By Daniel Knowles
Last updated: August 3rd, 2011
It’s a sign of how jaded we are with the eurozone crisis that when Italy’s and Spain’s economies are on the brink of collapse, only the FT has it on the front page. These are Europe’s fourth and fifth biggest economies – their commitment to repay their debt ought to be unquestioned. And yet investors – those not on holiday anyway – have driven debt yields up above 6 per cent. Those aren’t much below the levels that sent Ireland, Portugal and Greece to the EU in search of bailouts. Italy and Spain were not thought to be insolvent, but if they are forced to roll much of their existing debt at those rates, they will be soon enough.
This is largely unnecessary. The euro is a vice around indebted countries, as they cannot devalue, but it needn’t be so tight. As Ambrose Evans-Pritchard observed yesterday, the European Central Bank is tightening its monetary policy – it is, in effect, acting like the Bundesbank, setting monetary policy only for fast-running Germany. In Italy, the money supply is crashing – and as every good monetarist should know, that means deflation and economic retrenchment. This is insane – it is as absurd as when Andrew Mellon advised Herbert Hoover to “purge the rottenness” out of America’s financial system at the height of the Great Depression.
As I have written before, indebted countries cannot simply leave the euro. Since my last piece, Barry Eichengreen has written a new short paper and it explains more clearly than I did the problem – to go back to the lira or the peseta would mean shutting down the financial system in Italy and Spain for months, maybe years. It would cause, as he puts it, “the mother of all financial crises”. But there is another solution which would work – the European Central Bank should lower interest rates and introduce a programme of quantitative easing. Quite explicitly, it should seek to inflate away southern Europe’s debts.
This plan will, of course, be terrible for Germany. Its economy has resurged thanks to its incredible competitiveness – Germany now runs a bigger external surplus than China. Loose monetary policy would save Italy, but the bulk of the inflation would be in Germany, where there is no spare capacity. German exports would decline and the businesses that produce them would lose out and have to sack workers. Yields on German bonds would pick up – not because of a fear of default, but because the pension managers who look after Germany’s immense private savings would look elsewhere for returns on their hoard of cash.
But for Europe overall, that is ideal. Indebted countries like Greece, Italy and Spain (and dare I say it, the United Kingdom), need to export their way back to prosperity. For this to happen, Germany needs to start importing. The easiest way to achieve that is to make German goods more expensive – exactly what a big dose of inflation would do. If Germans don’t want inflation – and given their history, you can understand why they might not – then there is one other alternative; Germany could leave the euro itself.