Anatole Kaletsky

Last week I discussed in this column the idea that the vast amounts of money created by central banks and distributed for free to banks and bond funds – equivalent to $6,000 per man, woman and child in America and £6,500 in Britain – should instead be given directly to citizens, who could spend or save it as they pleased. I return to this theme so soon because radical ideas about monetary policy suddenly seem to be gaining traction. Some of the world’s most powerful central bankers – Mario Draghi of the European Central Bank last Thursday, Eric Rosengren of the Boston Fed on Monday and Mervyn King of the Bank of England this Wednesday – are starting to admit that the present approach to creating money, known as quantitative easing, is failing to generate economic growth. Previously taboo ideas can suddenly be mentioned.

Rosengren, for example, suggested that the Fed should expand the money supply without any limit as long it sees unnecessary unemployment. Draghi has similarly promised to spend whatever it takes to prevent a euro breakup, although politically his ability to do this remains in doubt. Most interesting was a speech by Adair Turner, chairman of Britain’s Financial Services Authority and leading contender to be the next governor of the Bank of England. This speech strongly challenged the pervasive complacency of central bankers and called for new ideas that might combine central-bank money creation with government decision making on how to bypass banks and inject this money into the non-financial economy of consumption, investment and jobs.

The radical alternative discussed here last week – QE for the People (or QEP, for short) – would bypass banks completely by distributing newly created money straight to the public. It is not yet on anyone’s agenda, but neither is it any longer dismissed as a joke.

Given the clear political attractions of giving money to citizens, rather than bankers, it may start to gain attention, at which point there will surely be powerful objections to this idea. Apart from the obvious observation that bankers and financiers are very powerful interest groups, there are four genuine arguments against QEP as a way to stimulate economic recovery.

The first is that it wouldn’t work. Since banks and bond investors simply hoarded most of the $2 trillion delivered to them via QE, maybe citizens would do the same. Instead of spending their QEP bonuses to buy consumer goods and houses and create jobs, citizens scarred by the financial crisis might simply save their bonuses or use them to pay down debts. This could indeed happen. But if it did, economic prospects would still be transformed, since the debt burdens crushing many households would be lightened. If the $2 trillion in QE had instead been used to repay consumer debts, U.S. household debt would be reduced from 83 percent to 70 percent of GDP, roughly where it was in the 1990s. The excess leverage created by the housing and credit bubble would be eliminated at a stroke.

The second objection to QEP is that it would work too well. The present slump would turn suddenly into a boom and create inflation. Excessive inflation is always a valid argument against excessive monetary stimulus, but the problem with inflation today is that it is too low. Central banks all over the world are explicitly trying to increase it by reducing interest rates to zero, and the Fed is particularly adamant about this. If central banks print too much money for too long, then inflation will follow. But the same applies to the present policies of zero interest rates and standard QE. Nobody worries about the inflationary risks of these standard policies any longer because they don’t seem to be working, but this may actually mean that an accidental monetary overdose is more likely if the central banks stick to standard QE.

Another, more powerful, version of the “works too well” critique relates to politics and moral standards. If distributing printed money proved successful, this discovery would corrupt society. Politicians would bribe voters before elections and citizens would stop working, preferring to collect handouts from the central bank. Of course, these things would happen if QEP continued forever. But the same is true of all popular policies, including tax cuts, welfare spending and low interest rates. What limits the moral hazard of these policies is not ignorance, but democracy. Governments that lose control of inflation get punished by voters – and the same would apply if central banks continued printing money for longer than required, whether this money went straight to voters or banks. Indeed, if QEP proved effective, central banks would have to print less money than under standard QE.

Which leaves the final and most persuasive objection: the idea that money could be given to citizens without raising taxes or increasing the government’s debt burden seems too good to be true. Economists often say that “there is no such thing as a free lunch,” but this is not true. In fact, economics since Adam Smith has demonstrated that the world is full of free lunches. Free economic exchange means that one person’s gain need not result in another’s loss. When properly managed, industrial specialization, international trade, market competition and full-employment macroeconomic policies can all produce gains without any substantial losses. In the deepest and most protracted economic slump since the 1930s, QE for the People may be another such idea whose time has come.

Through an almost astrological coincidence of timing, the European Central Bank, the Bank of England and the U.S. Federal Reserve Board all held their policy meetings this week immediately after Wednesday’s publication of the weakest manufacturing numbers for Europe and America since the summer of 2009. With the euro-zone and Britain clearly back in deep recession and the U.S. apparently on the brink, the central bankers all decided to do nothing, at least for the moment. They all restated their unbreakable resolution to do “whatever it takes” – to prevent a breakup of the euro, in the case of the ECB, or, for the Fed and the BoE, to achieve the more limited goal of economic recovery. But what exactly is there left for the central bankers to do?

They have essentially two options. They could do even more of what the Fed and the BoE have been doing since late 2008 – creating new money and spending it on government bonds, in the policy known as “Quantitative Easing.” Or they could admit the policies of the past three years were not working, at least not well enough. And try something different.

There is, admittedly, a third option – to do nothing, on the grounds that public bodies should stop interfering with the private economy and instead leave financial markets to restore economic prosperity and full employment of their own accord. This third idea is based on the economic theory that if governments and central bankers leave well enough alone, “efficient” and “rational” financial markets will keep a capitalist economy growing and automatically return it to a prosperous equilibrium after occasional hiccups. This theory, though still taught in graduate schools and embedded in economic models, is implausible, to put it mildly, especially after the experience of the past decade. In any case, experience shows that the option of government doing nothing in deep economic slumps simply doesn’t exist in modern democracies.

Returning, therefore, to the two realistic alternatives, central bankers and financiers are overwhelmingly in favor of the first: keep trying the policy that has failed.

While QE might still help in the euro zone, since the ECB is the only entity that can guarantee that Italy, Spain and France will not go into a Greek-style default, the U.S. and British situations are very different. The U.S. and British governments control their own currencies and therefore face no risk of default. What, then, would be the benefit of more QE in the U.S. or Britain?

So far $2 trillion has been created by the Fed and £375 billion by the Bank of England, but where has all this new money gone? It has certainly not appeared in my wallet or bank account – nor has it fattened yours,  unless you happen to be a bond trader or banker. The fact is that all the new money has been spent on buying bonds. QE has thus inflated bond prices and boosted bank profits, but achieved little else.

The one economic benefit of QE has been to help governments finance the huge deficits caused by recession without having to raise taxes, slash public spending or face Greek-style bankruptcy. In this sense, QE has certainly prevented the U.S. and Britain from suffering worse outcomes, but it has failed to stimulate employment or economic growth. This is exactly what Japan has experienced for 20 years – and as in Japan, additional rounds of QE now will merely act as an anesthetic, perpetuating stagnation but discouraging more effective stimulus measures.

One such radical measure is too controversial for any policymaker to mention publicly, although some have discussed it in private: Instead of giving newly created money to bond traders, central banks could distribute it directly to the public. Technically such cash handouts could be described as tax rebates or citizens’ dividends, and they would contribute to government deficits in national accounting. But these accounting deficits would not increase national debt burdens, since they would be financed by issuing new money, at zero cost to government or to future generations, instead of selling interest-bearing government bonds.

Giving away free money may sound too good to be true or wildly irresponsible, but it is exactly what the Fed and the BoE have been doing for bond traders and bankers since 2009. Directing QE to the general public would not only be much fairer but also more effective.

Suppose the new money created since 2009, instead of propping up bond prices, had simply been added to the bank accounts of all U.S. and British households. In the U.S., $2 trillion of QE could have financed a cash windfall of $6,500 for every man, woman and child, or $26,000 for a family of four. Britain’s QE of £375 billion is worth £6,000 per head or £24,000 per family. Even if only half the new money created were distributed in this way, these sums would be easily large enough to transform economic conditions, whether the people receiving these windfalls decided to spend them on extra consumption or save them and reduce debts.

Distributing money to the general public was the one response to intractable recessions and liquidity traps that united Milton Friedman and John Maynard Keynes. Their main difference was that Friedman proposed dropping dollar bills out of helicopters, while Keynes suggested burying pound notes in chests that unemployed workers could dig up. Unfortunately modern economics, based as it is on simplistic and misleading assumptions about self-stabilizing markets, has forgotten the insights of these great students of deep economic slumps. In today’s world of electronic money, we would not even need Friedman’s helicopters or Keynes’s ditchdiggers. Just a few lines of computer code – plus some imagination and courage from our central banks.

Editor’s note: This piece was updated August 2 to reflect new developments.

PHOTO: Doug O’Neill, trainer of Kentucky Derby winner I’ll Have Another, displays his winnings after cashing a 200-to-1 future bet on the horse at the Primm Valley Casino in Primm, Nevada, June 25, 2012.  REUTERS/Las Vegas Sun/Steve Marcus

As London prepares for another display of British pageantry and good humor to match the unlikely triumph of last month’s rain-sodden Royal Jubilee, a less impressive aspect of Britain’s stoical “stiff upper lip” may detract from the national pride associated with hosting the Olympics. In the global race out of recession, Britain has just been revealed as a prime contender for the wooden spoon.

Not only was the shocking drop of 0.7 percent in Britain’s second-quarter GDP reported on Wednesday much bigger than investors and independent economists had expected but it almost matched the 0.8 percent fall in Italy’s GDP the previous quarter. And that Italian drop holds the record for the biggest quarterly contraction suffered by any G7 country since the immediate aftermath of the Lehman crisis. Much more important than such statistical trivia is the fact that Britain’s economic output is still 4.5 percent below the peak level it reached in the first quarter of 2008, more than four years ago. The U.S. and German economies, by contrast, are now significantly bigger than they were before the crisis and, in this sense at least, have left the recession behind them. And even the euro zone as a whole, despite the severity of its financial crisis, has done much better than Britain, with GDP just 2 percent below its peak in 2008.

National economic performance is not, of course, a competitive Olympic sport, and there is more to economic success than GDP growth. Still, there is a good reason for connecting the Olympics with economics: International competitions and comparisons can teach useful lessons and create incentives to improve economic management.

The most instructive international comparison at present is between the British and American efforts to clamber out of recession and financial crisis. This race is about as close as economics can get to a controlled experiment of the kind favored by natural scientists, in which sharply different policies are applied to two countries with broadly similar structures and initial conditions, facing similar economic problems.

In 2008, the U.S. and Britain were two advanced economies with large financial sectors, dangerous housing bubbles, heavy consumer debt and similar government deficits and debt levels relative to GDP. Both suffered extremely severe banking crises that forced their governments to take on huge additional liabilities by guaranteeing their biggest banks. For two years after the Lehman crisis in September 2008, the two economies followed broadly similar policies: slashing interest rates to zero, allowing large expansions of their budget deficits and financing the resulting debt with newly printed money. The two economies moved closely in tandem, as economic theory would have predicted: both on the way down until mid-2009 and then on the way up until mid-2010.

But then, in the summer of 2010, the newly elected British government set a radically different course for one very specific and controversial aspect of economic policy – government borrowing. Instead of simply tolerating the big budget deficits that had resulted from weak economic growth, as both the U.S. and British Treasuries had done until 2010, David Cameron decided his top priority would be to reduce government borrowing. He planned to do this by slashing public spending and imposing substantially higher tax rates. The U.S. government, meanwhile, continued with a fiscal policy of benign neglect. Despite all the sound and fury in Washington about deficits and debt limits, U.S. tax rates and public spending plans remained broadly unchanged through 2011 and 2012, with a small cut in payroll taxes largely offsetting the fiscal impact of cuts in local government spending and employment. In all other respects conditions in the two economies remained unchanged. Both central banks continued to print money and to keep interest rates near zero. The dollar and the pound moved very little against one another, and exports grew moderately in both countries, despite the crisis in the euro zone. In short, this really was a controlled experiment on the impact of different fiscal policies.

Curiously enough, the two economies began to diverge from the moment this controlled experiment started, with the British economy contracting in the third quarter of 2010, while growth accelerated in the U.S. In the period since then, the U.S. economy has expanded by 2.7 percent, while Britain has contracted by 0.8 percent. The latest results of this experiment will be revealed on Friday, when the U.S. GDP figures are published and can be compared with the 0.8 percent fall in British GDP just announced.

It may be said, of course, that the British policy of fiscal consolidation was still justified, even if the U.S. enjoys much stronger growth, as it almost surely will. After all, controlling public debt and deficits is an important national objective that counts for more than simply juicing up short-term growth.

But this is where we get to the really significant and surprising feature of the race out of recession. Britain’s heroic spending cuts and tax increases imposed by the Cameron government may contrast starkly with lassitude and cowardice displayed by politicians in Washington. But this dramatic political contrast has made absolutely no difference on the debt and borrowing outcomes the two countries have actually achieved, because the British austerity has simply prolonged recession, while U.S. fiscal laxity has allowed the economy to grow. According to the latest IMF figures, published two weeks ago, the U.S. budget deficit has been reduced from 10.5 percent of GDP in 2010 to 8.2 percent in 2012. This reduction is a slightly bigger reduction in the deficit than Britain has managed to achieve in the same period – from 9.8 percent to 8.1 percent.

In short, any country determined to control public borrowing should forget about fiscal austerity and instead do everything to grow as fast as it can – a fitting economic message from Olympic Britain.

PHOTO: A rower from Hong Kong trains for the single sculls at Eton Dorney near London in preparation for the Olympic Games, July 25, 2012. REUTERS/Jim Young

Why is it that the U.S., Britain and Japan, despite their huge debts and other economic problems, have not succumbed to the financial crises that are threatening national bankruptcy for Greece, Spain and Italy – and perhaps soon for France?

After all, even the strongest British and American banks, such as HSBC and JPMorgan Chase, have now admitted that they were as accident-prone as their continental rivals. Borrowing by the U.S., British and Japanese governments is well above European levels relative to the size of the economy. These governments are not even considering fiscal consolidation as ambitious as the 3 percent deficit targets now being written into national constitutions across most of Europe – and Britain has missed by a wide margin the much less demanding targets David Cameron set himself in 2010.

Given that financial markets are supposed to be dispassionate arbiters of economic management, why are they punishing Mediterranean countries with cripplingly high interest rates, while the British, U.S. and Japanese governments are left free to borrow without any apparent limits at almost zero cost?

In the U.S., the standard answer is that the dollar enjoys “reserve currency status,” since it is the main currency of global trade and investment. But this explanation is clearly wrong, or at least irrelevant, as evidenced by the equally low interest rates in Japan and Britain, without this supposed ”status.” Moreover, the euro has been increasingly used as a reserve currency, but this has been no help to Greece, Italy or Spain.

Which brings us to the less flattering Eurocentric explanations of the unequal treatment meted out by investors to what they often describe as “the Club Med” countries. These range from philosophical statements whose precise meaning is never clear – such as Europe’s lack of “political solidarity” or “economic convergence” – to claims verging on racism that prudent investors would never lend money to these countries because their national characters are rotten to the core: The Greeks are all corrupt, the Spaniards inefficient and the Italians lazy. As for the French, well maybe they are oversexed or rude – or just French.

Such impressionistic explanations of market behavior are not just insulting and morally repugnant (imagine if such national stereotypes, which appear constantly in the German and British media, were applied to Jews, Africans or Muslims). They are also factually wrong – for example, Italians on average work 27 percent longer than German workers (1,773 hours each year versus 1,390, according to the U.S. Bureau of Labor Statistics, and Italy’s long-term pension liabilities are smaller than Germany’s (relative to GDP), according to the IMF.

Worst of all, however, the racist stereotyping that passes for rational analysis of the European crisis deflects attention from a genuine difference between Europe and the rest of the world that perfectly explains the markets’ behavior. There is one simple difference between all the European victims of financial crisis and the lucky countries that are given a free pass by investors, despite even bigger deficits and worse banking crises. The countries with immunity control their own currencies and central banks. They thus have the power to print money, which they use to the full. By the principle of Occam’s razor, this one simple explanation should be viewed as the main reason for Europe’s present crisis.

The ability to print money, officially known as quantitative easing (QE), has allowed the U.S., British and Japanese governments to run whatever deficits they wanted and to offer their banks unlimited support without suffering the sky-high interest rates that are now driving the Club Med countries toward bankruptcy. Instead of raising money from private investors, these governments finance their public spending and deficits by borrowing from their own central banks. This means that the U.S., British and Japanese governments are actually much more solvent than their huge deficits suggest, because much of their debt does not really exist. They are an accounting fiction – an IOU from one branch of government, the treasury, to another, the central bank. The Bank of England, for example, is lending £375 billion to the British government in 2009-12, out of a total planned deficit of around £450 billion. The Fed’s $3 trillion balance sheet effectively reduces the U.S. government’s total debt by 20 percent, from $16 trillion to $13 trillion.

Of course using printed money to finance government deficits cannot permanently solve structural economic problems such as poor education, crumbling transport infrastructure or unaffordable pension commitments – and in some circumstances financing of deficits by central banks can be extremely dangerous, generating rapid inflation. But the world today is not threatened by inflation and overspending, as it was in the 1970s and 1980s. Instead the danger is generally thought to be deflation caused by inadequate investment, weak consumer spending and falling wages, as in the 1930s. Thus a policy that would rightly have been denounced as counterproductive and irresponsible 40 years ago, is now both necessary and prudent – as demonstrated by the willingness of every major central bank in the world, including the ultimate guardians of monetary stability at the Swiss National Bank, to undertake QE. The only important exception has been the European Central Bank.

On Wednesday this week the IMF issued a report publicly urging the ECB to implement a “sizeable” program of quantitative easing. If the ECB did this, the euro crisis would soon be resolved. If, on the other hand, Europe will not allow its central bank to play by the same rules as the Fed and the Bank of England, then all efforts to save the euro are doomed to failure.

PHOTO: A photographer takes a picture of the construction site of the new headquarters of the European Central Bank (ECB), in Frankfurt July 16, 2012. REUTERS/Kai Pfaffenbach

The state of the world economy these days reminds me of the famous telegram from an Austrian general, responding to his German counterpart toward the end of World War One. The German described the situation in his sector of the Eastern front as “serious but not catastrophic”.  In the Austrian sector, the reply came, “the situation is catastrophic but not serious”. In much of the world today the economic situation is verging on catastrophic, but “not serious” seems a perfect description of the political response.

Four years after the Lehman crisis, economic activity and employment in the OECD has not yet returned to its pre-crisis level. Unemployment is at postwar highs in every major European country apart from Germany and, while the U.S. jobless rate is now a little below its postwar record, it has been stuck above 8 percent for longer than at any time since the Great Depression. And in Britain, the long-term loss of output assumed by the government’s latest budget forecasts implies, according to Goldman Sachs calculations, that the six months of the post-Lehman crisis did greater permanent damage to the country’s productive capacity than the Great Depression or World War Two.

Now consider the response. In the U.S., the four years since Lehman have been dominated by economic debates among politicians, media commentators and business leaders on issues that are almost totally irrelevant to unemployment and the pace of economic recovery: how to reduce long-term budget deficits and whether to tweak the top rate of income tax from 36 percent to 39.6 percent. In Britain, the biggest economic controversy this year has been the extension of value added tax to hot pies. Europe’s response to the deepest economic depression in living memory – and an even more alarming xenophobic nationalism that threatens the literal disintegration of the euro and the European Union – has been to debate the bureaucratic “modalities” of bank regulations, fiscal treaties and pension reforms in the next decade.

How to explain this insouciance in the face of the gravest threat to the Western world since the height of the Cold War? In the U.S. and Britain the answer is straightforward, if unappealing: party politics. In Britain, the Conservative-Liberal coalition has managed to lay all the blame for the country’s economic troubles on Labour’s Gordon Brown, so far at least. Thus there has been very little public pressure on the Cameron government to change its economic policies, and no political advantage in doing so.

In the U.S., the Obama administration’s efforts to revive the economy with public spending have been stifled by congressional Republicans, while Democrats have thwarted conservative ideas about using tax cuts to stimulate enterprise, investment and consumption. Business leaders and media opinion-formers have aggravated this political impasse by whipping up fears about budget deficits, despite the record-low yields set by the markets on U.S. Treasury bonds.

The good news is that U.S. politics created a self-stabilizing feedback of sorts. If the U.S. economy continues to deteriorate, the Republicans will probably win both the presidential and congressional elections and would then be free to pursue an aggressive tax-cutting policy modeled on Reaganomics. Big tax cuts would doubtless increase budget deficits, but they might well pull the U.S. out of recession as they did in 1983. If, on the other hand, the U.S. resumes tolerable levels of economic growth and employment creation, then a re-elected Obama administration would have a strong mandate to overcome or co-opt what would then be a chastened Republican opposition.

Now for the bad news, which comes, of course, from Europe. The euro zone, in contrast to the U.S. and Britain, is paralyzed not by cynical political calculations but by profound misunderstandings of economics and finance. European leaders do not seem to understand that the fiscal and banking unions they are relying on to save the euro can only work under a very specific political condition: Restrictions on national sovereignty over budgets and bank regulation (as demanded by Germany and resisted by France, Italy and Spain) have to be agreed on at the same time as mutual support for debts (as demanded by France, Italy and Spain, and resisted by Germany). Moreover, the banking and fiscal unions can only work if they are backed by a central bank commitment to buy government bonds and thereby maintain near-zero interest rates for a long period, as in the U.S. and Britain.

German politicians and voters believe, however, that centralized control over national budgets and banks is sufficient to resolve the euro crisis – and until this control is fully established, Germany refuses even to discuss mutualizing or monetizing national debts. On the other hand, Mediterranean politicians – and certainly their voters – refuse to cede national sovereignty unless Germany offers them the quid pro quo of support for their national debt burdens explicitly and in advance.

This stubborn opposition of national interests and philosophies in Europe, unlike the political gridlock in Washington, will not be overcome just by elections. It seems to take more than a mere economic catastrophe for politicians to get serious in Europe.

PHOTO: A structure showing the euro currency sign is seen in front of European Central Bank (ECB) headquarters in Frankfurt July 11, 2012. REUTERS/Alex Domanski

Last Friday global stock markets and the euro enjoyed their biggest one-day gains of the year. The S&P 500 jumped by 2.5 percent and the euro by 1.8 percent against the dollar. This Friday we will find out whether these moves were just a blip. Why this Friday? Because that is when the U.S. government publishes its monthly employment statistics – and these figures have more influence on global markets than anything that European leaders may or may not decide.

There are four reasons to believe this. The first is the very fact that Europe so dominates the news. Financial markets are not moved by events; they are moved by unexpected events. Once a story has appeared on newspaper front pages around the world every day for months, what are the chances that it will radically surprise? At this time last year, there was still widespread misunderstanding and complacency about the European crisis. The European Central Bank, for example, was so complacent that it was raising interest rates when it should have been cutting them. But today, investors and policymakers are obsessed with Europe’s grim prospects. A genuine surprise would have to be something much worse, or much better, than the scenarios market participants already know.

This observation leads to the second reason for shifting attention from Europe. For Europe to generate a favorable surprise that lasts for more than a few days or weeks is literally impossible. The market is too aware that for the euro to survive it has to go through a  lengthy and uncertain process of political federation. But Europe’s capacity for negative surprise is quite limited too. Everybody knows that Europe is in deep recession, that Greece will never repay its debts, that Spanish banks are insolvent, that debtor countries will all miss their budget targets and that German-imposed austerity will prolong the recession for years. The only news from Europe that would shock the markets would be a total breakup of the euro and Lehman-style financial meltdown. Such a breakup is possible, but it isn’t yet the most likely scenario. Unless a breakup happens, Europe will create lots of volatility, but the trend in financial markets will be set by events elsewhere.

Which brings us to the U.S. and the third reason to shift attention. The U.S., unlike Europe, really does have the capacity to surprise. The U.S. economy is balanced on a knife-edge. In the months ahead, the U.S. could accelerate back to the fairly robust growth it enjoyed in the fall of 2011 and winter of 2012. If this happened, it would come as a big surprise to bond markets in the U.S., Germany and Britain, which are now priced for many years of Japanese-style stagnation. Alternatively, the U.S. economy could continue to weaken, as it has since April. In that case a double-dip recession would become increasingly likely – and stock market investors everywhere would be in for a shock.

So should we expect the U.S. to produce a bullish or bearish surprise? Nobody can say for sure – and that is the final reason to expect U.S. news to drive the markets. Because the U.S. is balanced so finely between expansion and recession, every statistical release can tip expectations in a significant way. Recent experience confirms this. Since late 2010, the sustained trends in global financial markets have been driven largely by U.S. statistics, especially the monthly employment reports. The unexpectedly strong employment report of Oct. 7 last year launched the 30 percent bull market that began that week – and the end of that powerful rally in early April exactly coincided with the shockingly weak employment report published on Apr. 6, a bearish trend that was then reinforced by bad employment figures on May 4 and June 1.

In short, Europe creates a lot of noise in financial markets, but the signal comes mostly from the U.S. Why then is the opposite impression so widespread? Partly because debating European politics is much more fun than drily dissecting U.S. statistics. But mainly it’s because the euro and global stock markets tend to move in the same direction from day to day. This daily correlation, which reflects the mood swings of short-term traders between risk-aversion and risk-seeking, creates the impression that Europe is driving financial markets around the world. But on anything longer than a daily basis, the euro and the global stock markets are not correlated at all. Think back to the start of the post-Lehman recovery in global markets, on Mar. 10, 2009. Since that day, when one euro was worth $1.26, it has gone exactly nowhere, while the S&P 500 has more than doubled and the MSCI world equity index has risen by 78 percent.

So where will stock markets move next? If the employment growth announced on Friday proves better than the expected 90,000, the global equity rally will probably gain momentum. If the payrolls disappoint, the rally will quickly fade. The euro, meanwhile, will remain a hostage to the European story, whose tragic futility brings to mind the famous lament from Macbeth about human life: “It is a tale told by an idiot: full of sound and fury, signifying nothing.”

The fundamental problem of the euro is widely seen as one of “herding cats” – the impossibility of coordinating complex policies among 17 discordant nations, each with different interests, traditions and ideas. This is not true. The dividing line in Europe is much simpler. On one side are France, Italy, Spain and every other significant country, backed by the U.S., Britain, the IMF, the European Commission and the leadership of the European Central Bank, proposing serious and complex technical solutions based on genuine fiscal federation, which means the sharing of national debts. On the other side is Germany, occasionally supported by Finland, Austria and Slovakia, always saying Nein!

Every new veto threat from Angela Merkel increases Germany’s embarrassing isolation, as Joschka Fischer, its former foreign minister, recently warned: “Germany destroyed itself – and the European order – twice in the 20th century. It would be tragic and ironic if a restored Germany … brought about the ruin of the European order a third time.” But if Germany’s role as spoiler is increasingly recognized, why don’t the other countries do what this column suggested last week: Tell Merkel to put up or shut up – either abide by majority decisions or leave the euro?

The standard answer is that Germany is the “paymaster” of Europe; so without Germany the euro zone would be “bankrupt”. Such metaphors are a lazy substitute for clear thinking. To see why, compare the consequences of Germany leaving with the Greek exit, which was described as “manageable” by European officials only a few weeks ago. German departure would be less disruptive than Grexit for three reasons.

First , a Greek devaluation would trigger capital flight from the next weakest country – Spain, then Italy and France. Germany would not create such domino effects. Once the Deutschemark was restored and revalued, there would not be a “next strongest” country to attract capital flight. Of course, some people might still send their money from Italy or France to Germany, to speculate on further revaluation, but that would be no different from investment flows out of Europe at present into dollars, pounds or Swiss francs.

Second, and most crucially, the euro zone would become a more credible and coherent unit without Germany. Liberated from German obstruction, the ECB would be able to follow the examples of the U.S., Japanese, British and Swiss central banks, using quantitative easing to bring down interest rates to zero at the short end and to around 2 percent on long-term bonds. Just as important, the euro governments could finally form a genuine fiscal union, using the entire fiscal capacity of the euro zone to back jointly guaranteed eurobonds. The euro zone could then be treated again as a single economic unit, comparable to the U.S., Japan or Britain – and in terms of key fiscal ratios it would score well. Public deficits in euroland ex Germany were 5.3 percent of GDP in 2011, according to the IMF, compared with roughly 9 percent in Britain and 10 percent in the U.S. and Japan. Gross debt (including financial bailouts) was 90.4 percent of GDP, against 98 percent, 103 percent and 205 percent in Britain, the U.S. and Japan, respectively. Trade deficits were much smaller than in Britain or the U.S. In short, euroland without Germany would be far from bankrupt – and the key reason for the euro crisis isn’t lack of competitiveness but Germany’s refusal to mutualize and monetize public debts.

Third, a euro break-up caused by Germany withdrawing would be far less chaotic from a legal standpoint than a break-down in which the euro disintegrated as weak countries were pushed out. The euro without Germany would remain a legal currency, governed by the same treaties as before. International contracts in euros would be legally unaffected, but simply devalued in terms of new German marks or dollars, just as British contracts were devalued when the pound fell from $2 to $1.40 from 2008 to 2009. Only contracts within Germany governed by German domestic law, for example retail bank deposits and wage deals, would be redenominated into marks. The German government would face no legal challenge if it decided to save money by repaying bonds in devalued euros (as specified in the contract) instead of converting them into marks (as speculative investors might hope).

None of this means that a German exit would be painless. German export companies would lose sales because of the strong mark. Most German banks would have to be recapitalized by the government, since their mark liabilities would not be matched by devalued assets in the euro zone. The Bundesbank would probably require the biggest recapitalization in history, since its loans to the Target2 clearing system run by the ECB (698 billion euros at the end of May and rapidly rising) would only be repaid in devalued euros.

But these would all be local difficulties for Germany, not existential threats for the whole of Europe. For the rest of Europe, a euro without Germany would be perfectly feasible and even attractive. Pressuring Germany to leave the euro therefore need not be an empty threat.

If European leaders can only make Merkel understand that she seriously risks exclusion from the euro, she may start to behave in a more cooperative way. In that case, the costs and benefits of actually expelling Germany will never have to be tested.

PHOTO: A man holding an umbrella in the colors of the European Union enters the  Chancellery in Berlin before talks between government and opposition leaders about the EU fiscal pact, June 21, 2012. REUTERS/Thomas Peter

As financial markets slide toward disaster, scarcely pausing to celebrate the “success” of the Greek election or the deal to recapitalize Spanish banks, the euro project is finally revealing its fatal flaw. One country poses an existential threat to Europe – and it is not Greece, Italy or Spain. Every serious proposal to resolve the euro crisis since 2009 – haircuts for bank bondholders, more realistic fiscal consolidation targets, jointly guaranteed eurobonds, a pan-European bailout fund, quantitative easing by the European Central Bank – has been vetoed by Germany, and this pattern looks likely to be repeated next week.

Nobody should be surprised that Germany has become the greatest threat to Europe. After all, this has happened twice before since 1914. To state this unmentionable fact is not to impugn Germans with original sin, but merely to note Germany’s unusual geopolitical situation. Germany is too big and powerful to coexist comfortably with its European neighbors in any political structure ruled purely by national interests. Yet it isn’t big and powerful enough to dominate its neighbors decisively, as the U.S. dominates North America or China will dominate the Far East.

Wise German politicians recognized this inherent instability after 1945 and abandoned the realpolitik of national interest in favor of the idealism of European unification. Instead of trying to create a “German Europe” the new national goal was to build a “European Germany.” Unfortunately, this lesson seems to have been forgotten by Angela Merkel. Whatever the intellectual arguments for or against German-imposed austerity or the German-designed fiscal compact, there can be no dispute about their political import. Merkel’s stated goal is now to create a “German Europe,” with every nation living, working and running its government according to German rules.

Merkel doubtless believes that she is helping Europe when she maternally instructs the Greeks, Italians and Spaniards to “do their homework” and so become good little Germans. But like its less benign predecessors, this effort to impose German hegemony is guaranteed to fail. Europe’s leaders must therefore start considering a previously unmentionable question, perhaps as soon as next week’s summit, if the euro crisis intensifies. This question is not whether Europe will agree to live under German leadership, but whether Germany will agree to live under EU leadership – or whether the other nations must form a united front against Germany to prevent the destruction of Europe, as they have repeatedly in the past.

To be specific, the euro’s only chance of survival now depends on a decisive move toward political and fiscal union. Angela Merkel plays lip service to such political union, even claiming that democratic accountability is her main condition for financial rescues; but what she means is accountability to German voters, German newspapers and German constitutional judges. She promises to “do whatever it takes to save the euro” but vetoes anything that might actually work, claiming deference to German public opinion or national interests.

Europe must now call this bluff. At next week’s summit, France, Italy and Spain can turn the tables on Merkel by presenting her with an ultimatum: Led by President Hollande, who has abandoned President Sarkozy’s Gaullist pretensions of parity with Germany, the big three Mediterranean countries could agree on a program that really might save the euro: a banking union, followed by jointly issued eurobonds and backed by ECB quantitative easing. If Merkel tried to block these policies, the others could politely invite her to leave the euro, since Germany’s political pressures evidently made membership impossible on terms its partners could accept – essentially the proposition Merkel put last month to Greece. Without Germany, the euro zone would have much smaller internal imbalances and much more political coherence, with a much weaker currency and higher inflation, both of which would make debts easier to resolve.

Merkel would probably insist on Germany’s legal right to remain within the euro, ironically echoing the Greek position. At this point the other nations could play their trump card: To reduce interest rates and make their economies more competitive by weakening the euro, the debtor nations could vote for unlimited bond purchases by the ECB. The Germans on the ECB council would doubtless oppose this, but even with support from Finland, Slovakia, and perhaps Austria and Holland, Germany could command no more than 7 votes out of 23. Germany would then face the very same existential choice about its relations with Europe that Merkel has inflicted on Greece and other debtor nations.

Germans will almost certainly support the political concessions that might give the euro a chance of survival, including fiscal transfers and some mutualization of debts, once they realize that their only alternative is isolation from the rest of Europe. But before they agree to a European Germany, voters may need to be reminded that trying to create a German Europe always leads to disaster.

PHOTO: German Chancellor Angela Merkel (R) and British Prime Minister David Cameron arrive for a statement to the media before bilateral talks in Berlin, June 7, 2012. REUTERS/Tobias Schwarz