[Debate] (Fwd) Roberts on Euro crisis, Soros on 'Target2' danger; both stress German centralised neolib quandary

[Patrick Bond]

    The euro end game?
    <http://thenextrecession.wordpress.com/2012/06/05/the-euro-end-game/>


by michael roberts

The crisis of the euro seems to be heading to another climax, perhaps 
even to the end game.  Banks and other purchasers of government bonds 
increasingly refuse to buy more Spanish government paper, driving the 
cost of borrowing each extra euro for the Spanish government towards 8% 
a year, an interest cost that will make it impossible to meet the fiscal 
targets on the budget deficit and the public debt set by the Euro 
leaders.  At the same time, corporations and households are beginning to 
worry about the safety of their cash deposits in Spanish banks, as they 
are told every day in the press that these banks are holding huge 
amounts of bad debts from defaults on mortgages and loans to building 
developers, now that the Spanish property bubble has burst big time.  So 
deposits are leaking out of the Spanish banking system - nearly EUR100bn 
in the last three months (see graph below) - a similar sort of pace that 
the Greek banks have experienced in recent months.


It looks increasingly likely, despite the desperate efforts of the 
Spanish government to avoid it, that Spain will have to ask for Eurozone 
funding to get it through its loss of ability to borrow in bond 
markets.  But here's the problem.  Spain's government would need about 
EUR500bn over the next three years (budget deficit: EUR130bn; sovereign 
bond rollovers EUR150bn; regional debt rollovers EUR100bn; T-bills 
EUR75bn and bank recap EUR100-130bn).  The bond markets are not closed 
to Spain yet, but even allowing for this, the combination of budget 
deficit, regional and bank re-financing would add up to EUR330bn.  If 
you add in Italy, which the markets would focus on next, that could be 
another EUR400bn.  If that amount has to come from the existing Eurozone 
fund mechanisms, the EFSF (the current temporary funding mechanisms) and 
ESM (the permanent one supposedly starting in July), it will use up all 
the funds being contributed by the Eurozone governments and borrowed by 
them in the bond market.

Spain will then have to comply with draconian fiscal measures demanded 
by the dreaded Troika, just as Greece, Ireland and Portugal have to 
now.  And, given the difficulties that the Troika programmes are having 
in trying to meet the fiscal targets set, despite the huge efforts of 
these governments to impose austerity on their people, private sector 
creditors are not convinced that they will work.  Instead, after Spain, 
Italy would come into the firing line.  And if Italy is forced into a 
bailout, the game would be up.  There is just not enough money in the 
current Euroland kitty to handle that for three years.

On top of this, of course, is the serious risk that the Greek people 
will elect a government totally opposed to its existing Troika austerity 
package, or at best pledged to 'renegotiate' the package.  Then that 
would pose the issue for the Euro leaders about whether to continue to 
finance Greek banks and the Greek government through the ECB and the 
EFSF.  If that ceased, then Greece would default and the issue of its 
exit from the euro would become immediate.

The Greeks are furious.  A recent poll showed that 42% of Greeks 'blame 
themselves' for their situation as opposed to only 26% of Spaniards and 
only 19% of Italians and Britons.  They are really referring to their 
leaders, in both public and economic circles.  The poll also found that 
the Greeks thought they are the hardest workers in Europe.  And as I 
have reported before in other posts (see /An alternative programme for 
Europe,/ 11 September 2011), the statistics show that in 2010 a Greek 
worker worked an average 2,109 hours per year, well  ahead of the 
average slacking German who works only 1,419 hours and ahead of the UK 
worker (1,647 hours) and indeed even the two-week holidaying US worker 
(1,778 hours, incidentally the same hours as Italy!).   So the answer to 
why Greeks think they are the hardest workers in Europe is simple. The 
Greeks think they are the hardest workers because they are!  The Greeks' 
economic misfortune is attributable to other factors (e.g. low tax 
collection and corruption from the rich and lack of capital investment 
by the weak Greek capitalist sector among other things) and not due to 
the stereotypical laziness of the nation that so suits the German tabloids.

Also 80% of Greeks want to stay in the euro.  They know that leaving the 
Eurozone and the European Union would be no solution.  Re-adoption and 
devaluation of the drachma would cause the value of Greece's government 
debt, already at 160% of GDP, to soar, probably doubling or trebling.  
So any devaluation would have to be followed by a default.   Also, 
devaluation would not save Greece's exports of shipping charters -- 
which are priced in dollars anyway -- but default would cause great harm 
to Greek banks and Greek savers who own the greatest proportion of Greek 
government bonds. They would be wiped out by an outright default. 
Converting their assets and liabilities into drachmas, like the 
pesofication of deposits in 2000 in Argentina, might keep Greek savers 
and banks afloat for a while.  But a huge devaluation would also drive 
up inflation, making Greek savings worthless.

The point is that Greece's real income and wealth will fall sharply in 
any case, regardless of whether Greece exits the Eurozone or not. The 
choice is between an economic slump with inflation or one without 
inflation. A devalued drachma will not help Greece's economy recover 
faster from the deep recession. In the last drachma period before 2001, 
there was a recurrence of currency crises resolved through devaluations 
that did not improve the 'competitiveness' of Greek capitalism on a 
lasting basis.  Indeed, no country has ever devalued its way to 
prosperity. What Greece needs is relief on its burden of debt and new 
investment in technology and jobs, not devaluation.

If Greece drops out of the Eurozone, the inevitable adjustment to a 
lower standard of living will be unfairly distributed because it will 
happen through inflation. Citibank economists have estimated that Greece 
would experience 20% inflation and a 20% decline in GDP from 2007 to 
2016 (see graph below).  The majority of working Greeks are the most 
exposed to inflation because they do not own foreign bank accounts or 
other inflation-protected assets. It is also doubtful that Greece would 
attract much investment from abroad. Who would guarantee the stability 
of the drachma after its devaluation? No Greek exporter, hotel, or 
restaurant would convert euro income into drachmas, knowing that the 
drachma tomorrow would be worth less each day. The drachma would be the 
main currency for government employees and pensioners only.

The flipside is that 'letting Greece go' will also hit the rest of the 
Eurozone, with direct losses of up to 5% of Eurozone GDP, along the 
dynamic losses of output and incomes (see my post, /Greece: heading for 
the exit?/, 17 May 2012).

So is there any way out for the Euro leaders from a Greek exit, a 
Spanish and Italian bailout and the eventual break-up of the euro?  
Well, the history of currency unions that have survived like the US 
dollar or the UK pound shows that they only do so after political as 
well as economic integration.  Political means moving to a federal 
government where the fiscal powers of the centre are strong enough to 
control the bulk of taxation and spending - a fiscal union.  Economic 
means a banking system that is integrated across all the region.  Both 
the US and the UK took hundreds of years of conflict and agreements to 
achieve that. The US dollar is a 'successful' union of 50 states after a 
turbulent history of more than 200 years that included defaults of eight 
US states on sovereign debt in the early 1840s; the Civil War; the 
emergence of the Fed as a key institution and the greater fiscal role of 
the federal system following the Second World War. The Eurozone is a 
'baby union', facing its first major crisis.

The Euro leaders need to find a way to move towards fiscal union and a 
pan-European banking system.  Fiscal union would mean that budgets, 
taxation and spending policies would be decided by a supranational 
body.  Banking union would mean a a pan-European government guaranteeing 
bank deposits (to stop a run on banks) plus a pan-European regulator to 
impose common rules for capital and risk.  Then the ECB could become a 
proper lender of last resort for European banks and governments, as the 
US Fed, UK Bank of England or the Bank of Japan are.  At the moment, the 
ECB is not legally able to be so or willing to do so, when there is no 
fiscal union.

This euro crisis has created powerful centrifugal forces that threaten 
to kill the baby euro currency union in its relative infancy.  The 
extent of these forces is revealed by the 'Target 2' settlements between 
the various central banks of the Eurosystem.  These are the net balances 
of euro credits and debits in the various countries in the Eurozone.  
Before the crisis began, there was little or no difference between the 
German Bundesbank's net balance of claims or liabilities with the 
ECB/Eurosystem than that for the Bank of Greece.  But now the Bundesbank 
has a massive credit with the Eurosystem, while the peripheral weak 
states in the euro area have combined accumulated net liabilities of 
equivalent size (see graph below).
<http://thenextrecession.files.wordpress.com/2012/06/target2-net-balance-500x379.gif>

What this shows is that the trade deficits being run by the likes of 
Greece, Spain or Italy with the likes of Germany and Holland are no 
longer being funded by cross-border private sector bank loans or 
corporate investment.  German banks will not lend to Greek banks and 
German corporations have stopped investing in Greece,  So the deficits 
are having to be covered by each national bank printing euros and 
lending this to importers and banks in the weak deficit economies.  That 
is a necessary process as long as the euro is one currency, where a 
Greek euro is equivalent to a German euro.  Stopping this funding would 
mean the end of the currency union.  But the fast-growing imbalances in 
Target 2 settlements show that the currency union is being stretched to 
breaking point.

Achieving fiscal union and banking integration are momentous tasks in 
such a short time -  and time is running out.  The 'financial markets' 
(banks, pension funds hedge funds and the rest) may still be convinced 
that a euro break up can be avoided if the bailout funds are doubled and 
there is a euro-wide agreement to support Spain and Italy through their 
austerity measures, along with new fiscal controls.

But as Mick Brooks put it in his excellent account of the euro crisis 
(/http://www.karlmarx.net/topics/europe/thecrisisofcapitalismandtheeuro/),"/the 
EU decision-making process is hopelessly flawed. .... The survival of 
the Euro is not, and never was, a matter of pure capitalist economic 
rationality. No such thing exists. The Euro's future will be the outcome 
of a complex interaction of political and economic factors. (We may 
have) underestimated the collective stupidity of the EU authorities  .. 
(so) the Euro's survival hangs by a thread."/

Apparently, the Euro leaders are drawing up plans to move towards fiscal 
and banking integration in time for discussion at the Euro summit at the 
end of this month.  But the Germans will only agree to a banking union 
and ECB support for Spain and Italy if the measures for fiscal union and 
more supranational control over government taxes and spending are 
agreed.  The French want the former, but not the latter.  They want 
German money, but not German control.  The Germans want more control for 
more money.  Mrs Merkel could not sell more funding to her electorate 
without that.  Things are coming to a head.


***

*George Soros Remarks*

*Festival of Economics*

*June 2, 2012*

*Trento, Italy*

Ever since the Crash of 2008 there has been a widespread recognition, 
both among economists and the general public, that economic theory has 
failed. But there is no consensus on the causes and the extent of that 
failure.

I believe that the failure is more profound than generally recognized. 
It goes back to the foundations of economic theory. Economics tried to 
model itself on Newtonian physics. It sought to establish universally 
and timelessly valid laws governing reality. But economics is a social 
science and there is a fundamental difference between the natural and 
social sciences. Social phenomena have thinking participants who base 
their decisions on imperfect knowledge. That is what economic theory has 
tried to ignore.

Scientific method needs an independent criterion, by which the truth or 
validity of its theories can be judged. Natural phenomena constitute 
such a criterion; social phenomena do not. That is because natural 
phenomena consist of facts that unfold independently of any statements 
that relate to them. The facts then serve as objective evidence by which 
the validity of scientific theories can be judged. That has enabled 
natural science to produce amazing results.

Social events, by contrast, have thinking participants who have a will 
of their own.  They are not detached observers but engaged decision 
makers whose decisions greatly influence the course of events. Therefore 
the events do not constitute an independent criterion by which 
participants can decide whether their views are valid. In the absence of 
an independent criterion people have to base their decisions not on 
knowledge but on an inherently biased and to greater or lesser extent 
distorted interpretation of reality. Their lack of perfect knowledge or 
fallibility introduces an element of indeterminacy into the course of 
events that is absent when the events relate to the behavior of 
inanimate objects. The resulting uncertainty hinders the social sciences 
in producing laws similar to Newton's physics.

Economics, which became the most influential of the social sciences, 
sought to remove this handicap by taking an axiomatic approach similar 
to Euclid's geometry. But Euclid's axioms closely resembled reality 
while the theory of rational expectations and the efficient market 
hypothesis became far removed from it. Up to a point the axiomatic 
approach worked. For instance, the theory of perfect competition 
postulated perfect knowledge. But the postulate worked only as long as 
it was applied to the exchange of physical goods. When it came to 
production, as distinct from exchange, or to the use of money and 
credit, the postulate became untenable because the participants' 
decisions involved the future and the future cannot be known until it 
has actually occurred.

I am not well qualified to criticize the theory of rational expectations 
and the efficient market hypothesis because as a market participant I 
considered them so unrealistic that I never bothered to study them. That 
is an indictment in itself but I shall leave a detailed critique of 
these theories to others.

Instead, I should like to put before you a radically different approach 
to financial markets. It was inspired by Karl Popper who taught me that 
people's interpretation of reality never quite corresponds to reality 
itself. This led me to study the relationship between the two. I found a 
two-way connection between the participants' thinking and the situations 
in which they participate. On the one hand people seek to understand the 
situation; that is the cognitive function. On the other, they seek to 
make an impact on the situation; I call that the causative or 
manipulative function. The two functions connect the thinking agents and 
the situations in which they participate in opposite directions. In the 
cognitive function the situation is supposed to determine the 
participants' views; in the causative function the participants' views 
are supposed to determine the outcome. When both functions are at work 
at the same time they interfere with each other. The two functions form 
a circular relationship or feedback loop. I call that feedback loop 
reflexivity. In a reflexive situation the participants' views cannot 
correspond to reality because reality is not something independently 
given; it is contingent on the participants' views and decisions. The 
decisions, in turn, cannot be based on knowledge alone; they must 
contain some bias or guess work about the future because the future is 
contingent on the participants' decisions.

Fallibility and reflexivity are tied together like Siamese twins. 
Without fallibility there would be no reflexivity -- although the 
opposite is not the case: people's understanding would be imperfect even 
in the absence of reflexivity. Of the two twins, fallibility is the 
first born. Together, they ensure both a divergence between the 
participants' view of reality and the actual state of affairs and a 
divergence between the participants' expectations and the actual outcome.

Obviously, I did not discover reflexivity. Others had recognized it 
before me, often under a different name. Robert Merton wrote about 
self-fulfilling prophecies and the bandwagon effect, Keynes compared 
financial markets to a beauty contest where the participants had to 
guess who would be the most popular choice. But starting from 
fallibility and reflexivity I focused on a problem area, namely the role 
of misconceptions and misunderstandings in shaping the course of events 
that mainstream economics tried to ignore. This has made my 
interpretation of reality more realistic than the prevailing paradigm.

Among other things, I developed a model of a boom-bust process or bubble 
which is endogenous to financial markets, not the result of external 
shocks. According to my theory, financial bubbles are not a purely 
psychological phenomenon.  They have two components: a trend that 
prevails in reality and a misinterpretation of that trend. A bubble can 
develop when the feedback is initially positive in the sense that both 
the trend and its biased interpretation are mutually reinforced. 
Eventually the gap between the trend and its biased interpretation grows 
so wide that it becomes unsustainable. After a twilight period both the 
bias and the trend are reversed and reinforce each other in the opposite 
direction. Bubbles are usually asymmetric in shape: booms develop slowly 
but the bust tends to be sudden and devastating. That is due to the use 
of leverage: price declines precipitate the forced liquidation of 
leveraged positions.

Well-formed financial bubbles always follow this pattern but the 
magnitude and duration of each phase is unpredictable. Moreover the 
process can be aborted at any stage so that well-formed financial 
bubbles occur rather infrequently.

At any moment of time there are myriads of feedback loops at work, some 
of which are positive, others negative. They interact with each other, 
producing the irregular price patterns that prevail most of the time; 
but on the rare occasions that bubbles develop to their full potential 
they tend to overshadow all other influences.

According to my theory financial markets may just as soon produce 
bubbles as tend toward equilibrium. Since bubbles disrupt financial 
markets, history has been punctuated by financial crises. Each crisis 
provoked a regulatory response. That is how central banking and 
financial regulations have evolved, in step with the markets themselves. 
Bubbles occur only intermittently but the interplay between markets and 
regulators is ongoing. Since both market participants and regulators act 
on the basis of imperfect knowledge the interplay between them is 
reflexive. Moreover reflexivity and fallibility are not confined to the 
financial markets; they also characterize other spheres of social life, 
particularly politics. Indeed, in light of the ongoing interaction 
between markets and regulators it is quite misleading to study financial 
markets in isolation. Behind the invisible hand of the market lies the 
visible hand of politics. Instead of pursuing timeless laws and models 
we ought to study events in their time bound context.

My interpretation of financial markets differs from the prevailing 
paradigm in many ways. I emphasize the role of misunderstandings and 
misconceptions in shaping the course of history. And I treat bubbles as 
largely unpredictable. The direction and its eventual reversal are 
predictable; the magnitude and duration of the various phases is not. I 
contend that taking fallibility as the starting point makes my 
conceptual framework more realistic. But at a price: the idea that laws 
or models of universal validity can predict the future must be abandoned.

Until recently, my interpretation of financial markets was either 
ignored or dismissed by academic economists. All this has changed since 
the crash of 2008. Reflexivity became recognized but, with the exception 
of Imperfect Knowledge Economics, the foundations of economic theory 
have not been subjected to the profound rethinking that I consider 
necessary. Reflexivity has been accommodated by speaking of multiple 
equilibria instead of a single one. But that is not enough. The 
fallibility of market participants, regulators, and economists must also 
be recognized.  A truly dynamic situation cannot be understood by 
studying multiple equilibria.  We need to study the process of change.

The euro crisis is particularly instructive in this regard. It 
demonstrates the role of misconceptions and a lack of understanding in 
shaping the course of history. The authorities didn't understand the 
nature of the euro crisis; they thought it is a fiscal problem while it 
is more of a banking problem and a problem of competitiveness. And they 
applied the wrong remedy: you cannot reduce the debt burden by shrinking 
the economy, only by growing your way out of it. The crisis is still 
growing because of a failure to understand the dynamics of social 
change; policy measures that could have worked at one point in time were 
no longer sufficient by the time they were applied.

Since the euro crisis is currently exerting an overwhelming influence on 
the global economy I shall devote the rest of my talk to it. I must 
start with a warning: the discussion will take us beyond the confines of 
economic theory into politics and the dynamics of social change. But my 
conceptual framework based on the twin pillars of fallibility and 
reflexivity still applies. Reflexivity doesn't always manifest itself in 
the form of bubbles. The reflexive interplay between imperfect markets 
and imperfect authorities goes on all the time while bubbles occur only 
infrequently. This is a rare occasion when the interaction exerts such a 
large influence that it casts its shadow on the global economy. How 
could this happen? My answer is that there is a bubble involved, after 
all, but it is not a financial but a political one. It relates to the 
political evolution of the European Union and it has led me to the 
conclusion that the euro crisis threatens to destroy the European Union. 
Let me explain.

I contend that the European Union itself is like a bubble. In the boom 
phase the EU was what the psychoanalyst David Tuckett calls a "fantastic 
object" -- unreal but immensely attractive. The EU was the embodiment of 
an open society --an association of nations founded on the principles of 
democracy, human rights, and rule of law in which no nation or 
nationality would have a dominant position.

The process of integration was spearheaded by a small group of far 
sighted statesmen who practiced what Karl Popper called piecemeal social 
engineering. They recognized that perfection is unattainable; so they 
set limited objectives and firm timelines and then mobilized the 
political will for a small step forward, knowing full well that when 
they achieved it, its inadequacy would become apparent and require a 
further step. The process fed on its own success, very much like a 
financial bubble. That is how the Coal and Steel Community was gradually 
transformed into the European Union, step by step.

Germany used to be in the forefront of the effort. When the Soviet 
empire started to disintegrate, Germany's leaders realized that 
reunification was possible only in the context of a more united Europe 
and they were willing to make considerable sacrifices to achieve it.  
When it came to bargaining they were willing to contribute a little more 
and take a little less than the others, thereby facilitating agreement.  
At that time, German statesmen used to assert that Germany has no 
independent foreign policy, only a European one.

The process culminated with the Maastricht Treaty and the introduction 
of the euro. It was followed by a period of stagnation which, after the 
crash of 2008, turned into a process of disintegration. The first step 
was taken by Germany when, after the bankruptcy of Lehman Brothers, 
Angela Merkel declared that the virtual guarantee extended to other 
financial institutions should come from each country acting separately, 
not by Europe acting jointly. It took financial markets more than a year 
to realize the implication of that declaration, showing that they are 
not perfect.

The Maastricht Treaty was fundamentally flawed, demonstrating the 
fallibility of the authorities. Its main weakness was well known to its 
architects: it established a monetary union without a political union. 
The architects believed however, that when the need arose the political 
will could be generated to take the necessary steps towards a political 
union.

But the euro also had some other defects of which the architects were 
unaware and which are not fully understood even today. In retrospect it 
is now clear that the main source of trouble is that the member states 
of the euro have surrendered to the European Central Bank their rights 
to create fiat money. They did not realize what that entails -- and 
neither did the European authorities. When the euro was introduced the 
regulators allowed banks to buy unlimited amounts of government bonds 
without setting aside any equity capital; and the central bank accepted 
all government bonds at its discount window on equal terms. Commercial 
banks found it advantageous to accumulate the bonds of the weaker euro 
members in order to earn a few extra basis points. That is what caused 
interest rates to converge which in turn caused competitiveness to 
diverge. Germany, struggling with the burdens of reunification, 
undertook structural reforms and became more competitive. Other 
countries enjoyed housing and consumption booms on the back of cheap 
credit, making them less competitive. Then came the crash of 2008 which 
created conditions that were far removed from those prescribed by the 
Maastricht Treaty. Many governments had to shift bank liabilities on to 
their own balance sheets and engage in massive deficit spending. These 
countries found themselves in the position of a third world country that 
had become heavily indebted in a currency that it did not control. Due 
to the divergence in economic performance Europe became divided between 
creditor and debtor countries. This is having far reaching political 
implications to which I will revert.

It took some time for the financial markets to discover that government 
bonds which had been considered riskless are subject to speculative 
attack and may actually default; but when they did, risk premiums rose 
dramatically. This rendered commercial banks whose balance sheets were 
loaded with those bonds potentially insolvent. And that constituted the 
two main components of the problem confronting us today: a sovereign 
debt crisis and a banking crisis which are closely interlinked.

The eurozone is now repeating what had often happened in the global 
financial system. There is a close parallel between the euro crisis and 
the international banking crisis that erupted in 1982. Then the 
international financial authorities did whatever was necessary to 
protect the banking system: they inflicted hardship on the periphery in 
order to protect the center. Now Germany and the other creditor 
countries are unknowingly playing the same role. The details differ but 
the idea is the same: the creditors are in effect shifting the burden of 
adjustment on to the debtor countries and avoiding their own 
responsibility for the imbalances. Interestingly, the terms "center" and 
"periphery" have crept into usage almost unnoticed. Just as in the 
1980's all the blame and burden is falling on the "periphery" and the 
responsibility of the "center" has never been properly acknowledged.  
Yet in the euro crisis the responsibility of the center is even greater 
than it was in 1982. The "center" is responsible for designing a flawed 
system, enacting flawed treaties, pursuing flawed policies and always 
doing too little too late. In the 1980's Latin America suffered a lost 
decade; a similar fate now awaits Europe. That is the responsibility 
that Germany and the other creditor countries need to acknowledge. But 
there is now sign of this happening.

The European authorities had little understanding of what was happening. 
They were prepared to deal with fiscal problems but only Greece 
qualified as a fiscal crisis; the rest of Europe suffered from a banking 
crisis and a divergence in competitiveness which gave rise to a balance 
of payments crisis. The authorities did not even understand the nature 
of the problem, let alone see a solution. So they tried to buy time.

Usually that works. Financial panics subside and the authorities realize 
a profit on their intervention. But not this time because the financial 
problems were reinforced by a process of political disintegration. While 
the European Union was being created, the leadership was in the 
forefront of further integration; but after the outbreak of the 
financial crisis the authorities became wedded to preserving the status 
quo. This has forced all those who consider the status quo unsustainable 
or intolerable into an anti-European posture. That is the political 
dynamic that makes the disintegration of the European Union just as 
self-reinforcing as its creation has been.  That is the political bubble 
I was talking about.

At the onset of the crisis a breakup of the euro was inconceivable: the 
assets and liabilities denominated in a common currency were so 
intermingled that a breakup would have led to an uncontrollable 
meltdown. But as the crisis progressed the financial system has been 
progressively reordered along national lines. This trend has gathered 
momentum in recent months. The Long Term Refinancing Operation (LTRO) 
undertaken by the European Central Bank enabled Spanish and Italian 
banks to engage in a very profitable and low risk arbitrage by buying 
the bonds of their own countries. And other investors have been actively 
divesting themselves of the sovereign debt of the periphery countries.

If this continued for a few more years a break-up of the euro would 
become possible without a meltdown -- the omelet could be unscrambled -- 
but it would leave the central banks of the creditor countries with 
large claims against the central banks of the debtor countries which 
would be difficult to collect. This is due to an arcane problem in the 
euro clearing system called Target2. In contrast to the clearing system 
of the Federal Reserve, which is settled annually, Target2 accumulates 
the imbalances. This did not create a problem as long as the interbank 
system was functioning because the banks settled the imbalances 
themselves through the interbank market. But the interbank market has 
not functioned properly since 2007 and the banks relied increasingly on 
the Target system. And since the summer of 2011 there has been 
increasing capital flight from the weaker countries. So the imbalances 
grew exponentially. By the end of March this year the Bundesbank had 
claims of some 660 billion euros against the central banks of the 
periphery countries.

The Bundesbank has become aware of the potential danger. It is now 
engaged in a campaign against the indefinite expansion of the money 
supply and it has started taking measures to limit the losses it would 
sustain in case of a breakup. This is creating a self-fulfilling 
prophecy. Once the Bundesbank starts guarding against a breakup 
everybody will have to do the same.

This is already happening. Financial institutions are increasingly 
reordering their European exposure along national lines just in case the 
region splits apart. Banks give preference to shedding assets outside 
their national borders and risk managers try to match assets and 
liabilities within national borders rather than within the eurozone as a 
whole. The indirect effect of this asset-liability matching is to 
reinforce the deleveraging process and to reduce the availability of 
credit, particularly to the small and medium enterprises which are the 
main source of employment.

So the crisis is getting ever deeper. Tensions in financial markets have 
risen to new highs as shown by the historic low yield on Bunds. Even 
more telling is the fact that the yield on British 10 year bonds has 
never been lower in its 300 year history while the risk premium on 
Spanish bonds is at a new high.

The real economy of the eurozone is declining while Germany is still 
booming. This means that the divergence is getting wider. The political 
and social dynamics are also working toward disintegration. Public 
opinion as expressed in recent election results is increasingly opposed 
to austerity and this trend is likely to grow until the policy is 
reversed. So something has to give.

In my judgment the authorities have a three months' window during which 
they could still correct their mistakes and reverse the current trends. 
By the authorities I mean mainly the German government and the 
Bundesbank because in a crisis the creditors are in the driver's seat 
and nothing can be done without German support.

I expect that the Greek public will be sufficiently frightened by the 
prospect of expulsion from the European Union that it will give a narrow 
majority of seats to a coalition that is ready to abide by the current 
agreement. But no government can meet the conditions so that the Greek 
crisis is liable to come to a climax in the fall. By that time the 
German economy will also be weakening so that Chancellor Merkel will 
find it even more difficult than today to persuade the German public to 
accept any additional European responsibilities. That is what creates a 
three months' window.

Correcting the mistakes and reversing the trend would require some 
extraordinary policy measures to bring conditions back closer to normal, 
and bring relief to the financial markets and the banking system. These 
measures must, however, conform to the existing treaties. The treaties 
could then be revised in a calmer atmosphere so that the current 
imbalances will not recur. It is difficult but not impossible to design 
some extraordinary measures that would meet these tough requirements. 
They would have to tackle simultaneously the banking problem and the 
problem of excessive government debt, because these problems are 
interlinked. Addressing one without the other, as in the past, will not 
work.

Banks need a European deposit insurance scheme in order to stem the 
capital flight. They also need direct financing by the European 
Stability Mechanism (ESM) which has to go hand-in-hand with 
eurozone-wide supervision and regulation. The heavily indebted countries 
need relief on their financing costs. There are various ways to provide 
it but they all need the active support of the Bundesbank and the German 
government.

That is where the blockage is. The authorities are working feverishly to 
come up with a set of proposals in time for the European summit at the 
end of this month. Based on the current newspaper reports the measures 
they will propose will cover all the bases I mentioned but they will 
offer only the minimum on which the various parties can agree while what 
is needed is a convincing commitment to reverse the trend. That means 
the measures will again offer some temporary relief but the trends will 
continue. But we are at an inflection point.  After the expiration of 
the three months' window the markets will continue to demand more but 
the authorities will not be able to meet their demands.

It is impossible to predict the eventual outcome. As mentioned before, 
the gradual reordering of the financial system along national lines 
could make an orderly breakup of the euro possible in a few years' time 
and, if it were not for the social and political dynamics, one could 
imagine a common market without a common currency. But the trends are 
clearly non-linear and an earlier breakup is bound to be disorderly. It 
would almost certainly lead to a collapse of the Schengen Treaty, the 
common market, and the European Union itself. (It should be remembered 
that there is an exit mechanism for the European Union but not for the 
euro.) Unenforceable claims and unsettled grievances would leave Europe 
worse off than it was at the outset when the project of a united Europe 
was conceived.

But the likelihood is that the euro will survive because a breakup would 
be devastating not only for the periphery but also for Germany. It would 
leave Germany with large unenforceable claims against the periphery 
countries. The Bundesbank alone will have over a trillion euros of 
claims arising out of Target2 by the end of this year, in addition to 
all the intergovernmental obligations. And a return to the Deutschemark 
would likely price Germany out of its export markets -- not to mention 
the political consequences. So Germany is likely to do what is necessary 
to preserve the euro -- but nothing more. That would result in a 
eurozone dominated by Germany in which the divergence between the 
creditor and debtor countries would continue to widen and the periphery 
would turn into permanently depressed areas in need of constant transfer 
of payments. That would turn the European Union into something very 
different from what it was when it was a "fantastic object" that fired 
peoples imagination. It would be a German empire with the periphery as 
the hinterland.

I believe most of us would find that objectionable but I have a great 
deal of sympathy with Germany in its present predicament. The German 
public cannot understand why a policy of structural reforms and fiscal 
austerity that worked for Germany a decade ago will not work Europe 
today. Germany then could enjoy an export led recovery but the eurozone 
today is caught in a deflationary debt trap. The German public does not 
see any deflation at home; on the contrary, wages are rising and there 
are vacancies for skilled jobs which are eagerly snapped up by 
immigrants from other European countries. Reluctance to invest abroad 
and the influx of flight capital are fueling a real estate boom. Exports 
may be slowing but employment is still rising. In these circumstances it 
would require an extraordinary effort by the German government to 
convince the German public to embrace the extraordinary measures that 
would be necessary to reverse the current trend. And they have only a 
three months' window in which to do it.

We need to do whatever we can to convince Germany to show leadership and 
preserve the European Union as the fantastic object that it used to be. 
The future of Europe depends on it.

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