I pick on Tyler because he is probably one the sharpest voices for what I see as a deep misunderstanding of the issue. Though, I think this misunderstanding is incredibly widespread – as holiday gatherings make clear.
Maybe these markets simply will shut down soon. There is so much talk about what the Germans should do, but I don’t see the viable options. With Germany’s own credit status now in doubt, eighty percent debt to gdp ratio, massive welfare state, and unfavorable demographics, are they supposed to endorse — going to endorse — ten or fifteen percent price inflation for a few years’ time, all with no guarantee of reforms in the economically weaker countries? And is that inflation then followed by a subsequent deflation? Or does it continue forever? And would Germany have to move to a regime of wage flexibility for the professions too? How politically feasible is that? I don’t see how the Germans benefit from going down this road, even if you think, as I do, that the alternatives are quite dire.
Germany doesn’t need to experience any of these things. Germany only needs to agree to letting the ECB stand as Lender of Last Resort.
I haven’t spoken with Tyler personally on this but from my conversations over the holidays I can see that the difficult thing to understand is that what is at issue here is the distribution of private claims over private resources.
On one level you can see this by noting that part of the reforms which Mario Monti is putting in place are to decrease tax evasion. Yet, taxes are simply the forcible extraction of private resources by the government. Its not as if taxes represent the government producing something or even government officials or government pensioners consuming less.
Taxes represent the transfer of resources under the threat of imprisonment. Now, if this could possibly solve your problem then you know that at root the problem has to be about who holds private claims over resources.
You can attack the problem in another way by seeing that Italy is roughly in primary budget balance. This means current borrowing exists only to repay past lenders. Again, this is an issue over the distribution of private claims.
To make the point more clear – this is explicitly not the case for Greece. From a budget standpoint Greece faces a more fundamental issue. It is currently in primary deficit. It would have shift resources from private control to public control in order to balance the budget given the current economic environment.
It is true that Greece’s economic environment is primarily the result of a fundamental mismatch in monetary policy between it and the core countries and so could be solved if Germany were to endure more inflation. However, Greece does face an immediate adding up constraint that Italy does not face.
A third way to see this is to imagine what would happen if Italy repudiated its debt vs. Greece. Italy would then be able to support itself on tax revenue. Greece would not. Greece would have to go back into the bond markets somehow and get more money.
Why is all of this important?
Its important because it means Italy doesn’t actually need anyone to transfer real resources to it. It simply needs someone to manage resource distribution among bondholders. The ECB can do this at virtually no direct cost.
Again that is because nothing actually has to be produced or transferred. Debt just has to be managed.
Perhaps, a fourth way to see this is by noting that you only need new savers to agree to step in where old savers were. This is ultimately a co-ordination issue between groups of savers. Its breaking down because there is a musical chairs issue. No one wants to be the last saver who can’t find someone to whom to transfer his savings.
The ECB can assure this doesn’t happen because the ECB controls the total amount of borrowing from European banks. It can constrict the amount of borrowing to make sure that someone steps up to take the transfer of Italian debt.
All of this is to say that Germany doesn’t have to suffer any near term economic bad effects. What Germany loses in supporting a move like this is the ability to pressure peripheral governments into changing their ways.
In theory one could agree to a new system, along the lines I have proposed, in order to keep the pressure on. The problem, of course, is that if you are even considering offering Lender of Last Resort status then you have signaled that you do not have a complete commitment to irrationality, in which case it immediately becomes in the interest of the peripheral countries to dig in and refuse to change unless Lender of Last Resort status is offered up front.