Both Sides are Wrong and Both Sides are Right

How ECB Chief Outflanked German Foe in Fight for Euro – WSJ.com.

This article shows how the he-said, she-said structure of mainstream media reporting limits the debate. The article presents the current Eurocrisis as a battle between two forces at the ECB. Draghi represents the easy money side with Weidmann leading the tight money advocates. The article ends with the statement, “The markets, however, are listening to Mr. Draghi.”

The markets pay attention to a lot of things in the short-term. Observing PIIGS rates recently, you would have to conclude that they are listening to Draghi. Ultimately, the economic fundamentals and the political situation dictate what will happen to the Eurozone.

Draghi’s argument in support of turning on the printing press is that including this tool is necessary to guard against speculation that the euro will break up.

Weidmann’s argument is that speculators are actually betting that Italy and Spain will eventually default. This belief is what is driving yields.

Weidmann believes that the elected governments in the countries in question need to enact reforms that stabilize their economies and fiscal positions.

Draghi thinks that the countries are reforming but despite these reforms, investors are still shunning these bonds because of the risk of a currency breakup.

Aren’t they both right here? The crisis is two-part. First, the countries have their own internal economic issues. Second, the issues are so severe that they might cause one of these countries to leave the eurozone leading to a breakup via the dreaded domino effect.

The situation in Spain, Italy, Portugal and Greece is that the countries have been growing more and more uncompetitive since joining the euro. Greece admitting it lied about its budget was merely the precipitating incident for this crisis. All of the pieces were in place waiting for a trigger.

In a nutshell, the euro allowed these countries and their citizens to borrow at rates much cheaper than they were used to. So borrow they did. A credit bubble, whether its based in housing or sovereign debt, eventually pops causing the economy to shrink.

In a country with its own currency, a burst bubble causes a devaluation. The country’s good and services become cheaper to foreigners, and they sell more. Their own debts also get devalued with the currency making service more manageable.

Weidmann is right. These countries have inefficient, relatively closed economies requiring reform to spur growth. They are also spending too much money and need to balance their budgets.

Draghi is right. The crisis has brought the potential of a eurozone breakup to the fore, and the ECB  must metaphorically throw all of its resources into a defense to dissuade attackers.

But they’re both wrong. Each man assumes an irreversible euro. Ultimately, defending this ill-fitting currency union will lead directly to its destruction.

In a war, if both sides decide that they will not surrender but will fight to the death, then the stronger side will eventually annihilate the weaker side.

Think of what happened to Germany in WWII. Hitler knew that he would be executed upon a German surrender, so this resolution was off the table. Even when it became apparent to him that defeat was inevitable, he had nothing to lose by fighting on. This policy led to Germany’s total destruction.

For contrast, look at the American Civil War. The weaker side eventually conceded that victory was impossible and surrendered rather than letting General Sherman destroy the rest of the country. This limited the devastation and also allowed the former Confederate states to gain political concessions in the wake of the war.

People point to the poisonous political atmosphere in Washington, where both sides refuse to work together and practice brinkmanship. This phenomenon of the last few years has spread to other systems it seems.

Rather that compromising, each side is intent on winning, which means that one side will lose in the end. However, there aren’t two sides here. There is only one eurozone. If one side loses, they both lose.

Germany insists on austerity and reforms for the periphery, but a currency and monetary policy too strong for thier needs does not allow them to fully implement these policies.

Germany benefits from belonging to the euro. It gets a cheaper currency than it should rightly have, which has spurred an export boom. Currently, it is the safe haven in the eurozone drawing additional capital away from the periphery, which lowers its own internal rates lifting its own economy even more.

It also benefits from being part of this currency union politically. Because of Germany’s history, it is difficult for it to practice statecraft in a way befitting a country of its economic importance. However, it can project power as a member of organizations like the EU and NATO.

While Germany receives all of these benefits, it refuses to fully pay for them. A currency union requires a fiscal union; the absence of which requires fiscal transfers. Understandably, Germany is hesitant to pay for other countries’ profligacy, but then it enjoys the benefits of the currency for free.

This is where Draghi has to step in. He is the leader of the ECB, so he has to defend the currency. The problem is that he is fighting a losing battle, because a successful defense of the euro requires a full fiscal union.

None of these countries have shown the inclination to surrender their sovereignty for such an enterprise. Of course, the rich countries do not wish to be on the hook for the poor countries debts, but the periphery does not wish to surrender that much sovereignty either.

Yet, both sides insist on maintaining the status quo of a shared euro. The northern countries enjoy the benefits of a single currency but do not wish to pay for it. The periphery does not wish to make the political changes necessary for them to remain competitive with the north within the union.

In the meantime, monetary policy is being deployed to give everyone more time to sort out this mess.

So there it is. The solution to the eurocrisis is simultaneously a matter of the correct political and monetary policies. If both sides do not work together to pursue each, then the euro is doomed.

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