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Are Europe’s rulers copying the policies of Herbert Hoover in 1929, or the French Monarchy in 1789?

26 January 2012

Summary:  There are two paths for Europe. The path it is on, leading to a painful future and fundamental change.  And the other path, with unknown risks and pain — but offering the potential for a better future.  The path chosen by Europe’s leaders reveals much about them.  The outcome will reveal much about Europe’s peoples.

Two major reports this week describe the perilous condition of the world economy.  Both are well worth reading.  Both raise serious doubts about the path that Europe is traveling.

The PIIE report goes into greater detail about treatment for Europe’s ills, giving the solutions recommended by our banking class — that dominate these discussions in the West.  Especially note two aspects, one recommended — and one omission.

(1)  Liquidate the people of the GIIPS and the institutions which serve them

The second ingredient is a far more aggressive program to reduce budget deficits and improve competitiveness in the periphery. These nations need to be highly competitive if they are to generate growth soon given the large risks overhanging their economies. This requires large wage cuts, public-sector spending cuts, changes in tax policy to attract investment and business, and stable politics.

… In a nation with a flexible exchange rate, adjustment is usually achieved with budget cuts and a sharp devaluation. Since euro area nations have forgone their right to devalue, they need to regain competitiveness through price and wage cuts, while even more sharply cutting budget spending. In essence, they need to increase volatility of their wages, prices, and budgets if they are prepared to forgo similar changes that could be achieved through the exchange rate.

The available evidence from the outcomes of the troika programs in Portugal, Ireland, and Greece, as well as the recently announced budget plans in Italy and Spain, suggests current policies will fail at this task.

… However, so far, there is little political will to take these necessary measures. Europe’s economy remains, therefore, in a dangerous state.

Boone and Johnson recommend very conservative policy changes.   Large cuts in wages,  Large cuts in public sector spending.  Changes tax policy to help the rich and businesses.  To be forced through by severe pressure from the nations of northern Europe and the institutions they control (eg, IMF and ECB).  Bismarck would consider these too far right-wing.

{Secretary of the Treasury Andrew Mellon} only one formula:  liquidate labor, liquidate stocks, liquidate the farmers, and liquidate real estate…. It will purge the rottenness out of the system.  High costs of living and high living will come down.  People will work harder, live a more moral life.  Values will be adjusted, and enterprising people will pick up from less competent people.
— Herbert Hoover in his Memoirs, bravely shifting the blame for the Great Depression

Institutions which benefited from the European regime of the past decade have failed cataclysmically.  Now the people of the PIIGS must pay with many years of austerity.  Much like the last days of France’s ancien regime.  It’s probably a viable solution, as competent rulers can herd their people like sheep.  Usually.

But not always.  Perhaps Boone and Johnson should read de Tocqueville’s The Old Regime and  the Revolution, and about the leading up to the Tennis Court Oath in 1789.  People can be pushed to far by elites who refuse to contribute to overcoming a nation’s problems.

(2)  There is another solution:  devaluation

“No question is so difficult to answer as that to which the answer is obvious.”
— George Bernard Shaw

As usual, these measures are described as necessary, with no alternatives even mentioned.  But there is tried and proven solution — painful but effective.  The periphery, or most of it, must leave the eurozone.  Combined with a partial default (direct or by redomination of the bonds) that would restore their competitiveness and open a pathway to a better future.

But Germany has benefited most from the eurozone, and breaking that would hurt them.  Their banks insolvent, due to their holdings of periphery bonds.  Its currency — whether euros or Deutschmarks — would soar, stifling its exports.  Their plan — so far working — requires painful austerity for the periphery and a lower euro (boosting German’s exports).  As the initial phase of the EMU (leverging up, 1999-2008) benefited Germany, so does the current deleveraging.

But it’s a  fool’s paradise.  Austerity will induce a recession, which will increase the deficits in the GIIPS, undoing any benefits from the austerity.  All the while eroding support for the eurozone.  No matter how many of the banks’ unprofitable securities the ECB takes off their books. No matter how large the profits the ECB generates for Europe’s banks (eg, the LTRO allows banks to borrow at 1% and invest in higher yielding government bonds).

The pressure will inevitably grow on the periphery nations; then real change will come.  Unification, which will end the current gravy train for Germany.  Or fragmentation of the eurozone, which also ends the Germany gravy train.

No matter what Wall Street thinks: the banks are not Europe.  Funneling money to the banks stabilizes the situation but fixes nothing.  Europe’s people might have a say in shaping its destiny before this cycle ends.  When they become sufficiently brave or desperate to speak up.

(3)  For more information: Other posts about the crisis of Europe

  1. The post-WWII geopolitical regime is dying. Chapter One , 21 November 2007 — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
  2. Can the European Monetary Union survive the next recession?, 11 July 2008
  3. The periphery of Europe – a flashpoint to the global economy, 8 February 2010
  4. A great speech by the PM of Greece. How soon until an American President says similar words?, 3 March 2010
  5. Governments cannot go bankrupt, 2 April 2010
  6. Our government’s finances are broken. How do we compare with our peers?, 8 April 2010
  7. The EU does Kabuki for Greece. Is it the next domino to fall?, 14 April 2010
  8. About the Euro crisis: the experts are wrong; the German people are right., 7 May 2010
  9. Former Central Bank Head Karl Otto Pöhl says bailout plan is all about ‘rescuing banks and rich Greeks’, 20 May 2010
  10. The Fate of Europe, nearing the point of decision, 13 September 2011
  11. Europe drifts towards the brink of a cataclysm, 26 September 2011
  12. Delusions about easy fixes for Europe, dreaming during the calm before the storm, 30 September 2011
  13. Every day the new world emerges, yet we see it not.  Like today, as Europe begs China for loans, 15 September 2011
  14. Is Europe primed for chaos, as it was in July 1914?, 7 October 2011
  15. We see the outlines of the next cure for Europe.  Will it work?, 14 October 2011
  16. Today Europe’s leaders took another step towards the edge of the cliff, 27 October 2011
  17. Where to from here, Europe?  Some experts share their views., 8 November 2011
  18. Status report on Europe’s slow re-birth (first, the current system must die), 10 November 2011
  19. Europe begins its endgame.  Watch and learn, for Europe’s problems are the world’s., 11 November 2011
  20. Will Italy stay in the Euro-zone?, 14 November 2011
  21. Looking ahead to see the new shape of Europe, 22 November 2011
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17 Comments leave one →
  1. jonh permalink
    26 January 2012 12:48 am

    “Boone and Johnson recommend very conservative policy changes. ”

    Which kind of conservative are we talking about?

    Like

    • 26 January 2012 1:34 am

      Do they come in flavors, like popslicles? Liberal – Conservative is a two-dimensional description of the current political spectrum. “Very conservative” means roughly in the furthest right quartile of the line.

      Like

    • jonh permalink
      26 January 2012 4:03 am

      I thought you may have meant conservative like ‘on the low end’.

      Like

  2. Fyodor permalink
    26 January 2012 1:26 am

    Love your work, so please accept my apologies for pointing out the typo in your title. France was a republic in 1879, and it’s clear you meant 1789.

    Like

  3. Hoyticus permalink
    26 January 2012 2:04 am

    The fact that the US is still deleveraging, Europe is trying to as well along with a slowdown in India and potentially in China, you would hope someone would propose a global debt restructuring in the same vein as the Marshall Plan for Europe post WWII to help foster a recovery

    Like

    • 26 January 2012 2:36 am

      “you would hope someone would propose a global debt restructuring ”

      There is no need for global deleveraging. Most of the developed nations have too much debt. The emerging nations have too much debt, having burned it off during the 1997-98 crisis (although some have some internal sectors with excess debt).

      “The fact that the US is still deleveraging”

      The private sector is deleveraging, mostly offset by Federal government borrowing. For more see “Notes On Deleveraging“, Paul Krugman, New York Times, 22 January 2012.

      Like

  4. guest permalink
    26 January 2012 2:39 am

    “they need to regain competitiveness through price and wage cuts”

    The PIIGS are active in such tradeable products as car manufacturing, textile, shoes, foodstuff, and services like tourism. The competition for these comes from countries such as Pakistan, Brazil, China, Vietnam, or Morocco, where salaries are 5-20 times lower than those in the PIIGS.

    In the industry, salaries constitute typically about 1/6th of the total production costs. Even a massive reduction in salaries (e.g. a factor 10) would bring marginal benefits at most. In other words, massive reductions in the cost of rent, water&power, transport, insurance, raw materials, etc, would be required to make those countries globally competitive (because Greater Germany is not importing anyway). I doubt that insurance companies, utilities, landlords and other large economic players are ready for that kind of sacrifice.

    Just from the orders of magnitude, it is pretty clear that the “conservative” solution is totally unrealistic. And whatever wage cuts, spending cuts and other measures are taken, they must be accompanied by “stable politics”.

    Case closed. It is “let them eat cake”.

    Like

    • 26 January 2012 3:18 am

      That’s an important point. Most economists have a bank-centric worldview. Part of that is not mentioning the size of the wage cuts needed. I’ve seen analysis suggesting thta cuts of 1/4 – 1/3 are needed. That has be done painfully by currency devaluation. I don’t know if its ever been done successfully by internal deflation.

      Consider Greece, to see the scale of the adjustments needed: from “Greece Should Default and Abandon the Euro” By Nouriel Roubini, 16 September 20111 (subscription only):

      Second, even if Greece were to be given significant relief on its public debt via an orderly but deep debt reduction under threat of default on its debt (i.e. a better debt exchange than the current one under a credible threat of default), the economy would not return to growth unless its competitiveness is rapidly restored. And, without a rapid return to growth, public and private debts would remain unsustainable while the social and political backlash against austerity and continued depression would come to a boil. There are only four options to restore competitiveness and growth, all requiring a real depreciation of the currency for Greece:

      • First, a sharp nominal depreciation of the euro toward parity with the U.S. would lead to real depreciation; this outcome is unlikely to occur as the U.S. economy is weak, thus exerting downward pressure on the U.S. dollar, while within the EZ Germany is still uber-competitive;

      • Second, a rapid reduction in unit labor costs via the acceleration of structural reforms and corporate restructuring, leading to a rapid increase in productivity growth above wage growth (the German solution); this option is also quite unlikely as it took almost 15 years for Germany to reduce its unit labor costs and restore its competitiveness via that process;

      • Third, a rapid five-year cumulative 30% deflation in prices and wages—about 5% per year for five years—(also referred to as the “internal devaluation” solution) would imply an equivalent real depreciation; this path to a real depreciation is unlikely to be feasible as it would be associated with another (socially unacceptable) five years of ever-deepening recession/depression; also, even if feasible, such deflation would make the country undertaking it more insolvent, given a 30% increase in the real value of its debts. Argentina tried the deflation route to a real depreciation and, after three years of an ever-deepening recession/depression, it gave up and decided to default and move off the currency board peg with the U.S. dollar;

      •Thus, if the first three options cannot restore competitiveness, the only other option left is the exit of Greece from the monetary union.

      Like

  5. guest permalink
    26 January 2012 2:41 am

    “a factor 10″

    Holy cow. I was meaning bringing from 1/6 to 10% (this is already cutting more than a third of wages).

    Like

  6. 26 January 2012 4:56 am

    “But there is tried and proven solution – painful but effective. The periphery, or most of it, must leave the eurozone. Combined with a partial default (direct or by redomination of the bonds) that would restore their competitiveness and open a pathway to a better future”

    This is from the Boone/Jones article.

    “If euro swap interest rates start to reflect bank credit risk and inflation risk from a euro breakup, then the market would no longer function. A pension fund could no longer use it to lock in an interest rate on German pensions since it would not reflect the new German currency rates. The holders of these contracts would, effectively, have little idea what they would be in a few years’ time. Hence, investors would try to unwind their swap contracts, while the turmoil from dislocations in this massive market would cause disruptive and rapid wealth transfers as some holders made gains while others lost. If the euro swap market ran into trouble, Europe’s financial system would undoubtedly face risk of rapid systemic collapse.

    This example illustrates why a small perceived risk of a euro area breakup could rapidly cause systemic financial collapse. The swap market is only one mechanism through which collapse could ensue.”

    “Rapid systemic collapse” is a bit more than just pain. This swap market stuff is pretty confusing, but I believe Simon Jones if he says it can blow up the financial world. Does rapid systemic collapse mean we wake up one day and there’s a run on every bank in Europe? Or, maybe not, it’s a weird enough of an event that I don’t think anyone can predict exactly what follows.

    Yeah, austerity is part of the last ditch effort by the financial elites to squeeze the last drop of blood out of the population to keep the bond market rolling over for just a little bit longer — it is ultimately doomed. But there’s just too much money at stake, and I think they are going to use every bit of power these governments have to pay these bonds. This could go on for years, and it will not be pretty as the last bit of money is wringed out of the people. For everyone else, the ‘rapid systemic collapse’ might be preferrable, but that hurts the wrong people.

    Like

    • 26 January 2012 5:59 am

      Such events have played out dozens of times in the past. Solutions were found, and those nations did not get sucked down some giant financial drain. Boone and Johnson tell stories to frighten children, told to keep them obiedient to their parents’ will.

      Banks could be nationalized (as should have been done during the 2008-09 crisis), the stockholders and junior bondholders wiped out — depositors and senior bondholders protected. This has been done successfully by many nations. By free-market capitalist states such as Sweden and Russia. Even by that paradise of State Capitalism, the USA (eg, during the S&L crisis).

      The mad (but profitable to banks) network of derrivatives that again threaten to burn down civilization (as they threatened to do in 2008-09) coulld be unwound like any other contracts, with losses taken if the counterparties cannot pay up.

      No, maintaining the sacredness of banks and their bets is not on the list of commandments given us by Moses.

      Like

    • 26 January 2012 7:39 am

      Bank nationalisation gains ground with Republicans“, Financial Times, 18 February 2009 – Excerpt:

      High quality global journalism requires investment. Please share this article with others using the link below, do not cut & paste the article. See our Ts&Cs and Copyright Policy for more detail. Email ftsales.support@ft.com to buy additional rights. http://www.ft.com/cms/s/0/2ad3b750-fd27-11dd-a103-000077b07658.html#ixzz1kZNxd04o

      Long regarded in the US as a folly of Europeans, nationalisation is gaining rapid acceptance among Washington opinion-formers – and not just with Alan Greenspan, former Federal Reserve chairman. Perhaps stranger still, many of those talking about nationalising banks are Republicans. Lindsey Graham, the Republican senator for South Carolina, says that many of his colleagues, including John McCain, the defeated presidential candidate, agree with his view that nationalisation of some banks should be “on the table”. Mr Graham says that people across the US accept his argument that it is untenable to keep throwing good money after bad into institutions such as Citigroup and Bank of America, which now have a lower net value than the amount of public funds they have received.

      … Barack Obama, the president, who has tried to avoid panicking lawmakers and markets by entertaining the idea, has moved more towards what he calls the “Swedish model” – an approach backed strongly by Mr Graham. In the early 1990s Sweden nationalised its banking sector then auctioned banks having cleaned up balance sheets. “In limited circumstances the Swedish model makes sense for the US,” says Mr Graham. Mr Obama last weekend made clear he was leaning more towards the Swedish model than to the piecemeal approach taken in Japan, which many would argue is the direction US public policy appears to be heading. “They [the Japanese] sort of papered things over,” Mr Obama said. “They never really bit the bullet . . . and so you never got credit flowing the way it should have, and the bad assets in their system just corroded the economy for a long period of time.”

      Oh yeah, the Swedish model. I remember that. Here’s a heartbreaker from 2009. Obama, was going to adopt the Swedish model, not the Japanese model. He was going to nationalize the banking sector and staighten it all out. Here we are in 2012, and, oh man, Mr. Obama. What happened to you? What did they tell you?

      Like

    • 26 January 2012 1:18 pm

      I added the title and opening of the FT article. Note that toying with bank nationalization was a bipartisan enthusiasm — as with most major public policy initiatives in the US during the past two decades.

      Bamk nationalization was killed by the banks, who prefered massive aid from the government. They wanted a return on their massive investments in Washington — lobbying, hiring economists and ex-legislaturers, campaign contributions (aka bribes). And they got a return — a big one. Isn’t America grand?

      Like

  7. 26 January 2012 4:21 pm

    “Liquidate the people of the GIIPS and the institutions which serve them”

    It’ll be good to hear the tumbrils rolling again! Oh, wait. That’s probably not what you meant by “liquidate”

    Like

  8. 26 January 2012 11:14 pm

    Do none of these leaders have plans that go further than the next redtop headline ? Where are the visions of their nation , their people , the world and the peoples of the world , in 10, 20 , 50 years time ? It all seems reactive and short sighted .
    I think govs should think about sustainable economics , and if western people have to get by on less money , it might be a good thing to enlighten them now ,while my generation can tell them how its done .
    Maybe its time for a rethink on free trade , too .
    .

    Like

    • 27 January 2012 1:09 am

      Annanic, you raise an important question. Do Europe’s leaders have a plan? That has been a subject of debate for the last year.

      I believe Germany’s leaders have a plan: austerity followed by a German-centric European Union, with Germany dominating both fiscal and monetary policy. Germany has been the large winner so far from the European Monetary Union, which is why they have so strongly defended it. This is misunderstood by the news media, who write as if the GIIPS nations have benefited and long-suffering Germany paid. In fact the opposite is true, and Germany’s leaders plan to continue the game (passing our just enough aid to prevent the losers from walking out).

      Like

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