I believe that misconceptions play a large role in shaping history, and the euro crisis is a case in point.
Let me start my analysis with the previous crisis, the bankruptcy of Lehman Brothers. In the week following September 15, 2008, global financial markets actually broke down and by the end of the week they had to be put on artificial life support. The life support consisted of substituting sovereign credit—backed by the financial resources of the state—for the credit of financial institutions that had ceased to be acceptable to counterparties.
As Mervyn King of the Bank of England explained, the authorities had to do in the short term the exact opposite of what was needed in the long term: they had to pump in a lot of credit, to replace the credit that had disappeared, and thereby reinforce the excess credit and leverage that had caused the crisis in the first place. Only in the longer term, when the crisis had subsided, could they drain the credit and reestablish macroeconomic balance.
This required a delicate two-phase maneuver—just as when a car is skidding, first you have to turn it in the direction of the skid and only when you have regained control can you correct course. The first phase of the maneuver was successfully accomplished—a collapse has been averted. But the underlying causes have not been removed and they surfaced again when the financial markets started questioning the creditworthiness of sovereign debt. That is when the euro took center stage because of a structural weakness in its constitution. But we are dealing with a worldwide phenomenon, so the current situation is a direct consequence of the crash of 2008. The second phase of the maneuver—getting the economy on a new, better course—is running into difficulties.
The situation is eerily reminiscent of the 1930s. Doubts about sovereign credit are forcing reductions in budget deficits at a time when the banking system and the economy may not be strong enough to do without fiscal and monetary stimulus. Keynes taught us that budget deficits are essential for countercyclical policies in times of deflation, yet governments everywhere feel compelled to reduce them under pressure from the financial markets. Coming at a time when the Chinese authorities have also put on the brakes, this is liable to push the global economy into a slowdown or possibly a double dip. Europe, which weathered the first phase of the financial crisis relatively well, is now in the forefront of causing the downward pressure because of the problems connected with the common currency.
The euro was an incomplete currency to start with. In 1992, the Maastricht Treaty established a monetary union without a political union. The euro boasts a common…
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