Until very recently I thought a total collapse of the euro pretty unlikely. To be sure, Greece and Cyprus would leave, and perhaps even Portugal, Finland and Slovakia. But there would still be a currency union between France, Germany and Italy, and everyone else was only a rounding error anyway. I now think there is a genuine risk of total collapse – indeed, I think the risk of there not being a currency union between France, Germany and Italy in five years' time is now above 50%.
What has changed is that German policymakers appear close to the point of capitulation on agreeing to pool debts across the Eurozone, through Eurobonds or mass purchases of Spanish and Italian government bonds or some massive extension of the ESM-EFSF bailout fund. Such debt pooling, advocated by many as the only route to salvation for the euro, would (as the Germans rightly insist) be its likely instrument of destruction. France could not afford to pool debts with Italy, and younger Germans would not be willing to do so, whatever the current generation of politicians decide. Agreement to debt pooling is an acknowledgement that the euro is probably finished and one is seeking a pain-minimising route to its orderly end.
With the insane Spanish bank bailout, policymakers appear to have crossed the Rubicon. Having agreed to bail out the Spanish, how could they refuse to bail out the Italians? Perhaps the fine print of the Spanish bank bailout will change everything – fine print often does. Perhaps, as the rules of the EFSF demand if such funds are to be used for bailing out banks (as is intended for Spain), support for the Spanish banking sector will be conditional upon Spanish bank bondholders being "bailed in" (i.e. having their loans converted to equity) and we shall finally be back on the path to sanity. But, alas!, I fear not. It is not certain that debt pooling would lead to the collapse of the euro – nothing is certain in this crisis. But it is more likely than not, and British policymakers should now have plans to respond to that scenario.
A disorderly collapse of the euro would be accompanied by mutual recrimination, multiple further sovereign defaults, and quite likely the disorderly disintegration of the European Union and Single Market. As I have noted before, the correct analogy is not that it would be a bit more serious than the collapse of the ERM, but, rather, that it would be a bit less serious than the collapse of the Roman Empire. A contraction of Eurozone GDP of 20% could well be on the cards; for the UK a GDP contraction of around 10%. A more orderly death for the euro might perhaps inflict only half that damage.
Tempting as it is to take the year off sick, curl up in bed and watch sport until it's over, British policymakers will need to devise some response. We can think of this in two parts: what to do in advance; what to do if and when it happens.
What to do in advance:
- Do not assume everything's going to be okay and we can carry on as if recent events were just a temporary blip.
- Prepare, but don't play your big cards until it's time. Keep something back to try to turn things around if they go bad.
- Get as much of the spending cuts done as quickly as possible, before things get really dicey.
- Do not get drawn into blaming different countries – the Germans, the Americans, the Chinese, the Iranians, the Tuvaluans, whoever – for one's own troubles. There will be enough hatred and recriminations once everything goes belly up without our needing to start blaming any other countries now.
- Forget any idea that there's a magic bullet out there – some more infrastructure spending; some credit easing scheme; some subsidy for new startups; some subsidy for new jobs – that will make all our problems go away.
- Keep cutting your own deficit as quickly as you can via spending cuts. Limit tax rises, because your policy on taxes is about to go into full reverse.
- Limit, as much as is diplomatically possible, your involvement in lending money to anyone else.
- Understand that Britain is very much like Ireland and Spain in having a banking sector that is far too large for the government to be able to afford to bail it out, and that to attempt to do so could bankrupt the sovereign. Yell from the rooftops at every occasion that you don't stand behind the British banks. Get the Chancellor to metaphorically sign in blood that he will not do any more bank bailouts. Tie your hands on this question as much as possible. Try to make it so explicit that it would bring down the government for you to reverse in any way and actually bail any of them out again.
- Abandon all formulaic prudential targets (capital or liquidity ratios) for banks. Everything should be based on a bank-by-bank judgement from the Bank of England. Say you are doing this – loudly.
- Try to raise Bank of England interest rates – if for no other reason than to give yourself some scope to cut them later.
- Tell households to panic. There is a time for panic. It is now. Over the past four years there has been far too much panic by policymakers and far too little panic by households. As a consequence, households have not cut back on their debts nearly so much as they should have done.
What to do if and when it happens:
- Tell households to stop panicking. It will be too late for panic to be useful by then.
- If British banks become insolvent or seriously inadequately capitalised, use the resolution tools that the British government has agreed. Place them into special administration; if banks are still viable value-generating entities convert bondholders into shareholders; make deposits senior to bonds. In addition, create a Deposit Access Fund to allow shareholders to withdraw 80% of their deposits (formally treated as a loan from the government qua administrator, to be recovered through the tax code if the bank is liquidated and its assets are insufficient to cover withdrawals). If banks are merely illiquid but not insolvent or inadequately capitalised, provide last resort loans from the Bank of England at a penalty rate.
- Keep cutting spending. If possible, cut it faster and deeper. Expect a further 10% cut in UK GDP and target spending falling to around 40% of that lower GDP level. If GDP doesn't fall that far, treat that as a piece of good fortune. In this round of spending cuts there must be absolutely no sacred cows – no budget exempt (with the possible exceptions of the police and defence).
- Forget doing more QE. It will not be a powerful enough tool under these circumstances. Instead, the Bank of England should print money to directly fund government spending. (An intermediate possibility would be for the Bank to engage in primary purchases of government debt – simply funding the government deficit, rather than, as in QE, intervening in the secondary market, buying second-hand government bonds traded after they have initially been bought by banks, pension funds, etc.)
- Because the Bank of England is funding spending with money-printing, it will be possible to cut taxes. This should take two forms: an income tax rebate sent to taxpayers; and a VAT cut. We should start with £37.5bn in income tax cuts, £12.5bn in VAT cuts and take it from there.
- Be in no doubt that such money-printing will in due course exacerbate inflation and imply another recession down the line to get inflation down. Embrace the inevitability of that.
- I repeat: do not start the above until the collapse happens. The Bank of England printing money to fund tax cuts cannot prevent the euro from collapsing; it can only react to it. And such a reaction will not avoid the pain – it will only make it slightly more bearable.