Wednesday, November 30, 2011

Solving Euro Crisis

Martin Wolf has a column about what IMF must tell the EU leaders. It is a rather generic diagnosis but it got me thinking. Here are my steps to solving a Euro Crisis.

Step 1: Put out the fire 

I borrow from Martin Wolf here. We need the EU leadership to come up with a "credible commitment to halt the contagion". Without this there is no tomorrow. You may read the entire suggestion by Martin Wolf.
There needs to be a credible commitment to halt the contagion, for sovereigns, banks and markets. One possibility would be to guarantee financing of rollover of public debts and fiscal deficits for Italy, Spain and Belgium for 2012 and 2013. That would cost up to €1,000bn ($1,300bn), though even this might be insufficient to arrest the contagion, given its current extent (see chart). The resources needed could come from leveraging the European Financial Stability Facility or from the European Central Bank or both, with the former taking on the risk of loss and the ECB offering liquidity. In the longer term, a conditional eurobond may provide a workable answer, as John Muellbauer of Nuffield College, Oxford, has argued.
Step 2: Create certainty to induce demand
I take it further than Martin Wolf here. He simply states that households must spend. I would go further, and correct the job-side first. The reason households are not spending lie in two categories, first is ability and second is intention. Both are missing. We can transfer a million Euros in each persons bank account and give them the ability but we cannot give them intention.  

Intention needs to be induced and can be induced by bringing certainty on the income side. Once people are confident that they will have income they will start spending. Alas, the political policies do not inspire much confidence.

Here income means income less bare essentials. Bare essentials should include food, basic healthcare and basic transportation. Both healthcare and transportation need to be credible. 

Thus, income can be created by creating, for the short term, jobs that tie-in with the competencies of the population. It means if Greeks are good at mining then create more mines, if they are good at electronics build more electronic factories.

Secondly, we need cost ceilings on food, healthcare and transportation. This will help limit the expense side. 

Long term solutions
For the longer term, multi-pronged approach is required. 
  1. We need to improve employability for new-age jobs through training. This goes concurrently with old-world jobs we force them to have. 
  2. We need comprehensive reform of entire social system, starting from economy, judiciary, taxation, media and politics.
  3. We must take the learning from EU crisis and go for a two-tiered world currency system. This will allow monetary policy and fiscal policy to have equivalence. EU can take two routes, member countries can cede fiscal freedom to EU governments or we can dissolve the EU as a monetary union. Dissolution must be structured and old loans must be marked to new loans in fair manner.