First loss is the best loss

In finance there’s a saying: the first loss is the best loss. The financier has loaned money, the borrower is unable to repay unless more money is advanced to “fund the imminent turnaround”. No-one likes to lose money and it’s also an admission of failure. Lending more money is an easy mistake to make, even when all the signs say that’s it’s a bad idea.

Greece was insolvent before the first European loans were granted, and no amount of lending could fix that. The five year recession, heightened by austerity have made that worse. The Greek economy is now 20% smaller, and the loans are a lot bigger. The first loss would have been the best loss, and now the loss will be worse.

Even with the “positive” outcome of the June 17 election it is probable that Greece will have to leave the Euro in the future.

The “good news” is that Europeans got a real fright about what could happen once Greece leaves – a run on the Greek banks, followed by runs on Spain’s banks, then Italy, followed possibly by France. They are no longer deluded about the possible consequences. Politicians are having to consider real solutions, not the band-aid remedies that they’ve tried so far.

The Euro’s design flaws need to be repaired through greater fiscal federalism. A ‘banking union’, with a European system to wind down or recapitalise troubled banks and a Europe-wide bank-deposit insurance scheme, would help break the feedback loop between weak banks and weak sovereigns. A ‘fiscal union’ in which all or part of the national debts are mutualised as joint Eurobonds would stop markets pushing sovereigns into insolvency, and would create a European asset that banks could hold. Moreover, if these were financed through federal taxes Eurobonds would be even more of a safe asset. Instead of providing liquidity indirectly to banks, the ECB could declare that it stands fully behind solvent sovereigns, just as the Fed stands behind the American government.

The Federalist papers of 1787-88 argue that trying to coerce a group of sovereign states to follow common rules is ultimately doomed. Leagues and confederacies are like feudal baronies: sooner or later somebody breaks the rules. And attempts to bring them into line lead to anarchy, tyranny and war. Europe is not at the point of war, but many a citizen feels an economic conflict is well underway.

For Alexander Hamilton, the leading author of the Federalist papers, the solution to the problem was to create a strong American federal government, acting directly on the citizen rather than through the constituent states. With the adoption of America’s federal constitution, Hamilton became treasury secretary. The federal government assumed the war debts of the ex-colonies, issued new national bonds backed by direct taxes and minted its own currency. Hamilton’s new financial system helped transform the young republic from a basket-case into an economic powerhouse.

Even discussing these measures is a huge challenge. The most influential politician in Europe, Angela Merkel, is starting to mention some of them. “She is a clever woman who is not an economist, surrounded by economists giving her contradictory advice,” says one close observer.

There is an influential group of German economists who are reminding anyone who will listen about the history lesson from the Weimar republic: printing money led to hyperinflation, then economic chaos, political extremism and ultimately to catastrophe for all of Europe.

The Economist

Inflation need not be the result of central bank funding if it’s carefully applied. The cure should not be made to kill the patient.

Even if the politicians finally see sense, it’s unlikely that the citizens of Europe will agree to such drastic measures. Perhaps another fright will help them.

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