Friday, 13 July 2012

If the desire is to save the Euro you wouldn't start from where we are now

Paul Krugman, who must be on a promotion tour for his book as he has been showing up for lots of TV interviews recently, was recently interviewed by Joe Wiesenthal and a clip entitled How the Euro crisis will end can be found on youtube here

In a nutshell Krugman's verdict on the fate of the single currency is that it hangs in the balance - he puts it at 50/50 - between a series of bank runs in the peripheral nations of the Eurozone which would lead to a complete disintegration, and a very hard to contemplate climbdown by the Bundesbank and the German government which would open the way for the ECB to backstop all of the sovereign debt of the troubled Eurozone states.

My point with this brief piece is not to opine on which is the more likely scenario, but rather to dwell on the closing comment from the interview in which Krugman makes the point that neither option is acceptable to Germany. In other words the German government and financial establishment are faced with an unpalatable dilemma.

A slightly different perspective on the unpalatable and very hard choice faced by the German authorities was also expressed by Dirk Schumacher, Senior European Economist at Goldman Sachs in the following quote:

"At the core of the reluctance of Germany to agree to some form of debt mutualization is the fear that this will lead to lesser efforts or even an abandonment of the reform course. Attaching conditions to debt mutualization cannot overcome this problem since – as this crisis has shown – sovereign countries cannot be forced to stick to past agreements if the population turns against them. Thus, the reluctance of Germany to “sign up” at this point makes sense: writing a blank check without having the necessary controls in place to ensure that it is used appropriately is only going to create problems down the road. Despite these obstacles, there is a strong consensus in the political class that a break up of EMU would have an immensely negative impact on Germany. But this does not mean that Germany will try to save the Euro at any cost."

Increasingly policy makers, not just in Europe, are being faced with a series of options all of which are "unacceptable". When confronted with such a policy bind there is a natural tendency for those who have to make policy announcements to do their utmost to avoid disambiguating the choices, and continue to prevaricate and play for time.

As long as messages from central bankers and policy makers can remain ambiguous, providing asymmetric information, then the prevailing paradigm of bipolar risk on/risk off asset allocations should enable systemic liquidity to be preserved. Unfortunately, today’s global financial system has become so interconnected, and the returns from most asset classes are so highly-correlated, that investors and asset managers, to a much larger degree than previously, are essentially undiversified and subject to systemic risk. Should market developments and signals become symmetrically disadvantageous then a more substantial systemic crisis than that seen in 2008 is a real possibility.

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