Monday, February 16, 2015

Failed Discipline, Failed Reforms and Grexit: Why the Euro Failed

There is no substitute for the discipline of a market that cannot be manipulated by political elites.

It's not that difficult to understand why the euro is doomed to fail. Given its structure, there is no other possible outcome but failure. Greece's exit (Grexit) will simply be the first manifestation of the inevitable structural failure of the euro.

To understand why this is so, we have to start with two forms of discipline: the market and the state. The market disciplines its participants by discovering the price of not just goods and services but of currencies and the potential risks generated by fiscal and trade imbalances.

When nations issue their own sovereign currencies, the global foreign exchange (FX) market enforces an iron discipline on all participants. If a nation prints excessive quantities of its currency without boosting its production of goods and services by an equivalent amount, the FX market punishes this nation by devaluing its currency.

The market provides unwelcome feedback to the imbalances of interest rates, credit and currency: imports become prohibitive, nobody wants to buy the nation's bonds unless the interest rate compensates for the higher risk, and so on.

The political and financial leadership of the nation would eliminate this feedback if they could. Unfortunately for the domestic leadership, the FX market is too big to manipulate for long. Domestic governments and central banks can try all sorts of fancy footwork (pegging their currency to stronger currencies, etc.) but in the end, the market will sniff out the fundamental imbalance between the rigged price of the nation's currency and its market value.

The domestic political and financial leadership/Elites are powerless to stop or evade the discipline of the FX market. They can complain and protest and claim an international conspiracy brought down their financial fantasies, but the reality is the market is made up of many participants, all of whom want to make money, not lose it by accepting a bunch of political BS as the actual truth.

The other form of structural discipline is imposed by the state (government in all its forms, including central banks). A typical example is the state legislature imposes a cap on state borrowing, i.e. the state is not allowed to borrow more than 3% of expenses annually.

We all know what happens to these kinds of state-imposed discipline: they are ignored, bypassed, watered down or gutted. Why is this so? The reason is that all political systems, regardless of their ideology, are influenced by powerful elites and vested interests.

When some political cap stands in the way of enriching or protecting a politically powerful elite or vested interest, the cap is quickly reduced to a PR play.

This is the fundamental flaw in state fiscal discipline: it is always a political construct and thus contingent on what benefits powerful elites and constituencies.

The disciplinary foundation of the euro is wholly political. In agreeing to join a monetary union of one currency, the EU nations eliminated the market's ability to provide feedback on the imbalances building up in their economies.

In effect, they replaced the discipline of a market that cannot be manipulated for a political discipline that can be manipulated as a matter of course.

Canny domestic politicos are well-versed in ways to hide fiscal and credit imbalances. Masking financial realities is their bread and butter.

So what happens when you impose a super-state (the EU) on the member nations? the super-state becomes the cozy home for canny politicos who play the same old hide-and-seek financial games on a larger stage.

The official response to this intrinsic lack of discipline is for the central banks to print money and issue more credit. Does issuing more money and credit provide any fiscal discipline? Of course not--it does the opposite, freeing the canny politicos (yes, the ones supposedly in charge of imposing discipline on the system) to escape any consequences from their fraud and profligacy.

The idea that the political leadership of a state or super-state could impose a discipline equivalent to that imposed by a market was always a fantasy. As a result, the idea that political discipline could impose painful and difficult reforms on politically powerful elites and vested interests was also a fantasy.

This is why Greece has no choice but to exit the euro. The politicos in the EU will "do whatever it takes" to extend the fantasy their discipline is equal to the discipline of the FX market, but everyone knows it's all PR and lies.

There is no substitute for the discipline of a market that cannot be manipulated by political elites, and as a result there can be no real reforms until the euro is dissolved and the FX market forces the true cost of systemic imbalances on the domestic participants who created and maintained the imbalances.

Reform cannot be triggered by borrowing more money--it can only be triggered by defaulting on existing debts that cannot be paid. Bailouts are never about enabling reform--they're about preserving the Status Quo Elites' and vested interests' share of the swag. 

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