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Wolf's howl: The euro zone has failed

One of the global economy's best brains lays out Europe's "intolerable options."
Euro zone debt crisis 03 06 2011Enlarge
Protesters run from tear gas during clashes which broke out at a march in Athens on Feb. 23, 2011. Greece was hit with a general strike against government austerity measures as Prime Minister George Papandreou seeks to convince the cash-strapped country's euro zone partners to extend the repayment of a massive rescue loan. (Louisa Gouliamaki/AFP/Getty Images)

When it comes to understanding the complex workings of the global economy, it's hard to beat Financial Times economics commentator Martin Wolf.

So when Wolf says the euro zone has "failed," you should probably pay attention.

Here's how he starts his piece today in the FT, which is subscription only:

"The eurozone, as designed, has failed. It was based on a set of principles that have proved unworkable at the first contact with a financial and fiscal crisis. It has only two options: to go forwards towards a closer union or backwards towards at least partial dissolution. This is what is at stake."

That's because the euro zone was constructed — in part — to bring Europe's disparate economies closer together so a single monetary policy would make sense across the entire bloc.

Here's how Wolf explains it:

"The eurozone was supposed to be an updated version of the classical gold standard. Countries in external deficit receive private financing from abroad. If such financing dries up, economic activity shrinks. Unemployment then drives down wages and prices, causing an “internal devaluation”. In the long run, this should deliver financeable balances in the external payments and fiscal accounts, though only after many years of pain."

So what's the problem now?

Mostly that borrowing comes from banks, many of which are now in big trouble. "When the crisis comes, liquidity-starved banking sectors start to collapse," Wolf writes. "Credit-constrained governments can do little, or nothing, to prevent that from happening. This, then, is a gold standard on financial sector steroids."

So that leaves Europe with two "intolerable options," Wolf argues:

"The eurozone confronts a choice between two intolerable options: either default and partial dissolution or open-ended official support. The existence of this choice proves that an enduring union will at the very least need deeper financial integration and greater fiscal support than was originally envisaged. How will the politics of these choices now play out? I truly have no idea. I wonder whether anybody does."

Paul Krugman picked up Wolf's theme in the New York Times:

"One way to summarize (Wolf's) argument is to say that slow-motion bank runs are already in progress in the European periphery, and that these countries’ banking systems are being sustained only by a process in which, say, Ireland’s central bank borrows from the Bundesbank and then lends the funds on to Irish private banks to replace the fleeing deposits."

It only gets gloomier from here, Krugman agrees.

"You can see why we’re now at the panic stage. The Bundesbank is already very upset about its large claims on troubled debtors, which are backed by sovereign debt as collateral. Yet if financing stops in the wake of a debt restructuring, the result will be to collapse the debtor nations’ banking systems, a process Martin believes would lead to their ejection from the euro. (He makes me look like an optimist!)

So the ECB keeps saying that restructuring is unthinkable. Yet austerity programs are not working; the prospect of a return to normal financing is receding rather than approaching.

If you ask me, the water level has now dropped so far that the fuel rods are exposed. We really are in meltdown territory."

http://www.globalpost.com/dispatches/globalpost-blogs/macro/eurozone-failure-wolf