The Kroog Versus The Biggest Bubble In History

Paul Krugman goes down to his local economist watering hole, bellies up to the fiduciary bar and orders two fingers of macroeconomic schadenfreude to pour on the floor in memory of the austerity-plagued euro.

The story so far: When the euro came into existence, there was a great wave of optimism in Europe — and that, it turned out, was the worst thing that could have happened. Money poured into Spain and other nations, which were now seen as safe investments; this flood of capital fueled huge housing bubbles and huge trade deficits. Then, with the financial crisis of 2008, the flood dried up, causing severe slumps in the very nations that had boomed before. 

At that point, Europe’s lack of political union became a severe liability. Florida and Spain both had housing bubbles, but when Florida’s bubble burst, retirees could still count on getting their Social Security and Medicare checks from Washington. Spain receives no comparable support. So the burst bubble turned into a fiscal crisis, too. 

Europe’s answer has been austerity: savage spending cuts in an attempt to reassure bond markets. Yet as any sensible economist could have told you (and we did, we did), these cuts deepened the depression in Europe’s troubled economies, which both further undermined investor confidence and led to growing political instability. 

And now comes the moment of truth. 

Indeed, the last two weeks have been rather unkind to the European markets.  Spanish bond spreads in particular are rather nasty.   Once again Krugman notes that the timeframe here for the collapse of the euro currency would be a half-life measured in months, not years.

So now what? Right now, Greece is experiencing what’s being called a “bank jog” — a somewhat slow-motion bank run, as more and more depositors pull out their cash in anticipation of a possible Greek exit from the euro. Europe’s central bank is, in effect, financing this bank run by lending Greece the necessary euros; if and (probably) when the central bank decides it can lend no more, Greece will be forced to abandon the euro and issue its own currency again. 

This demonstration that the euro is, in fact, reversible would lead, in turn, to runs on Spanish and Italian banks. Once again the European Central Bank would have to choose whether to provide open-ended financing; if it were to say no, the euro as a whole would blow up. 

Yet financing isn’t enough. Italy and, in particular, Spain must be offered hope — an economic environment in which they have some reasonable prospect of emerging from austerity and depression. Realistically, the only way to provide such an environment would be for the central bank to drop its obsession with price stability, to accept and indeed encourage several years of 3 percent or 4 percent inflation in Europe (and more than that in Germany). 

Both the central bankers and the Germans hate this idea, but it’s the only plausible way the euro might be saved. For the past two-and-a-half years, European leaders have responded to crisis with half-measures that buy time, yet they have made no use of that time. Now time has run out. 

So eternal financing by the ECB is unsustainable.  And serious price inflation in Germany where the Merkel government is already in trouble?  Also not happening.  That leaves the whole "euro blowing up" thing.  I keep saying this is the biggest threat to President Obama's re-election, not Mitt Romney.  If the euro goes completely pear-shaped and takes the US with it, we're going to end up neck deep in austerity crazed Republicans and we'll get this same mess in Europe now all over again a year or two down the road here.

It's enough to drive a man to drink.