When a country finds itself overburdened with debt, the solution – if the debts are denominated in its own currency – is to inflate its way out of the problem. Debt is denominated in nominal terms so inflation reduces the real debt burden. Ireland cannot do this, but the ECB can. It would not do it for Ireland or Greece or Portugal alone but if Spain comes under attack, given its size relative to the European Financial Stability Facility, this option will be forced up the agenda.
What would inflating our way out of the debt entail? It can be seen as a type of orderly default. Assume for the sake of argument that the ECB is the owner of all Irish bank bonds; the Irish taxpayer currently owes these funds to the ECB. The ECB could accept a debt for equity swap, which would mean a substantial haircut, so that it – rather than the Irish taxpayer – now owns the banks. It recapitalises them by printing money and then sells them on. The downside is higher European inflation (it will have to take similar steps all across Europe because many banking debts are in fact to other banks, meaning that many will require recapitalisation) and a higher risk premium on all European debt. The risk premium could be moderated though by a pan-European regulatory system which would tackle one of the design flaws in the entire single-currency project.
The major design flaw was that there was no mechanism to tackle asymmetric (i.e. region-specific) shocks. The US has a huge federal budget which absorbs a major share of such shocks; e.g. if California goes into recession, it pays 25 cents less in federal taxes for each dollar its income drops, and it receives 10 cents more in federal funding. There is no such “fiscal federalism” in Europe (the nearest to it, the Structural Funds programmes, transfer about one cent for every dollar gap in income). Asymmetries prevail however, as is evident in that the business cycle in peripheral countries such as Ireland is out of sync with Germany and the core eurozone countries. This design flaw featured strongly in contributions made by Kevin O’Rourke, myself and others (all of us at the UCD School of Economics at the time) during the Irish national debate on whether to join the single currency. So Spain and Ireland got very much lower interest rates than were appropriate over their respective booms, which fuelled their property bubbles. The problem could have been reduced, though not eliminated, by tight pan-European regulation of the financial system.
These design flaws must be tackled in one way or another if the eurozone is not to stumble from crisis to crisis, though it is doubtful that there is the political will for substantial fiscal federalism. There is no painless way out of the current crisis, but inflating our way out of the debt and coming to grips with the design flaws look to me to be the least painful option.
I try to make these points in a politics programme recorded several days ago and due to be shown on RTE when the EU/IMF announcement is made. They’ll only use snippets so I’ve tried to join up the dots here.