It can't be good for the stocks real owner.

Actually, if somebody borrows a stock to sell it short, then that's not naked short selling. That's just short selling. Naked short selling is when you don't even bother to borrow it.

That's all the time we have today, folks. "See" you next week.

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Steven Pearlstein
Steven Pearlstein is a business columnist for The Washington Post. He won a Pulitzer Prize in 2008 and is co-moderator of the On Leadership discussion site.
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