Three options for the eurozone

Option 1:  Do massive bailouts of the PIGS, unleashing enormous moral hazard and removing the incentive to address their unsustainable budget policies.  Worst case is that the entire eurozone goes broke.

Option 2:  Let the PIGS collapse, triggering bank runs all over Europe, which leads to a breakup of the eurozone and a severe recession.

Option 3:  Do 4% NGDP targeting, level targeting, from 2008.  Hopefully the various debt/NGDP ratios get more manageable in a few years.

You’ll notice that I do much more blogging on the Fed than the ECB, even though the European situation is currently much worse.  That’s because the euro-crisis doesn’t play to my comparative advantage as a blogger.  It involves issues like moral hazard, game theory, budget theory, one-size-fits-all policy problems, etc, where I have no special expertise.  So I’ll link to some other bloggers who handle these issues better than I can:

1.  Here’s Tyler Cowen explaining why we shouldn’t expect Germany to bail out the PIGS.   Tyler mentioned that the German debt is nearly 80% of GDP, but could have added that the GDP if the PIGS is much bigger than the German GDP.

2.  Here’s Matt Yglesias explaining why the “huge monetary and social costs” of a bit more inflation are tiny compared to the “huge monetary and social costs” of a deflationary collapse of the eurozone.

3.  Nick Rowe explains why a somewhat more expansionary policy would actually make the future value of the euro much less uncertain.

4.  Bill Woolsey argues that the central banks should focus not on being a “lender of last resort,” but rather accommodating changes in the demand for base money in order to keep NGDP growth on target.

PS.  Congratulations to Matt Yglesias on his new gig.  He’s arguably the best progressive economist in the blogosphere, which isn’t bad given that he’s not an economist.  I said “arguably” because Krugman’s a more talented macroeconomist.  But Yglesias can address a much wider variety of policy issues in a very persuasive fashion.  So he’s certainly in the top 5.  His blog is the best argument for progressive policy that I’ve ever read.  (But not quite persuasive enough to convince me.)



40 Responses to “Three options for the eurozone”

  1. Gravatar of William J McKibbin William J McKibbin
    19. November 2011 at 12:17

    I disagree that option 3 is viable — reality is that it is already too late for option 3 — only options 1 or 2 are viable — however, I am unable to predict which will happen, 1 or 2 — if history is any example, option 1 is most likely — essentially, the ECB must now decide whether to “print” Euros and bailout the southern flank of Europe, or instead, do nothing and prepare for a north/south war caused by economic refugees — again, the ECB is not in a position to protect northern Europe from the secondary effects of an option 2 decision…

  2. Gravatar of marcus nunes marcus nunes
    19. November 2011 at 13:13

    The ECB will march the whole EZ to it´s “grave”, but will not give up the ECB´s hard won credibility as an inflation fighter!

  3. Gravatar of William J McKibbin William J McKibbin
    19. November 2011 at 13:35

    Hi Marcus, I see your point about the ECB, and you may be correct in your prediction — here’s a new question: Should central banks have the power to cause a monetary collapse in sovereign states (?) — in essence, that’s what this is all about — many will say that such authority is vital for central bank authorities to maintain credibility — however, central bankers are not elected officials, and war tends eventually to humble ideological dogma regardless — I personally would not be surprised to see either Greece, Italy, Spain, or Portugal reclaim their sovereignty by leaving the Eurozone and figuring out their own path forward, regardless of the consequences — such a view would be nationalist in the extreme, but at least the people would have a say in their own future destiny — the problems in the Eurozone are very serious from where I sit as a spectator…

  4. Gravatar of marcus nunes marcus nunes
    19. November 2011 at 13:46

    Hi William, The ECB is not only causing a monetary collapse (Italy´s money supply has shrunk over the last months, for example), but more seriously the ECB has gone into the “business” of toppling governments (Italy, Greece)to get “on board” people that would abide by its wishes, the so called “technocrats”!

  5. Gravatar of Bogdan Bogdan
    19. November 2011 at 14:41

    I think the main problem is the structural deterioration of terms of trade between the northern and the southern countries and the aggravation of the external financing problem of the later which, given the unavailability of an exchange rate channel to correct this in a monetary union, must take the form of a real adjustment which, in turn, given the barriers to mobility of the workforce and capital, will have a negative effect on growth and will exacerbate unemployment.

    In other words, the external balance is at odds with the internal balance in these two broad regions of the eurozone and the collective monetary policy cannot be effective in equilibrating the overall, internal + external, balance of payments.

    In short, attempting to correct the deflationary pressure in the internal balance of the southern countries through euro wide monetary easing would lead to an inflationary pressure in the internal balance of the northern countries, which will only aggravate the external balance disequilibrium, that is the current account deficit of the southern countries and the surplus of the northern countries. Conversely, using monetary policy correct the external balance of the payments between these two regions, as is appropriate, implies deflation in the southern camp and sustainable monetary easing in the northern camp, which will allow for a reduction in the current account surplus of the later and a reduction in the current account deficit of the former.

    Fiscal policy would be more effective in dealing with the internal balance problems, but this would imply the creation of a permanent and inefficient transfer union between north and south to pay for the large pockets of unemployed people and resources.

    In the long run, as it were, the choice is between freeing these pockets of unemployed people and resources through structural reforms that enhance Europe wide workforce and capital mobility or breaking the currency union and, consequently, restoring the exchange rate adjustment channel. But in the long run… 🙂

  6. Gravatar of Bogdan Bogdan
    19. November 2011 at 14:46

    P.S. I also think that the short-run fiscal policy transfer union solution is now off-the table, due to the overlevredged public budgets, only the long run solution is left. 🙂

  7. Gravatar of Morgan Warstler Morgan Warstler
    19. November 2011 at 14:55

    Matty will grow to become a full blown libertarian. It is his obvious natural path, along the way it is good to poke and laugh at him, he has much to be embarrassed about. All grown men do, until someone recognizes the folly of their youth, they just don’t really count.

    Option #1-#3, don’t come close to the real outcome.

    Greece and the PIGS will stay in, and they will EAT SHIT, far more than Matty or any progressive wants them to eat… and they will CHANGE because of it.

    The Southern Euro states will actually sooner than later learn to compete like the Southern states in the US. They will go right to work, they will shrink government, they will come to terms with their people being not as productive and make the REAL sacrifices with lower labor costs and weaker government regulations.

    The future is ours. Everyone else will learn to be like us.

  8. Gravatar of Richard W Richard W
    19. November 2011 at 15:04

    Regarding Option 2

    The silent bank runs in the EZ and Eastern Europe are already happening. The repo market is grinding to a halt with increasing haircuts. Eastern Europe and the EZ is heading into a huge credit crunch with all the associated negative feedbacks. Moreover, they can’t contain it to the PIGS, as the likes of France and Austria are being drawn in. Austria are massively exposed to EE, and the French CDS at 222 presages a downgrade. A downgrade of France would lead to a downgrade of the EFSF bonds. The ECB will never do option 3, they will continue to do firefighting patched solutions as the whole thing unwinds and implodes.

  9. Gravatar of flow5 flow5
    19. November 2011 at 15:11

    The question is how to achieve the theoretical ngDp target. The answer is that you ignore the preliminary “transitory” price increases and accompanied asset speculation, while gunning MVt for 3 qtrs – then abruptly tighten (i.e., revert to the 5% ngDp path). This will maximize real-output & minimize inflation.

  10. Gravatar of ssumner ssumner
    19. November 2011 at 15:17

    William, I disagree. I think 3 is the only politically viable option.

    Marcus, I agree.

    Bogban, I don’t agree. I think the main problem is clearly the disastrous fall in NGDP. Whenever you get money that tight a financial crisis always follows.

  11. Gravatar of ssumner ssumner
    19. November 2011 at 15:20

    Morgan, Don’t count on Yglesias becoming a libertarian.

    Richard, I have no idea what will happen–every possibility seems politically unrealistic.

    flow5 I assume there’s a model somewhere behind all your cryptic comments, but I can’t imagine what it is.

  12. Gravatar of Bogdan Bogdan
    19. November 2011 at 15:27

    I think I understand your arguments regarding the effects of a fall in NDGP, but I think even a NGDP growth rule will have to stabilize a price level or an overall nominal GDP growth level. Assumming, for a moment, the world economy instead of the euroyone to be a currency union or on fix exchange rates, doesn’t a stable nominal GDP growth level requires external balance adjustments?

  13. Gravatar of Morgan Warstler Morgan Warstler
    19. November 2011 at 16:12

    Scott, Matty has traveled more distance between weirdo bleeding heart and libertarian than he has left to go.

    He came out as basically an appendage of his father. All that’s left is disgust with the naivete of young people.

    Remember that period when you as a college freshman went home and saw high school Seniors over Xmas? The internal personal disgust?

    The same thing happens to grown men, it just take slonger and they are more loving.

    I don’t know a single man who has becomes more liberal as he grows older… unless he was gay, and even then they still creep right after the shock.

  14. Gravatar of Lorenzo from Oz Lorenzo from Oz
    19. November 2011 at 16:48

    The Bank of France (helped by the Fed) rode the gold standard down to its destruction, why would not the ECB do the same to the euro? Disaster happens.

    To take an example from American history: the cheapest way to resolve the slavery issue would have been for the US Federal Government to buy up every slave and free them. But Northern working class votes paying taxes to pay off the richest people in the US to generate free labour competitors for themselves while diluting the vote of white Southern males (in places like North Caroline, massively so) was utterly politically unacceptable. 600,000 dead Americans later … (BTW claims that the American Civil War was a fight over tariff policy are so stupid as to be risible: trade policy simply does not matter enough–Australia managed to peacefully federate while politics was bitterly divided between Protectionists and Free traders as the two main Parties.)

    One reason disaster happens is a mixture of complacency and failure of imagination: people simply fail to believe that it could come to [fill in disaster here]. Along with clinging to a certain framing of “necessary principles” in an uncertain world: often, the more uncertain the scary complexities, the more the principles are clung to for reassurance. Particularly if a different potential disaster looms in their imagination (such as hyperinflation).

  15. Gravatar of Essayist-Lawyer Essayist-Lawyer
    19. November 2011 at 17:25

    This post reminds me of the old joke about the national security bureaucrat approaching the President on an international crisis with three options: (1) Unconditional surrender; (2) global thermonuclear war; (3) whatever the bureaucrat really wants to do.

  16. Gravatar of Bogdan Bogdan
    19. November 2011 at 17:28

    Lorenzo from Oz,

    I wasn’t trying to make a value judgement here, and I really don’t see any connexion between the eurozone economic difficulties and the obsessive US North-South historical slavery politics, but maybe this is just me.

    In any case, many people in Europe are aware that there has been a lot of waste during the 2000 decade of ample liquidity, particularly in the periphery of the eurozone, but also in the EU candidate countries to the eurozone of Eastern Europe as well as in Great Britain, in that wages and government transfers outstriped productivity gains. This is a situation that cannot continue indefinetly. There is no question about whether European economies need structural reforms or whether more mobility of the workforce and capital is necessary in order to give eurozone monetary policy more room to manoeuvre, the problem is that in the good years such reforms have been posponed, blocked, avoided and ignored by European politicians for much too long and hence contributed to greatly aggravating the current crisis.

    Both the stringent debt ceiling and the push for more liberalization of the common market were there in order to make the currency union work; it cannot work when debt level skyrocket and politicians start to reverse the liberlizing trande in the name of a social Europe, as has been clearly the case in the last 6-7 years. The consequences are more unsocial.

  17. Gravatar of Jacob Jacob
    19. November 2011 at 18:11

    Anyone else think this is Draghi’s version of a marijuana pipe and a Hawaiian shirt?

  18. Gravatar of David Wright David Wright
    19. November 2011 at 19:14

    I am interested in your take on a variant of option 2. Why couldn’t some PIGS default but stay in the euro? Economicly, I know that’s not generally thought to be the best option. A new currency allows easy bank recapitalization and devaluation to improve competitiveness and spur export-led growth. But politically, most PIGS citizens seem to want to keep the euro even after default. Why are you so sure it can’t play out that way, with the PIGS attempting Baltic-style austerity to balance their budgets and internal devaluation to restore competitiveness and growth?

    For what it’s worth, the original euro treaty appears to endorse this variant. It explicitly said (1) you can’t leave the euro and (2) no one will bail you out. (2) seems at least an implicit acknowledgement that default is possible for a euro country and (1) implies that they won’t leave even after defaulting.

  19. Gravatar of ChrisA ChrisA
    20. November 2011 at 00:55

    Hmm, this is strangely similar to my comment to Tylers post at;

    Did you just plagiarize me? You changed my third option however, to suggest that the ECB try NGDP targeting. As others have noted however I don’t think there is time for this to work anymore. That would solve the long term solvency problem, but not the short term liquidity problem.

  20. Gravatar of Mark A. Sadowski Mark A. Sadowski
    20. November 2011 at 01:05

    Scanning your latest posts all I have to say is good job, spot on, keep up the good work! Haliluliah!!

    As you might imagine things are a little hectic for me these days. The world seems on the verge of a monetary explosion which we should have all forseen.

    P.S. In my educated opinion the ECB will do nothing until it is too late.

  21. Gravatar of Peter N Peter N
    20. November 2011 at 01:47

    It’s to late for solutions that involve changing peoples’ behavior. It’s just too slow. We’re down to days left now.

    Italian bonds are headed for 10%, and there’s a Europe-wide slow motion bank run. The German and especially the French banks are immensely leveraged and hold hundreds of billions of dollars of questionable assets. There’s talk of $1 trillion to recapitalize the European banks (that’s BEFORE the auditors come in and start looking under the rug), and that doesn’t include the cost of propping up the PIIGS, which has to be done, because of the banks enormous sovereign debt exposure (particularly France). An Italian meltdown would bankrupt the banks before they could be recapitalized.

    Europe is as big as the US economically and could find the resources, but it’s not a country, and we see how much this matters.

    Generally widespread bank runs are the last stage before a crash. They have to stop this NOW.

  22. Gravatar of jb jb
    20. November 2011 at 02:46

    I generally agree that more inflation is a better option than bailout, but it seems culturally impossible. But socialists bathe in the waters of moral hazard on a daily basis, and don’t seem to care.

    So what’s a little more? Bail out the PIGS w/a mix of new and old money, and then set more stringent guidelines on managing budgets. That will solve the problem for sure!

    re: MattY:
    He’s definitely one of the better econ-policy bloggers out there, and I’ve enjoyed watching him grow less liberal over time. But I don’t see him going full libertarian – t I like his ‘pragmatic progressivism’ just fine – it raises useful policy objections to libertarian philosophy, and helps me understand a little better how the progressive brain works. If he goes full libertarian, I’ll lose that.

  23. Gravatar of Doc Merlin Doc Merlin
    20. November 2011 at 03:08

    “Do 4% NGDP targeting, level targeting, from 2008. Hopefully the various debt/NGDP ratios get more manageable in a few years.”

    Won’t work as it isn’t a liquidity crisis but an insolvency crisis. Your suggestion would work if it was a liquidity crisis however.

  24. Gravatar of Doc Merlin Doc Merlin
    20. November 2011 at 04:41

    The problem is a solvency problem, not a liquidity problem, so a bailout would not help, anyway.

  25. Gravatar of Money in a Post-Apocalyptic Society « Modeled Behavior Money in a Post-Apocalyptic Society « Modeled Behavior
    20. November 2011 at 06:27

    […] couple of Market Monetarists seem to be suggesting that the ECB should forget about standing as Lender of […]

  26. Gravatar of jm jm
    20. November 2011 at 06:28

    Sure, a lot of guys get more libertarian over time, but what happens after they turn fifteen?

  27. Gravatar of ssumner ssumner
    20. November 2011 at 07:12

    Bogdan, Yes, I specifically talked about level targeting.

    You asked;

    “doesn’t a stable nominal GDP growth level requires external balance adjustments?”


    Morgan, You said;

    “I don’t know a single man who has becomes more liberal as he grows older…”

    I take it you’ve never met Paul Krugman.

    Lorenzo, I entirely agree.

    Essayist-Lawyer, I was thinking of making the same remark.

    Jason, What is “this?”

    David, I agree that that is possible. But how large a default? A big one would bring down the northern banks–so you be right back in bailout territory. Germans would be paying the Italian debt. It’s the third biggest debt in the world. And German debt is already 80% of GDP.

    ChrisA, You asked:

    “Did you just plagiarize me?”

    No, but thanks for the idea. I need to read the better comment sections for new ideas.

    Thanks Mark.

    Peter, I agree that urgent action is needed, but I think monetary stimulus is the most effective of the options. (As it was in 1933.)

    jb, You said;

    “So what’s a little more? Bail out the PIGS w/a mix of new and old money, and then set more stringent guidelines on managing budgets. That will solve the problem for sure!”

    I assume you are being sarcastic.

    Doc Merlin, You said;

    “Won’t work as it isn’t a liquidity crisis but an insolvency crisis. Your suggestion would work if it was a liquidity crisis however.”

    I agree that it is a solvency crisis–which is precisely the point of my proposal to raise NGDP.

  28. Gravatar of dwb dwb
    20. November 2011 at 07:13

    spanish debt-gdp is lower than germany’s (60% vs 80%). But look at the yield differential and ask why does the market think Spain’s debt is unsustainable while Germany’s is.

    I think “moral hazard” and “bailout” is a specious argument here, when it comes to sovereigns (except maybe Greece). debt is sustainable on a reasonable nominal growth path. It’s not sustainable on other, lower, growth paths. moral hazard assumes poor judgement as to riskiness, with the cost being borne by another party. Spain do anything particularly risky compared to France and Germany, in fact it made “reforms” faster than other countries, it merely was hit very hard by a real estate crash and tax receipts dropped.

    The real illogic here, though, is that Germany’s is not sustainable either, if Italy’s and Spain’s isn’t, because Germany is exporting to markets in a recession, and because if Spain and Italy fail then Germany will have to bailout German banks.

    It will be interesting to see what Germany does once the Euro fails. The ensuing recession will kill exports and tax receipts in Germany putting it in a very poor budget situation. moral hazard, hah!

  29. Gravatar of ssumner ssumner
    20. November 2011 at 07:34

    dwb, You said;

    “I think “moral hazard” and “bailout” is a specious argument here, when it comes to sovereigns (except maybe Greece). debt is sustainable on a reasonable nominal growth path. It’s not sustainable on other, lower, growth paths. moral hazard assumes poor judgement as to riskiness, with the cost being borne by another party.”

    I agree about Spain, but the other 4 PIGS behaved vary recklessly with their budget, albeit in different ways. Ireland’s foolish decision was in bailing out bank creditors, which created massive moral hazard. Greece, Italy and Portugal had excessive national debts.

    I agree that falling NGDP growth is the key issue, which turned manageable problems into an immediate crisis.

  30. Gravatar of Peter N Peter N
    20. November 2011 at 08:52


    It’s a matter of time. Your idea might very well have worked a few months ago, and it might still work if the ECB bought some time for it to work.

    Either the central bank lends freely on good credit, or the teacher has to call timeout until the children learn to behave. You’re proposing a 2 or 3 month solution and I doubt you have one month.

    Without the ECB or the Fed, we may see a bank holiday.

  31. Gravatar of flow5 flow5
    20. November 2011 at 09:21

    There is a model. It’s worked since 1915. You know when to push on the gas pedal & when to hit the brakes. Bernanke’s mistakes are obvious. Anyone that made those kind of glaring errors would have been fired if others had looked at the data.

  32. Gravatar of achilleas achilleas
    20. November 2011 at 09:27

    moral hazard should not be considered an issue for countries. It is really stupid to think that a whole country will start behaving reckelessly because of the expected bailout.

    check euro-nomics blog.

  33. Gravatar of flow5 flow5
    20. November 2011 at 09:54


    March 30, 2010: “Been saying this for the last 6 months. Should see shortly. Stock market makes a double top in Jan & Apr. Then the real-output of final goods & services falls/inverts from (9) to (1) from Apr to May.

    Recent history indicates that this will be a marked, short, one month drop, in rate-of-change for real-output (-8). So stocks follow the economy down”

    I.e., Bernanke was completely responsible for the 1000 flash crash. Later it was covered up.

  34. Gravatar of James in London James in London
    20. November 2011 at 11:37


    Just finished “When Money Dies: The Nightmare of the Weimar Hyper-Inflation” by Adam Fergusson. Disaster does happen, as you say. 1923 Germany was quite a big one. The Germans remember it well and who it helped bring into power. Sophisticated economists complaining about the ECB’s apparent credibility hang-up need to refresh their historical knowledge, and how easy it is to put off difficult decisions once a government starts paying for its bills with printed money.

  35. Gravatar of StatsGuy StatsGuy
    20. November 2011 at 12:31

    It seems the Euro area bond market is undergoing a titanic margin call right now. Those bonds are levered 25 to 1 under Basel rules as AAA instruments – official downgrade or no, banks are selling to try to shore up capital requirements.

    This is a replay of 2008 from the Euro side – the ECB might have learned, or it might decide not to do anything until the banks are under direct and immediate threat.

    Scott – German sovereign debt is not much better than French or Spanish, really, though the export economy seems in better shape. But the markets have decided that the Bund is the “flight to safety” asset. We’re witnessing a bank run… by the banks.

    I can understand the ECB wanting to see fiscal reform before monetizing anything, but they’ve given no signal that they will even selectively support regimes that do commit to changes.

  36. Gravatar of flow5 flow5
    20. November 2011 at 12:36

    Right now MVt shows that the economy is set to collapse in June 2012.

  37. Gravatar of Becky Hargrove Becky Hargrove
    20. November 2011 at 16:06

    James in London,
    “When Money Dies” was a really good book, but sometime it does seem that nations have overreacted to the story it told.

  38. Gravatar of Lorenzo from Oz Lorenzo from Oz
    21. November 2011 at 04:41

    Bogdan: my American Civil War example is merely an illustrative one, useful because it is a democratic politics example of particular intensity. The point is that disaster can happen, there is nothing to say the eurozone’s problems will be resolved successfully.

    The rest of what you say in your comment seems perfectly sensible, except to reiterate Scott’s perennial point that income falls make dealing with debt harder.

  39. Gravatar of Lorenzo from Oz Lorenzo from Oz
    21. November 2011 at 04:44

    James in London: to make the point that Scott makes in a later post — hyperinflation did not bring the Nazis to power, deflation did.

    Also, the hyperinflation bogey is just that, a misleading bogey. Hyperinflation is a deliberate act of government policy, there is no reason to think it is at all likely either in the US or in the eurozone. Debt crunches from income well below trend–that is clearly a problem.

  40. Gravatar of ssumner ssumner
    21. November 2011 at 12:32

    Peter, It’s worth noting that FDR’s expansionary monetary policy of 1933 brought a quick end to the banking crisis–although other things were also done, so it’s hard to separate out individual causal factors.

    I certainly agree that the ECB and Fed need to act decisively, and I’d add that there is zero chance they do as much as I think is needed. So unfortunately my proposal will never be tested.

    But I don’t think it is too late. Just too little.

    achilleas, I am talking about governments, for which moral hazard is a huge problem–I should not have implied countries.

    James, I hope the Germans don’t think inflation brought the Nazis to power. It was very clearly deflation that brought them to power. They were a minor footnote as late as 1929–six years after the hyperinflation. After 4 years of deflation (1929-33) they took power.

    Statsguy. I agree. A reasonable compromise might be for then to buy everything, in proportion to each countries GDP. They actually wouldn’t have to buy much to restore confidence if there was a credible policy of much faster NGDP growth.

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