How the Fed Can Save the World
It is a truism to say the world economy is in crisis and has been since the Lehman bankruptcy induced crash of 2008. As in most such cases different experts offer different sets of causes, divided more by prior ideology than observed facts. So let us put ideology aside and start with facts. This is a financial or balance sheet crisis as happened in 1929, not a business cycle contraction as the world is more used to dealing with.
This is the first such worldwide collapse since 1929. There have been such implosions on a national level [Japan, Sweden, Mexico to name three of the most well known] since WW2 but this is the first global incident since the Great Depression. Some causes of this year’s specific relapse are transitory and part of the nature of the world. The Japanese Tsunami, the Arab spring’s run-up of oil prices, the BP oil spill of last summer are all the sort of one-offs that are part of the human condition. There is no policy cure for them. The best one can do is take actions at the margin to mitigate their effects.
In reverse the long term global structural problems [Asian mercantilism, a German economy geared to manufacturing exports, the worldwide flood of hot money that the perpetual export surpluses of these and OPEC produce, the over reliance of the Anglo-American economies on consumption and finance, the huge OPEC generated surpluses of a handful of oil exporting states, a neoliberal Washington consensus that at its core thinks the whole world can get rich running a trade surplus with the US, the gridlock in the US political system that precludes any serious budgetary relief from a medium term debt implosion] have no easy, fast solutions. Experts different on the solutions and all possibilities are both painful in the short run and trample on established interests. In the medium term all of these need attention but this has been true for a generation.
However there is one recurrent source of massive instability that can be dealt with. The on-going collapse of the Euro project is destabilizing the world and risks another Lehman moment where the entire system freezes and implodes over counterparty risks. It was obvious at the time of creation that the Euro project was a leap in the dark. The ERM worked because the burden was on the other nations to match Germany’s fiscal and monetary policy. The other ERM currencies became de facto DM’s by staying within the snake. When this proved impossible [UK, Italy 1992] nations dropped out of the snake and suffered accordingly. The Euro project reversed this. Once in there was no visible mechanism to expel wayward members. The so-called terms [on budget deficits, debt etc.] were near immediately shown to be bogus as France and Germany would not apply the terms to themselves. This in itself could have be accepted if the Euro had been restricted to the Rhine 5. For political reasons the French pushed the Euro project to fringe countries whose fiscal abilities were always suspect. We now have a rolling series of implosions on the PIIGS.
These implosions expose the root problem of the Euro project. There is neither a common treasury nor a central bank on the level of the US Federal Reserve. Europe has near choked on dealing with tiny Greece and Portugal [a very good case can be made that Eire is different as the EU is engaged in a disguised bailout of its own banks who own most of the Irish bank debt that Eire nationalized and whose nationalization Is why Eire requires a bailout – absent such a nationalization Eire has both a budget and a trade/payments surplus]. All three of these are small and peripheral to the European project. The next two targets of market speculation [Spain, Italy] are not. They are two of the larger economies in the world. Bailing these out will require heavy lifting, possibly more heavy lifting than the current European institutional structure [and the patience of the German voting public] will permit. Yet a firewall is needed.
The analogy becomes the Mexican bailout of 1995, http://en.wikipedia.org/wiki/1994_economic_crisis_in_Mexico#Financial_assistance_package , http://en.wikipedia.org/wiki/Robert_Rubin#1990s_global_financial_crisis , where the USG created a firewall by keeping Mexico afloat. Spain should be left to the EU to handle. Its politics are more poisonous [including a looming national election, a fiscal civil war between the lame duck Socialist central government and the near bankrupt regional governments many of whom are now in the hands of the Popular Party opposition, and a property bust that dwarfs US real estate troubles]. Brussels, Frankfort and the Rhine axis should be left with this tar baby, as they have the most investment in the European project and indeed in a governable Spain that has not split into its component regions.
Italy has a long term fiscal problem from mammoth national debt, a static rigid economy, an aging population and a political leader drowning in immense political, personal and financial scandals. It has also shown an ability to service such sky high debt levels for a generation [1980’s]. Italy runs a primary budget surplus [public spending before interest payments]. It is on the road to a surplus net of interest within the next few years. It has a de facto near two party system with both parties committed to fiscal rectitude, albeit with different formulas of how to reach the goal. It has a set of technocratic financial experts who can guide this regardless of which coalition is in power.
If the Fed undertook to make Italy a firewall the speculative attack on the Euro ends with Spain. If the Feds stands ready to be buyer of last resort for Italian funding needs at an agreed rate of say 2% it will return large profits to the US treasury. It will focus the EU institutions on saving or severing the other four PIGS [one less I for Italy being the firewall]. As long as Italy holds we probably avoid a Lehman moment where banks on both sides of the Atlantic suddenly discover how much counterparty risk they have.
This plan would create a political firestorm in the US from the usual Paulite Fed haters. Every option has political risks and Paul’s following while loud is also a fringe wing of the US right. There is also the currency risk involved. Italy would have to fund its needs in dollars to the Fed and then buy futures to limit its exposure. In the context of a currency market that trades in trillions of dollars a day even a trillion dollars of such risk spread at maturities over a five year period [the probable need for the firewall] is handalable.
For those who would say this is not the US’s problem, look at the effects each Euro crisis of the past two years has had on US financial markets. Then compare the size of the Greek and Portuguese economies and foreign debt to that of Italy and Spain. The two of them together might not crash the world system beyond hope of recovery. Might not but does anyone like the size of the bet? In 2008 the US authorities gave in to the orthodox claims of moral hazard and limits of legal authority. They let Lehman fail. We are still living in the wreckage of that decision. This crash would probably be larger and the system being crashed is far more vulnerable. QED.
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