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Krugman's mistake, and the point that you don't address in your projection, is failing to realise that a Euro exit cannot be ringfenced. Once Germany kicks Greece out, France is sure to follow within a few years.


Will it work? Three reasons it won't

... The idea that exiting the eurozone is a simple matter of devaluing is dead wrong. It confuses the correct view that Greece and Portugal and Ireland would have been better off outside the euro with the quite different, and catastrophically erroneous, view that exiting is the optimal strategy. ...

... Germany's new Plan A is doomed. Here are three reasons:

The first reason is that, in the short, run, just like in the case of Lehman's, the Frankfurt optimists are assuming that they know the unknowable (just like, prior to 2008, they assumed they had created riskless risk). The interconnections between the Portuguese banks with those of Spain, and of the Greek banks with those of France and Germany, are of the sort that will only see the light of day when disaster strikes. And when they do appear in full Technicolor their sight will be terrifying.

The second reason is that the massive liquidity injection into the Italian and Spanish banks, not to mention the French and German ones, will operate like large cortisone doses injected into a cancer patient. They will cause temporary relief but, at the same time, they will give the underlying malignancies time to grow nastier, bigger and deadlier. In short, the remaining eurozone's banking sector will turn into a monster version of Japan's zombie banks of the 1990s, brewing en masse the next banking crisis and embedding the virus of recession everywhere, from Spain to Germany, from France to Italy.

The third reason is structural. The eurozone's troubles stem from the lack of a pan-European system of supervising the banks, of managing public debt and of planning for aggregate investment. None of these three constituents of the Crisis will be dealt with if Greece, Portugal and possibly Ireland are amputated - even if the stumps are effectively cauterised. This means that on the Morning After, Italy will be the next Greece and Spain will be the new Portugal. The internal imbalances of the eurozone, after a brief lull, will start rearing their hideous heads again, and, in conjunction with the zombie banks and the recessionary environment, it will not be long before another round of amputations will become `inevitable'.

There is, in other words, no way to ringfence the crisis unless all deficit countries all the way to France are ejected and all that remains is a Neuro consisting of Germany, Netherlands, Finland, Luxembourg and maybe a couple of others, which could only remain a surplus country by engaging in massively mercantilistic currency policy in competition with China.

In other words, finally the Bundesbank would accept responsibility for countering upwards pressures on its currency's exchange rate, or else there would be massive internal deflation and/or one of the Virtuous Four Euro countries would find itself a net importer once the Neuro(tic)zone achieves balanced external trade at a stable exchange rate.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman

by Migeru (migeru at eurotrib dot com) on Sat Mar 17th, 2012 at 09:54:49 AM EST

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