Wednesday, 7 March 2012




A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy..."
Alexander Fraser Tytler, Scottish lawyer and writer, 1770

"Do not trust the horse, Trojans. Whatever it is, I fear the Greeks even when they bring gifts."
Virgil, Aeneid, Book 2, 19 BC:


By now everyone is aware of the tragedy unfolding in Greece. Its sovereign bond market has become quite agitated with the 10-year Greek government bond trading around 7% and now yielding near 400 basis points more than the corresponding Bunds. At the same time, Greek credit default swaps – measuring the cost of insurance against a Greek sovereign default – have exploded to reach 425bps (see below).

The human and economic cost of the corrective measures that the Greek government will try to implement will be staggering, one way or the other, even if fears of social unrest and economic collapse temper their degree of austerity.

Many commentators have talked at length of the underlying causes that led Greece to this tragic situation and are exploring the possible consequences of this crisis. This article aims to contribute to that debate by underlying causes and consequences less obvious than the debt-fuelled crisis of 2007/2008 or the political games that are going to surround the likely bail-out of Greece.

For, indeed, these days, the Euro-skeptics are gloomily rejoicing. They are finally proven right. As they said all along, the EMU cannot work, given the disparity of the countries involved and the lack of credible mechanisms to enforce the budgetary discipline required by the Maastricht treaty.

Were Greece to have its own, free-floating, currency, the FX market would have led to its de facto devaluation and, so the skeptics’ discourse goes, de facto re-establish Greece’s competitiveness. Instead of which, Greece will have either to go through an unnecessarily brutal austerity regime or be bailed out by the rest of the EU, unfairly penalizing thrifty Germans.

The sad truth is that the Euro-skeptics are right. But they are right for the wrong reasons. And thus, their solution – stopping or reversing the European project is certainly not the only solution worth talking about.


The EMU created a single currency for the European Union (give or take a few opt-outs). However, due to the strong euro-skepticism already existing back then, the EU had to stop there in its objective of an “ever closer union”. At least for the time being. Or even permanently, depending on who was talking.

Thus, all on its own and with no one really forcing its hand, the European Union managed to trap itself into what is well known amongst economists as the “Triangle of Impossibility”. The Triangle of Impossibility, also known as the Impossible Trinity, the Inconsistent Trinity or the Unholy Trinity) is the hypothesis that it is impossible to have all three of the following at the same time:

 - A fixed exchange rate
 - Free movement of capital
 - An independent monetary policy

In the words of Nobel Prize winner Paul Krugman: “The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe)”.

We already experienced the problems that trying to achieve all three objectives at once can lead to with the Sterling crisis in 1992 when the UK had to exit the ERMI, incapable of raising interest rates high enough to defend its currency peg to the Deutsche Mark.

Within the Euro zone, we have free movement of capital, an independent monetary policy (ECB) and the various currencies constituting the Euro are pegged at fixed levels. Thus, we are trying to achieve exactly what cannot be done.

It is therefore not surprising we eventually ran into trouble, just as the GBP did in 1992. Indeed, many economists believe that the chosen level of the currency pegging at the inception of Europe guaranteed a crisis, sooner or later. But the thesis of this article is that, in reality, even if different, better, currency rates had be chosen, the Euro would have ran against the “triangle of impossibility” and thus into crisis, at some point. And countries cannot resort to the Keynesian quip that “in the long term, we are all dead”…


So, what are we to do? The Greek problem can be addressed via a series of country-specific measures – Deflation, regional subsidies or European bail-out. But that won’t make the “triangle of incompatibility” go away so crisis down the line would have to be expected. While dissolving the Euro would certainly solve that issue, it is a very unlikely result given the benefit the European populations and businesses see in it and given the political capital that was invested by the whole European mainstream political class in its creation. Ejecting the weakest members of the club is also possible but would severely damage the whole EU, with countless political and administrative tangle-ups.

But these are not the only solutions. The voices for further integration could still win out. As Obama advisor Rahm Emanuel said: “Never let a serious crisis go to waste”.

Governments have, broadly speaking, three tools to intervene within the economy. There’s the monetary policy (interest rates), the fiscal policy (taxes) and the budget policy (government spending). The EU, through the ECB, only controls one of these tools, namely, the monetary policy. As we say with Greece, individual member countries still do as they please when it comes to fiscal and budgetary matters, treaties or pacts be damned.

Surrendering these tools to the EU is massively explosive, politically speaking. Indeed, it would void national governments of meaning. Therefore, this will not happen in the near future. But, if we do not want to hear about an EU federal state, a la USA, quite yet, we should still look for greater harmonization and cross-control in these areas. If the EU had had a greater say of Greek public finance, we could hope that the politicians and bureaucrats in Brussels would have noted faster and rein in the profligacy of the Greek politician class, which was busy retaining or acquiring power by means of budgetary spending or unrealistic promises to the Greek people. Similarly, a harmonized budget across the EU could possibly be more effective in subsidizing the EU areas where spending is actually needed or would have the greater economic boosting effect. In this case, assuming that Greece would rank high on such a list, it would mean that its need for infrastructure development would have been better met and better financed. Instead of which, the Greeks will have to suffer several years, maybe a decade, of austerity and deflation.