05 March 2013

Yanis Varoufakis: From contagion to incoherence - Toward a model of the unfolding eurozone crisis

This post offers readers a fully-fledged analytical model of the unfolding eurozone crisis. It begins with a macro-economic analysis of the crisis's causes and then models the feedback between Europe's institutional and policy responses and the contagion process that began with Greece.

Introduction: Toward a macro-model of contagion

For three years now we have been discussing the eurozone crisis and the contagion dynamic that brought the eurozone to the verge of disintegration. However, to Varoufakis's knowledge, no macro-economic model of this process has been offered; at least not one that depicts the dynamic feedback mechanism between the crisis and Europe’s responses (or lack thereof) to it. With this paper, Varoufakis tries to make amends and to offer a simple analysis of the nexus between:

(a) a monetary union whose very design removed internal shock absorbers while, at once, magnifying both the probability and the magnitude of a future crisis,

(b) a political response to the (preordained) crisis that involved the creation of toxic bailout funds which accentuated the crisis,

(c) the underlying macro-economic imbalances which are in fact deepening, thus rendering the European Union’s fiscal and monetary strategies logically incoherent, and

(d) a European Central Bank whose decisive intervention to offer medium term financial stability (the LTRO and OMT re-financing programmes for banks Italy-Spain respectively) came at the price of reinforcing long-term disintegration.

Conclusion

The eurozone was founded on two principles.

Principle 1:  That its central bank would be explicitly banned from acting as a lender of last resort (for states and/or banks facing insolvency).

Principle 2: The principle of Perfectly Separable Sovereign Debts.

Thus the scene was set for contagion following a financial crisis that could readily cause pairs of national banking systems and states sequentially to titter on the verge of bankruptcy. Europe’s reaction was to establish a new institution EFSF-ESM that would borrow on behalf of its (still) solvent Member States in order to prevent sovereign defaults. Alas, the structure of that ‘special purpose vehicle’ was such that, with its bonds redolent with the whiff of toxic derivatives, deeper and faster contagion followed.

At some point, in a bid to prevent the European Monetary Union’s disintegration, the ECB stepped in. But to be allowed to step in (with its LTRO and OMT programmes) the ECB first had to enter into a Faustian Bargain with the surplus countries: In exchange for being unshackled from the prohibition from acting as a lender of last resort, the ECB had to commit to using its coercive powers in order to impose the greatest austerity upon the weakest Member States. And thus the ECB-based ‘solution’ worsens the fundamental eurozone’s macro-economic conundrum so as to bring temporary stability to the inter-bank and bond markets.

This paper offers a simple analytical model of the above. Its conclusion is that, at this stage of the eurozone crisis, the ECB’s intervention has arrested contagion at the expense of greater macro-economic incoherence. And since the latter always, inevitably, reinforces the former, all celebrations of the crisis’ taming are likely to prove pure folly.

Summary with link to full paper

© Yanis Varoufakis