The inspiration for this post is Wolfgang Münchau’s latest piece in the FT which scores 10/10 for logical clarity, as always:

Why is Greek GDP falling so fast contrary to what official forecasts have claimed? … If the economy misses the targets, more austerity is applied, which causes a continued fall in GDP, followed by another failure to meet the target. In other words, the troika is demanding policy action whose effect will be a further deterioration in the Greek economy, and thus a further deterioration in the debt ratio, which in turn requires further policy action of the same self-defeating kind.

Münchau wonders if the IMF that is part of the troika is the same IMF that in its latest World Economic Outlook summarised the lessons of past debt crises as follows:

“The first lesson is that fiscal consolidation efforts need to be complemented by measures that support growth: structural issues need to be addressed and monetary conditions need to be as supportive as possible”

Monetary conditions are anything but supportive, given the usurious real interest rates faced by the private sector and the public sector in both Greece and Spain. The biggest structural issues, which are (i) the fact that the Eurozone is not an Optimum Currency Area (OCA) and (ii) the zombie banking systems, which starve the economy of oxygen and must be restructured responsibly, have been elevated to holy cow status and are not being dealt with either.

Worse, the twin monetary and structural failures feed each other in a reinforcing vicious “monetary / structural” loop, via the deflating economies of the periphery. The higher the real interest rate, the larger the economic damage, the less optimal a currency area the Eurozone becomes, the more the victim economy contracts, the more oxygen (austerity, real interest rate) needs to be diverted from the collapsing real economy to keep zombie banking systems throughout Europe going, which leads to permanently elevated interest rates in the teeth of a pro-cyclical fiscal policy.

Evidently, this is a crisis where failure to act decisively earlier on, together with excessive reliance on unwarranted hope has led to a deflationary receding horizon situation. Europe needs a 21st century Churchill more than ever, but Chancellor Merkel, Presidents Sarkozy and Hollande and Prime Ministers Brown and Cameron did not rise to that challenge. Per Münchau:

European policy makers have always clung to the hope that a subsequent recovery would take care of all the problems. They chronically underestimated the effect of austerity on growth, especially if other countries in the region pursue the same policies. As the IMF noted in its study, many successful episodes of debt reduction were accompanied by good economic growth elsewhere. Greece and Spain are not so lucky.

Of course they are not going to be so lucky. How can a “debt to GDP” reduction exercise possibly be successful with the simultaneous mutli-year application of a policy cocktail consisting of the following three ingredients:

(i) a fixed exchange rate regime which forecloses export-led stimulus (the Euro is irreversible),
(ii) a contractionary monetary policy (the usurious interest rates propping up failed banking systems) and
(iii) a pro-cyclical fiscal policy (the Weimar-style externally imposed austerity)?

Indeed, if this lethal cocktail did anything else other than kill the patients, we would have to throw out the lessons of 800 years of financial and economic history. It is no surprise then to read Münchau’s dramatic conclusion:

My conclusion is that present policy is not consistent with these two countries’ survival in the eurozone. This is not a prediction that they have no choice but to leave. It is merely a statement of policy choices.

A better set of policy choices would be for the stronger countries to depart from the Euro and create the Northern Euro. The northern countries could offer generous Marshall-plan style grants, conditional on the adoption by the southern countries of the needed structural reforms of their banking systems, public finances and labour markets. Only then would the cleaned up banking systems and bond markets be in a position to settle at a more appropriate interest rate. The three together should lead to the expansion of investment into the deflated economies, absorbing their spare capacity.

This is what European solidarity would look like – if it really existed. The only solidarity that we have evidence for so far is between each country’s bankers and politicians, who misguidedly believe that they must hang together lest they all hang separately.