Regular readers will immediately recognize that Professor Rodrik's plan is essentially your humble blogger's blueprint for economic recovery with one difference.
Professor Rodrik thinks that banks need to be recapitalized immediately by their sovereigns when in fact they are designed so that they can be recapitalized over several years using retained earnings.
Letting the banks recapitalize themselves through retained earnings frees up the sovereigns to use their resources pursuing stimulative economic policies.
The eurozone periphery suffers from both a stock problem and a flow problem. It has too large a debt stock, and too little competitiveness to achieve external balance without significant domestic deflation and unemployment.
What is required is a two-pronged approach that targets both problems simultaneously.
The prevailing approach – targeting debt through fiscal austerity and competitiveness through structural reform – has produced unemployment levels that threaten social and political stability.
So, what can be done differently?
The most direct way to address the debt problem is a write-down, coupled with recapitalization of those banks that will suffer large losses as a result. This may seem extreme, but it simply recognizes the reality that much of the existing debt will not be paid back without new flows of official financing.
As the IMF now acknowledges, it might have been better to restructure Greek debts from the outset than to engage in a “holding operation.”
Debt reduction by itself clears the way for growth, but does not directly trigger it.
Policies that directly target expenditure rebalancing within the eurozone and expenditure switching within the peripheral economies are also needed.
These include: policies to boost eurozone-wide demand and stimulate greater spending in creditor countries, especially Germany; policies that aim to reduce non-tradable prices; income policies to reduce the peripheral economies’ private-sector wages in a coordinated fashion; and a higher ECB inflation target to allow room for movement in the real exchange rate via nominal changes.
These policies would require Germany to accept higher inflation and explicit bank losses, which assumes that Germans can embrace a different narrative about the nature of the crisis. And that means that German leaders must portray the crisis not as a morality play pitting lazy, profligate southerners against hard-working, frugal northerners, but as a crisis of interdependence in an economic (and nascent political) union. Germans must play as big a role in resolving the crisis as they did in instigating it.
France will most likely play a critical role as well. France is big enough that if it threw its support fully behind the peripheral countries, Germany would be isolated and would need to respond. But, so far, France remains eager to separate itself from the southern countries, in order to avoid being dragged down with them in financial markets.
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