Tuesday, August 09, 2011

The Euro Tipping Point. Or why 'Europe' is screwed in theoretical economic terms

By Tyler Cowen:


Suppose that of the N member-states, F (e.g. 3, as is the case at the moment of writing) have ‘fallen’ out of the money markets and into the EFSF’s bosom. The EFSF must then finance their debts entirely until the Crisis ends. To do so it must seek loan guarantees from the N-F still solvent member-states. It is extremely easy to show that the contribution (as a portion of their GDP) of the N-F solvent member-states to the ‘fallen’ member-states, let’s call it αF (where the subscript indicates the number of ‘fallen’ states that must be supported) equals some newfangled debt-to-GDP ratio: The numerator is the total debt of the ‘fallen’ and the denominator is the total GDP of the still solvent member-states. (See here for a brief proof.)  The reason I choose to call αF a toxic ratio is that, with every member-state that ‘falls’, this ratio rises even if GDP and debts remain the same. Moreover, every new casualty boosts the toxic ratio αand guarantees that yet another member-state will join the rank of the ‘fallen’. And as if this were not enough, nothing can stop this process while everything else remains the same. Including the potential size of the EFSF.

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