European Debt Dominos

So, as everyone knows, the ECB came out yesterday with its latest plan to stem the creeping European sovereign debt crisis. This one involves potentially unlimited ECB purchases of sovereign debt, so long as its maturity is less than three years (presumably so that the ECB can pull the plug within three years on non-complying governments) and the country in question agrees to comply with fiscal policy reforms (i.e., austerity).

I don’t have any particular ability to forecast whether this will succeed or fail. My inclination is that it will succeed for a while and then turn out to be insufficient, for the reasons that others have identified. Central bank bond-buying will enable governments to borrow money at manageable yields, so their national debt will not spiral out of control solely because of climbing interest rates. But to bring debt levels down will require actual economic growth, and more austerity—even if it isn’t quite as austere as that imposed on Greece in the past—will not generate growth. In addition, the ECB’s promise to “sterilize” its bond purchases—I believe by selling other assets to raise the cash for bond purchases, so the net effect will not be to create money—means that this is not a particularly expansionary form of monetary policy.

This is as good an occasion as any, however, to ask a question I’ve been wondering about for, oh, years now. Every discussion of the European crisis includes the following domino theory (although no one calls it that anymore, for reasons I’ll get back to): If Greece leaves the Eurozone, that proves that it is possible to leave the Eurozone—or, put another way, that the powers that be cannot keep the Eurozone intact. If people realize that it is possible, then bond markets will bet even more heavily against Spain and Italy, which will force them to leave the Eurozone, which would be terrible. Hence Greece cannot leave the Eurozone.

The reason no one calls this a domino theory anymore is that the original domino theory was thoroughly discredited. Remember the fall of Vietnam? Do you remember the ensuing communist takeover of the free world? No, because it didn’t happen.

It seems to me that the current version of the domino theory, where Greece plays the role of Vietnam, rests on a logical flaw. The premise is that (a) if Greece leaves the Eurozone, that implies that the powers that be (Germany, the ECB, the IMF, etc.) are incapable of preventing any individual country from leaving the Eurozone. This ignores two other obvious logical possibilities. One is that (b) the powers that be might have the ability to protect any country they choose to protect, but might decide that Greece is not worth the trouble. The other is that (c) the powers that be might have the ability to protect some countries that are not in such bad shape as Greece (Spain and Italy come to mind).

For whatever reason, the powers that be have chosen to embrace the domino theory, calling the euro “irrreversible,” among other things. In practice, this means that they have staked their credibility on keeping Greece in the Eurozone. And having committed themselves to this position, they have ensured that should Greece leave the Eurozone, it will be interpreted to mean (a) rather than (b) or (c). In other words, by embracing the domino theory, they have made the domino theory more likely to actually be true. Which means that despite yesterday’s announcement, the future of the euro still depends on the ability of Greece’s incompetent, unloved political class to continue imposing austerity on its people.