Saturday, May 5, 2012

Why the crisis matters and how it can be resolved

May 4, 2012

CREDIT is the grease that lubricates the engine of modern economies. If it stops flowing, a global recession is guaranteed. That's the fear.

A related concern is that ultimately Greece and some of the other debt-ridden countries of Europe may figure out that they really need to print their own money to climb out of the hole they are in. That will mean a break-up of the euro zone, which will be a huge shock to the global economy.

The odds of this happening soon are slim. European nations' decision to forge a monetary union was the culmination of a post-World War II political project that sought to bind European nations' destiny together so that there won't be another war between neighbours. A break-up of the euro zone will be a serious setback to that political goal. Yet, it's hard to see how the current monetary arrangement will survive without a fiscal union.

In a fiscal union, countries will no longer have independent finance ministries. The tax revenues of all euro zone countries will be pooled and then distributed among them by a centralised finance ministry according to some formula.

This central ministry will also raise money from the markets on behalf of all states by selling 'euro zone bonds' that are jointly guaranteed by all euro-area nations. Germany and Spain can continue to sell their own bonds - much like California does. But US law does not allow California to go bankrupt; and, in such an arrangement, nor would it be possible for Spain to go bankrupt. The euro zone will come closer to becoming a United States of Europe.

How will this help?

To answer that question, we need a history tour, and look for clues in the past - not in Europe's past, but in that of the United States of America as that nation was just being born.

Circa 1790, the US was a fledgling nation state that had recently thrown off the British colonial yoke after a costly war of independence. Just like Greece today, back then Massachusetts, South Carolina and 11 other US states were in trouble. Altogether these 13 states had accumulated war debt of US$25 million and had no real hope of being able to pay it.

So the question was whether the newly created federal US government should assume this bad debt, or let Massachusetts and other states default.

States like Virginia and North Carolina that had paid off their own war debts abhorred bailing out Massachusetts, much like Germany today resents rescuing Greece. Politicians of Virginia reckoned that they would gain little from the higher taxes that their state would have to bear to pay off the debt of Massachusetts.

But the first Treasury Secretary of the US, Mr Alexander Hamilton, was a man of tremendous foresight. In order to establish a reputation for the federal US government's creditworthiness, he cajoled Virginia to go along with the plan to bail out Massachusetts. To do this, Mr Hamilton gave up his demand that the capital of the new nation be in New York. The Virginia delegation wanted a site along the Potomac River. Thus it was the resolution of a debt crisis that saw Washington becoming the capital of the US.

This story has a couple of messages for present-day Europe: A debt of US$25 million for the United States of 1790 translates into a €1.2 trillion (S$2 trillion) liability for today's Europe, according to Citigroup economist Nathan Sheets. Mr Hamilton was not playing with small change; he was committing his nation to an onerous burden. If Germany wants to see a stable, prosperous Europe, it cannot avoid taking on a large commitment.

The second message is that economists will not be able to solve Europe's debt problem. It will take far-sighted politicians of Mr Hamilton's calibre and vision.

Does German Chancellor Angela Merkel have what it takes? We should leave that question to future historians.

ANDY MUKHERJEE

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