The euro crisis, The hazards of crisis

The euro crisis

The hazards of crisis

Feb 7th 2012, 14:02 by R.A. | WASHINGTON

RIGHT now, an awful lot of very smart people are looking at Europe, scratching their heads, and wondering two things:

1) Is it possible that the euro zone has actually figured out a way to muddle through this mess?

2) Did they somehow do all the things I said they needed to do without me noticing?

I don't know whether the euro zone has figured out a way to muddle through this mess. It seems pretty clear to me that the euro zone has not done the things I thought it needed to do to make it through, but at the moment it isn't that easy to figure out what the ECB's actual underlying strategy is. Perhaps time will vindicate me in every way; so I say to myself every morning. My feeling is that the crisis is about the fear that institutions will be unable to make good on their obligations, that failure to make good on these obligations will cause significant financial and economic disruption, and that the only way to solve the problem is to figure out how to handle a potential shortfall in a manner that's as minimally disruptive as possible—perhaps through inflation and/or financial repression.

I don't know if that's wrong or not. What seems somewhat clearer now is that a lot can happen if one manages to avoid a sudden meltdown. The channel through which that meltdown would occur would almost surely be the banking system. And the ECB seems to have closed off that risk for now by accepting lots of questionable collateral in making huge, cheap, longer-term loans to banks.

I find myself thinking back to 2008, yet again. There was no reason that Lehman had to fail. It had tons of assets on its books; it just happened that they were of such dubious value that no one trusted in the bank's solvency. But there were other options. The Fed could have said (as it did to a much greater extent after Lehman fell) that it would take Lehman's toxic crud as collateral and extend it huge, cheap, long-term loans. If the Fed were willing to accept the crap as collateral, Lehman would have survived. And if AIG had still needed help in that case, then the Fed could have pulled a similar trick there, too.

The government may have rooted its arguments against doing this sort of thing in legal constraints, but as we saw in 2008 and again in the euro crisis, the legal and regulatory environment are quite flexible in times of crisis. The real reason the government didn't help was much simpler: it didn't want to, because it was concerned about moral hazard.

As it turned out, this calculation was horribly mistaken. If you demonstrate to the world that some banks are in fact too big to fail and can never be allowed to fail, then you've made the problem of moral hazard massively worse. And when we look back on policy choices since the fall of 2008, it is clear that the one mistake governments and central banks are determined not to repeat is the failure of a large financial institution.

And then it's impossible not to wonder: should Lehman have been saved? How might things have been different if the Fed had simply thrown gobs of money at the financial system? How might the euro crisis have gone differently? It's surprising how difficult it is to avoid thinking about the situation moralistically—to feel that there was indeed something good and purging in the near-collapse of the financial system. There wasn't, though. Lehman's shareholders were punished severely, but the vast majority of financial institutions made it through all right, despite the fact that their behaviour hadn't been much better than the victims'. And meanwhile, millions of workers and businesses suffered tremendously despite having done nothing wrong.

There may be another problem, of course: that when failure is never allowed the system becomes more brittle and the cost of a blow-up, which probably isn't avoidable for ever, rises. Frankly, I haven't decided how to think about this problem. It looks, however, as if the ECB is attempting to engineer what the Fed did not in September of 2008. And we're all left stroking our chins and thinking, will it work? Should it?