Introduction: This is the fourth in a series of dashed off speculative opinions. Normal procedure on the FM website for these topics would be 3 thousand word posts, supported by dozens of links. I dont’ have the time to finish them, and too many of these outlines have accumulated in my drafts file. Perhaps these will spark useful debate and research among this site’s readers.
In this third year of recession of the worst recession since the 1930s, reserves are depleted around the world. Cash reserves of households, businesses, and governments. This increases our susceptibility to a shock. A poor bio-metaphor to this is the poor health of the world’s peoples in 1918. The global economy remains unstable, as it was in 1929. Many links in the world’s economic machinery have broken. Although the global economy might be in recovery, the stress remains great. Another link might snap at any moment, increasing the stress on the remaining links — some of which might in turn also snap. Since the data is conflicting (as usual during times of large change), we don’t know how close they (or us) are to the edge. Central Bankers know this, which is why they keep the petal to the metal while talking about exit strategies.
One of the most dangerous flashpoints is Europe’s periphery (the USA is another). Iceland, Ireland, Portugal, Spain, Italy, Greece, Eastern Europe up to the Baltics. The european economy is highly integrated, and collapse in even a peripheral nation might ripple though the region with unpleasant consequences. So rescue efforts are under weigh by the EU and IMF. But the people of one of more of the crippled nations will certainly reject the prescribed austerity measures. Greece is first in line, and general strikes are already being planned. Red emphasis added.
George Magnus, a senior economist at UBS, comments on these developments in “The Return of Political Economy”, 3 February 2010 — A terrifying analysis expressed in mild words. Excerpt:
In the Euro Area, the politics are complex. Politically, the chances of some of the sovereign invalids being able to implement required fiscal restraints are small. In others, the changes of doing so over a protracted period without social unrest are questionable. However, politically, nothing short of the integrity of the Euro and the Euro Area are at stake. For this very reason, the issue will probably not come to had in the immediate future, or for some time, because all Euro Area countries have strong vested interests in foreign a path back to stability as quickly as possible, and all the more so since contagion has spread to Portugal and Spain. But what will this need?
Austerity packages never work in a vacuum. One of more of 4 crucial ingredients have to comprise the setting. These are…
- currency debasement,
- a sharp fall in interest rates,
- monetization of debt, and
- a bail-out financing package.
In the Euro Area the first 3 are all impossible. The first 2 are self-explanatory, and the ECB cannot monetize. It might not, strictly speaking, even be able to accept Greek collateral {government bonds} if the sovereign {debt of Greece} is downgraded again {by the ratings agencies}. — Just as the ECB is raising its collateral standards again.
The bail-out is the only option that gives Greece a chance, and possibly other countries too, should the need arise. … The question fro the Euro Area is how long it could carry on like this, that is, if Greece or any other country in question were unable or unwilling to deflate and deleverage public debt over an extended period of time. And in the process, it is by no means impossible, or indeed illegal that, in extremis, a form of default could occur. For example, a temporary moratorium on interest payments.
… In the end, the question as to whether this might happen and under what circumstances has a lot to do with Germany. Would Europe’s major creditor nation and hub be willing to take the risk of compromising the integrity of the Euro, or would it be willing to do whatever is necessary to preserve it? In short, Germany might be willing to sign some big cheques in the interests of the cohesion of the Euro Accord and , one could add, its own banking system, but would it do so ad nauseam? And if so, or if not, what does that tell us about Germany itself?
However you answer this says much not just about financial stability of the Euro, but about what the economies of Germany, Italy, and Spain etc will look like in the next 5-10 years as they try )or not) to strike a balance between social cohesion and quiet, or noisy, decline on the the one hand, and structural economic reform and renewal on the other.
… In the US, the mid-term elections later this year will play a similar role.
So only one of the 4 remedies is possible. The first 3 (the ones we did) are not possible under the European Monetary Union. That leg of the stool cannot possibly carry the load for long. Therefore structural change is inevitable — unless a strong recovery shows itself right now. Otherwise the European unity project will fail under the pressure — or grow stronger, to a true union. None can reliably forecast what path Europe’s people will choose.
A closing note
Debate continues over exactly what sparked the Great Depression. The initial shocks were less than those of 2008. But, of course, the current continues to evolve. Much time remains on the clock for for another conflagration to erupt.
Other articles about the possible break-up of the European Monetary Union
Important insight #1: “It’s All Greek to Me“, Edward Hugh, 7 December 2009 — Conclusion:
We might be forgiven for getting the impression that to date rather than acting as a stimulus to deep economic reform, Euro membership has rather acted to reward those countries who would get into more and more debt, with ever less sustainable economic models, by supplying them with funding at far cheaper rates of interest than the markets would otherwise make available. It is this particular clockhand that Europe’s leaders would now dearly like to turn backwards, and this is why I have little doubt that it is in Greece that a stand will now be taken. If not, then that longest of long runs may arrive rather sooner than some of us, at least, are comfortable with.
Important insight #2: “Department of ‘Urrk!’“, Blog of Brad DeLong (Professor of Economics, Berkeley), 21 June 2005 — Esp note the comments.
Brad Setser (major expert on global captial flows, now with Council for Foreign Affairs): re: Italy. I agree that deflation is never a good idea — particularly if you have as much debt as Italy. Real interest rates can be quite large with signficant deflation even if nominal rates are around 3%. Among other things, the debt dynamics get ugly. But for Italy to regain competitiveness without outright deflation, but rather lower inflation rates than the rest of the eurozone, the overall eurozone inflation rate probably needs to be a bit higher. 2% overall may be too low — far too low — in an environment where some economies need to adjust by having lower inflation rates than their partners.
{FM note about Setser’s comment: (1) Brad’s point is that the German-dominated ECB will not tolerate inflation far above 2%, even if Italy and Spain desperately need it. (2) His observation about deflatinon in a high-debt economy applies as well to the US as Italy.}
Edward: The problem is structural, Italy (and Portugal, Greece and Spain) have specialised in supplying certain kinds of manufactured products (and tourism) to the rest of the EU. Now the new eastern europe members and China are assuming this role, and they can’t convert to higher value activities quickly enough. Look at the average education levels. I don’t remember Italy off hand, but Spain, Portugal and Greece have something in the 8 to 9 years per head. Germany and France have 12 to 13 years. Think Mincer equations as a rough and ready rule of thumb. And demography is important in many ways, but here in the difficulties of improving general educational level with a top heavy population in terms of age. This is why I was so opposed to all that nonsense they used to spout about Harrod-Samuelson-Balassa: it just wasn’t relevant to the case in hand. But it did seem like a convenient ‘excuse’.
Other useful articles:
- Can the European Monetary Union survive the next recession?, FM website, 11 July 2008
- “Can Euroland Survive?“, Stephanie A. Kelton and L. Randall Wray, Levy Institute, November 2009
- “Withdrawal and expulsion from the EU and EMU: some reflections“, Phoebus Athanassiou, European Central Bank, December 2009.
- “Greece’s financial crisis puts the future of the euro in question“, The Obsever, 7 February 2010
- “Europe Risks Another Global Depression“, Simon Johnson (former Chief Economist of the IMF), The Baseline Scenario, 7 February 2010
Afterword
Please share your comments by posting below. Per the FM site’s Comment Policy, please make them brief (250 word max), civil and relevant to this post. Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).
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EU might break up ? How very , very , sad . How we will miss our Daily Directives , and paying our tithes to Brussels and Strasborg . Is it to soon to start stockpiling party poopers , funny hats ,fireworks and booze ?
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FM reply: You would not jest if you realized that the EU is the apartment next door. Any fire will spread rapidly.
a bail-out financing package.
No question No doubt Just waiting while the Euro drops; beggar thy neighbor in full swing. Will never “end” until it does!
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FM reply: Note that the US government has extended “bailout” aid — direct grants and loans — to US States. For example, the unemployment insurance trust funds are exhausted in 26 States. Payments continue funded by loans from the Federal government. See the list here. California has borrowed almost $7 billion, and more each week. The EU is at a crossroads. Are they a nation, or neighborhood association?
Magnus’ analysis is good. Greece is being offered up to the wolves. It really is that medieval. A total failure of leadership on the part of the EU, and from Germany in particular who benefits so much from the aggregate demand stimulus pas de deux that is their trade surplus with the poorer EU states and the peg.
The fact that they can’t be bothered to sort out the collateral rules and don’t want the IMF to intervene because it is embarassing tells you all you need to know. Balancing the budget is obviously incompatible with the austerity measures. The putative reason is a fig leaf so no one else feels queasy while they eat. Suffering builds character. Liquidate corruption; liquidate profligate Greek politicians; liquidate Greece. That’s why they are doing it–superstition: the Gods are angry. They need an offering!
Greece as homo sacer. Yes, it’s extreme, but Jesus…
In and of itself a Greek bankruptcy or bond default should – in theory – not affect the Euro as such very much, Greece being maybe 3% of the total {see my post Will Greece’s default bring down the Euro?“}. However, just as a Californian bankruptcy would reflect badly on the “state of the Union” as a whole so would the default of on EU country, coupled with the rising interest rates and thus further destabilisation of the remaining over-leveraged member states, make investors wonder when sovereign default across the board is likely. Thus they wouldn’t commit themseves to bonds of longer maturity and that’s the beginning of the end.
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FM reply: I disagree. Greece is unlikely to just default or go bankrupt. More likely if pushed to the edge they’ll leave the EMU, redenominate their government debt in drachma — and then implement stimulus programs like the rest of the world has done. If successful, others will probably follow — such as Italy. That would shake Europe to its core, probably destroying the unitification program on which so much effort has been expended — and dashing the hopes for a united Europe to be a major player on the world’s geopolitical stage.
Germany should leave. Everyone else needs it to have a flexible exchange rate. That’s the obvious but sadly implausible answer. But at least we can enjoy the irony: while all of us here were busy bleating about Chimerica, we did not notice the exact same dynamic at work in our midst.
@crisismaven
The problem for Germany is, that a bailout for Greece lead to the same expections of the other PIGS countries, something Germany can not handle.
@vimothy
The German workers have faced substantial income losses in the last decade, so it is not a fun job to sell them a large-scale bailout of at least four countries. The other point is everybody who gives money wants to see reforms first, otherwise its a waste, considering the causes of the problem in Greece.
@FM
If I read serious (German) articles on the options for Greece and others, most authors do not assume Greece could leave the EMU and implement a successfull recovery. The huge level of debt require devaluation and cause skyrocking interest rates IIRC. The other issue are structural problem of the Greece economy, solutions require the cooperation of the Greece people and the change of bad habits, that have caused most of the problems, here most authors are not optimistic. :-(
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FM reply: Quite right, the opinion of the core EU nations is that the PIIGS are trapped, having suffered a crippling lose of competitiveness — but unable to do anything about it. So these nations can be pushed to the edge, forced to make changes that are “good for them.” The combination of arrogance and complacency this displays is incredible. But then, these characteristics account for Europe’s centuries of devastating wars — a history perhaps unmatched in humanity’s history.
This is all discussed at length in the July 2008 post Can the European Monetary Union survive the next recession?
Goldman Sachs is at it again. From Instapundit! “Greek Debt Crisis – How Goldman Sachs Helped Greece to Mask its True Debt“, Der Spiegel. Very interesting. I wonder what other games are being played?
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FM reply: First, hiding debt for clients is a common function of corporate finance departments at investment banks. Second, it’s not necessary for the US government to do so, since its books are inferior to those of a child’s lemonaid stand. Forget about the balance sheet. The accountants cannot certify books of many government departments — such as DoD. In plain English, nobody knows where the money goes. So we’re in no position to sneer at Greece.
It’s not sneer at Greece as it is towards Goldman Sachs and our lack of action to reign them in. The games being played by GS, being caught in Greece or in Mexico, I’m just wondering what we have not caught them at yet. As you have documented many times, they are a major problem along with the other large banks.
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FM reply: No concievable reform will prevent advisors — investment banks or someone else — from helping businesses or governments manipulate accounting systems. Good accounting systems and 3rd party audits can minimize the scope and damage from such activities. Governments tend to have neither. Blaming Goldman for this is silly. Esp when generations of accountants have warned about the US government’s terrible accounting systems. If we don’t demand that the government work with some minimal standards, then it will not do so. That’s life. Mother Nature does not give a damn.
“they are a major problem along with the other large banks”
The problem is their speculative activities, as lenders and traders. Volcker’s proposals would help rein in these activites. Under today’s conditions these proposals are dead.
@FM
You conclusion is not correct. There is still the real possibility that Gremany gives money, garantees for Greece loans etc., while Greecs stays in the EMU, the trick here is to sell this to the German people and to avoid an automatism in case of the larger countries.
For this the chances are not so bad. See the today’s headline of the Financial Times Deutschland.
The basic problems, i.e. structure of the Greek economy, has to be change in any case. I prefer a solution within the EU.
FM reply: “Quite right, the opinion of the core EU nations is that the PIIGS are trapped, having suffered a crippling lose of competitiveness — but unable to do anything about it. So these nations can be pushed to the edge, forced to make changes that are “good for them.” The combination of arrogance and complacency this displays is incredible. But then, these characteristics account for Europe’s centuries of devastating wars — a history perhaps unmatched in humanity’s history.”
I’m not at all sure I understand the thrust of your comment, Fabius. Do you think it is “arrogant” to require austere fiscal reforms of countries like Greece, which have been driven to the brink of ruin by their own irresponsible fiscal practices, in return for aid? Who is the “arrogant” party—Germany? Such demands may be unrealistic, but I don’t see them as arrogant. Do you expect the Germans to simply pour money down the drain indefinitely?
As the strongest economic power in the EU, Germany certainly has some capacity to “bail out” staggering Greece (or at least steady it for a while), and I think Germany is willing to do this—but no one can reasonably expect such aid to be unconditional.
All in all, the prognosis is poor. The whole concept of a European Monetary (and political) Union was a very risky proposition from the start, due to the great differences in economic power of the countries involved. Converting such disparate economies as those of Italy, Greece, Germany and France to a single currency never seemed like a terribly good idea to me. Given the recent world-wide financial debacles, this arrangement has been subjected to strains that will probably end in its collapse. The poorer nations will not accept the austerity measures demanded by the richer ones—in the present instance, I think the Greek government will either have to backtrack, or it will fall. Also, I doubt that even Germany actually has the necessary resources to subsidize the failing “southern tier” of the EU.
There is also the question of how long the German people would tolerate their government’s generosity, should it proceed to give financial aid to Greece (and to the other weak countries of the “Southern tier” of the EU). Many Germans already believe—with some justice—that the switch to a common European currency was disadvantageous to their standard of living. So far, this discontent has mostly been confined to subdued muttering. I expect that the German public’s discontent could easily manifest itself in more drastic ways as the EU continues to drift toward the abyss.
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FM reply: Your tell this as a fable, ignoring the actual history. Today’s crisis did not just happen. It was the result of policies by the EU core nations — esp Germany — and was widely predicted at the birth of the EMU (see the links I provide). Germany and France set interest rates and the value of the Euro at levels that worked for them, but were destructive to the nations of the EU rim. Meanwhile the deslusional stability of the Euro allowed rim nations to borrow more than they otherwise would. Now the consequences arrive, a result of actions of all.
‘Do you think it is ‘arrogant’ to require austere fiscal reforms ”
It’s arrogant to forbid Greece to use 3 of the 4 remedies (the ones the US and China used), and then refuse to extend the 4th. That is in effect saying “just suffer”. The resuling crash will be the responibility of all parties.
FM reply: “Note that the US government has extended “bailout” aid — direct grants and loans — to US States. For example, the unemployment insurance trust funds are exhausted in 26 States. Payments continue funded by loans from the Federal government. See the list here. California has borrowed almost $7 billion, and more each week. The EU is at a crossroads. Are they a nation, or neighborhood association?”
Clearly, they’re a “neighborhood organization”. They have all the characteristics: pompous bureaucrats, arbitrary rules, intense politics, and no real power. Or were you offering the first alternative as a serious possibility? The EU exists because the European-model nation states are sublimating, as is nationalism itself. However, the willingness of the old once potent states to surrender their identity and sovereignity does not automatically call into being a new state, or a new united Europe. That kind of entity can’t be forged out of amorphous desires or vague visions; decay is not a creative force.
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FM reply: While I agree with you, nobody can accurately predict how people will behave at historical inflection. However your analysis is, IMO, the way to bet.
What did you mean? Sublimating how?
Turning into gas and diffusing?
FM wrote: “Germany and France set interest rates and the value of the Euro at levels that worked for them, but were destructive to the nations of the EU rim. Meanwhile the deslusional stability of the Euro allowed rim nations to borrow more than they otherwise would. Now the consequences arrive, a result of actions of all.”
The for the second half of your response I can find a lot of consensus, the reason for the many problems was cheap money in combination with no real pressure to invest the money in useful projects.
Most papers see the main issue in the construction of the EMU, i.e. that some aspects still are handeled/manipulated on the national level, while a useful instruments should be decided by one institution. The solution would require the transfer of more national souvereignty to Brüssel, correct?
The other question for me is, how were some of the smaller countries forced to adope a value of the EURO that hurts them, the exchange ratio was usually national problem and a devaluation at the beginning was possible IIRC? And how would you handle the situation, esp. how would you create a atmoshere in the PIGS that allow structural changes, the attempt to solve the problems, which were caused by to much liquidity with, more money is considered useless by most authors?
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FM reply: Small nations were offered lower interest rates (borrowing in Euros rather than their own currency) and reduced costs (imagine if the US had 50 currencies), in exchange for Germany running their monetary policy (a slight exaggeration). The current EU and EMU were seen, like their predecessors, as steps on the long post-WWII project to build a full union. Many people (me, too) believe the inherent flaws in this process will force them to take a large step forward — or backwards.
Sublimating: yes, exactly, like snow turning directly to vapor. There’s no visible intermediate state, no drama. I was first made aware of this phenomenon by Martin van Creveld (See The Rise and Decline of the State). The great European states once controlled the world, now they cannot control their back yards. The United States is, of course, not a European state, but it is by virtue of its history and (until recently, demographically) of the same type.
The states of Europe have already surrendered most of the features that make a state sovereign: their borders, their currency, and their ability to make war independently. Without sovereignity, there is no state. The EU is a kind of ghost-state: it possess a currency, a parliament, and a great many regulations. But it has no real power, no real borders, no army, and its currency isn’t looking at all well these days. In addition to the creation of the largely vaporous super-state, there is also a devolution: old provinces are regaining their independence. Scotland is a good example. The Soviet Union is another, far more spectacular one. I’d cite the Balkans, but they were never renowned for their stability.
What of the World’s Only Remaining Superpower? First of all, “Only Remaining” can be a bad thing: maybe there is no market for superpowers any more; maybe they’ve gone out of style and we haven’t noticed. Certainly, this superpower seems to be having trouble holding on to at least one of the key aspects of sovereignity: its borders. Its economy looks a bit shaky these days. As for its ability to wage war…well…the less said the better.
FM: “Germany and France set interest rates and the value of the Euro at levels that worked for them, but were destructive to the nations of the EU rim. Meanwhile the delusional stability of the Euro allowed rim nations to borrow more than they otherwise would. Now the consequences arrive, a result of actions of all.”
I am in substantial agreement with you, Fabius. The only emendation I would make is that while the German and French Governments may have set the value of the Europe to their liking, the subjective perception of most Germans I have talked to is that they got the shaft. The original arrangement was an exchange of 2 Marks to 1 Euro, with retail prices to be cut accordingly. According to my sources, those price cuts never quite happened the way they were supposed to. I don’t have any objective evidence that this is true, but this perception must be factored into any calculation of how the Germans will react to bailing out the “Southern Tier”.
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FM reply: That’s another important piece of the impossible to assemble European unification puzzle! It’s an engagement where both sides (all sides, in this case) believe they’re making a sacrafice for the greater good. And grudgingly so. Perhaps under pressure these fragments will meld together, but that seems unlikely to me.