Posted by: Dirk | May 11, 2010

Carmen Reinhart is right (hopefully)

This is from the Economix blog of the NY Times, where she and some others answered readers’ questions:

The current E.U. plan does not envision restructuring; restructuring remains a taboo subject in official circles. Restructuring can be extremely disorderly, or it can be made less so (an under-the-rug restructuring) — if, for instance, French, German and other banks holding Greek debts are offered support from their governments if the interest rates on Greek debts are trimmed and maturities lengthened. Officials, of course, deny such a scenario to be possible — which, of course, means nothing.

The current plan is about saving the E.U., not about saving Greece per se. This includes reducing speculation about the demise of the euro as well as concerns about what a Greek default could do to financial institutions in France and elsewhere. This is understandable. The sharp easing in monetary policy in the summer of 1982 in the United States, for example, was not about helping Mexico and other emerging markets cope with default but about softening the blow for American banks that had high exposure to the newly (or nearly) defaulted sovereign loans.

She is absolutely right with this. Since markets are interconnected and European banks hold Greek debt, a default would have dire consequences. Therefore, the default option has to be cancelled by providing a guarantee of cheap long run funding. However, some commentators like Wolfgang Münchau of the FT disagree:

Alternatively, central banks might prioritize financial stability over price stability and keep the monetary floodgates open for as long as possible. This, I believe, would cause the mother of all financial market crises – a bond market crash – to be followed by depression and deflation.

In other words, there is danger no matter how the central banks react. Successful monetary policy could be like walking along a perilous ridge, on either side of which lies a precipice of instability.

Here is what I perceive to be the big questions: will “IT” happen again? Will wage deflation in Greece (and later Spain, Italy, Ireland, etc.) cause a debt deflation, which then spreads through the euro area and then the world? If your answer is yes, then we are somewhere between Inferno and Purgatory, and if your answer is no, adjustment through changes in the price level works and everything will be heavenly. A question of belief for the laymen, a question of balance sheets for those in power.



  1. Reblogged this on wernerschwartz.

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