Thursday, May 06, 2010

The Easily Solved EU Contagion Problem

As you may have noticed today, financial markets suffered yet another panic attack today related to the issue of Southern European debt. Unless action is taken, this problem will likely only get worse, because of the self-fulfilling prophecy mechanism, which is to say in this case that fears of default drives yields higher, and then the higher yields helps further boost those fears, which in turn increases yields further, which in turn further raises default fears which in turn further raises yields and so on in a vicious spiral.

Thus, at this point, the primary problem isn't the large deficits but the vicious spiral self-fulfilling mechanisms, something which is illustrated by the fact that bonds from the governments of the United States, Japan, France and even Britain are considered "safe havens" while Italian bonds are considered risky even though Italy had in fact a much lower deficit than these other countries.

If this continues, then the economies of Europe and to a lesser extent the rest of the world will suffer. Isn't there something that could be done to break this vicious spiral? Yet, it is, and it is surprisingly easy.

All EU leaders need to do is to essentially extend the problem-solving mechanism I discussed for Greece to all euro area countries, which is to say the ability to borrow at 5% in case you can't borrow cheaper on your own in return for pledges of significant austerity measures.
Since this is an arbitrage, and not a subsidy scheme, there is nothing economically unsustainable or irrational about this, no matter how many hundreds of billions of euros it requires. Greater sums will in fact only mean higher interest income for lenders like Germany and lower interest costs for borrowers like Spain or Greece in this arbitrage arrangement.

As a result of this Germany will be able to lower taxes for its citizens using the interest income, while borrowing countries will be able to whether the panic as they reduce their deficits under orderly conditions. It remains to be seen however, whether or not EU leaders will be rational enough to defuse this threat to the economic recovery in this simple way. Whether or not they respond in this way will be a simple test of how rational they are.