The periphery of Europe – a flashpoint to the global economy

Larry Kummer, Editor

14 years ago

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’.

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