Delusions about easy fixes for Europe, dreaming during the calm before the storm

Summary:   Rumors circulate of complex ways to bail out Europe’s banks and conceal the cost to France and Germany.  These new programs expend scarce political capital AND even more valuable time, while fixing nothing but the banks.  This shows recognition about the seriousness of Europe’s problems, but a political tone-deafness that suggests bad times lie ahead.  Here we look at the bases that must be touched to reach a solution.  At the end are links to other posts about Europe.

Other chapters in this series:

  1. Can the European Monetary Union survive the next recession?, July 2008
  2. The Fate of Europe, nearing the point of decision
  3. Europe drifts towards the brink of a cataclysm

Contents of this chapter

  1. Summary of the Euro-story as of today
  2. The way forward
  3. Politics
  4. A calendar, each event a potential spark to the endgame
  5. Some useful analysis by Edward Harrison
  6. For more information

(1)  Summary of the Euro-story as of today

Europe remains locked into overlapping problems.  The causes are almost irrelevant now (it was a systemic error, not moral failure; for details see What Really Caused the Eurozone Crisis? by economist Kash Mansori).

Uncompetitive nations (the PIIGS), carrying too much debt (some in the private sector, some government debt).  The banks hold much of this debt, so defaults will bankrupt them.   Europe’s complex and fragmented political attempts to deal with these problems, torn between its leadership’s desire to unify (for good reasons described in chapter one) and its peoples’ nationalism.  The economic and financial problems have technical solutions; the political problems dominate the situation — and political decisions will determine the outcome.

The current program (already acknowledged as inadequate) is version 2 of the European Financial Stability Facility (EFSF), approved yesterday by the Bundestag, with expanded powers and increased lending limits (from 255B to 440 B Euro).  It’s like the US TARP II program.

(2)  The way forward

Broadly speaking, Europe’s peoples must choose between a combination of three solutions.

  1. Full economic unification, which probably requires a political federation
  2. Some combination of default, bank recapitalization, and reform of the European Monetary Union (probably with fewer members)
  3. Massive monetization and probably inflation (IMO this is the least likely; perhaps impossible)

This week the rumor wires sang with stories about programs combining elements of #2 and #3, focused on massive bailout of banks (some discussed in the previous chapter).  These leaks from anonymous officials and proposals from think tanks were probably trial balloons, testing alternative plans for public acceptance.

The key questions to ask about these are (as always) who benefits and who pays?  We see the answers in the common elements of these plans.

  • They create paths for Greece to default (or even leave the EMU and devalue).
  • They provide massive gifts to Europe’s banks (especially those of Germany and France), mostly from the taxpayers of Germany and France.
  • They consist of complex shell games that conceal who takes the loss when Greece defaults (and perhaps leaves the EMU).

These proposals — perhaps none of which will be realized — tell us much about the thinking of Europe’s leaders.  They slowly realize that stopgaps will not work, and Greece (perhaps others) need fundamental restructuring.  But their narrow vision probably prevents success.

  1. Just like America’s leaders, banks are first in their hearts.  So they focus on Greece’s debts, drafting plans to shift the banks’ bad loans to government balance sheets.  While fixing banks is a vital part of the puzzle, their love blinds them to other (less banker-friendly) solutions — and to other and equally important problems.
  2. This is a decision point about the nature of Europe (unify or divorce).  Fiddling with banks does nothing to resolve this political decision.
  3. This is a technical question about the PIIGSs’ lack of competitiveness under an interest and currency regime designed for the EMU’s core nations (debt is a result of their uncompetitiveness).  A new Greek drachma might require a 50% discount to the Euro (per Roubini Global Economics).  Fiddling with the banks does nothing to resolve this issue.
  4. This is about austerity as a remedy for recessionary conditions in the GIIPS, despite its consistent history of failure without devaluation.  Fiddling with the banks does nothing to fix this incorrect macroeconomic prescription.
  5. This is a crisis of confidence, with Europe’s peoples losing trust in their leaders’ competence.  Fiddling with the banks exacerbates this slowly festering sore.  Germany’s governing coalition advocates measures tying together Europe; the opposition coalition supports unification (choose “potato” or “potahto”)

The focus on solutions for banks (and bankers) obscures the need for a complex solution to both political and economic problems, one that reduces debts and increasing competitiveness not just for Greece — but for all of the PIIGS.

  • Any solution will involve writing down asset values (aka realizing losses via some form of soft or hard defaults), transitional funding for the PIIGS, and reducing the export bonanza that has driven northern Europe (especially Germany).
  • A solution almost certainly will change the political structure of Europe, either unification or some form of fragmentation.  The latter ends any hope of great power status for Europe.  They might forge new institutions or reforge existing institutions (perhaps keeping the names to disguise their evolution).
  • A solution will become mechanically more difficult to implement during a crisis (a disorderly solution), but perhaps only a crisis will forge a consensus on making the necessary decisions.  Time is Europe’s enemy, relentlessly closing potential solutions.

(3)  Politics

Forging a political agreement looks difficult, and might require a crisis to force solutions.  Imagine if setting economic policy in America required the approval of each State and regional Federal Reserve Bank.  That’s similar to the actual situation in Europe.

Imagine running a modern state in pre-civil war America, where the three regions disliked and mistrusted each other.  Then the US government was small and relatively simple; even so regionalism resulted in a long bloody war.  Europe had its wars, leaving a legacy not promising for the cohesion required to form a nation.

Is there support in northern Europe for funding the bank bailouts required for both unification or divorce? Or  for the transitional aid required to avoid a chaotic divorce?  Telegraph Business Editor Ambrose Evans-Pritchard — although not always a reliable source — has good connections in Germany; he reports rising opposition to more aid to the PIIGS (see his articles on 26 September and 29 September).

Is there support in Greece for even more austerity? They must know its pointless without a devaluation to restore competitiveness.

(4)  A calendar, each event a potential spark to the endgame

  • October 3-7 –  Greece likely to vote on additional austerity measures and ways to raise cash
  • Early October — Officials of the “Troika” (EU-ECB-IMF) return to Greece and evaluate its compliance with their demands
  • Mid-October — Approvals completed for EFSF 2 (Neatherlands and Slovakia)
  • October 1 — Bitlateral talks between President Sarkozy and Chancellor Merkel
  • October 3-4 Eurogrop/EcoFin meeting — Finance Ministers review the Troika’s report and decide if to release the next tranche of aid to Greece
  • October 14-15 — G-20 Finance Ministers’ meeting
  • October 17-18 — EU Council meeting
  • November 3-5 — G-20 meeting in Cannes
  • December 9 — EU meeting, perhaps deciding to undertake new programs

(5)  Some useful analysis by Edward Harrison

(a)  “Spain is the perfect example of a country that never should have joined the euro zone“, 16 May 2011 — Accurate diagnosis must precede treatment; which Europe’s leaders have failed to do.  See this excerpt for a clear look at causes:

Nevertheless, if you look back to the previous decade, things were looking much better due to the property boom. In particular, the government’s finances were stellar.

Notice how the government’s budget is in surplus throughout most of the 2000s. Moreover, if you look at a list of countries in the world and rank them according to public debt as a percentage of GDP for 2009, Spain is well down the list (#44). In fact, it is much lower than Germany (#18) on the list. Below are the most recent figures for the crisis-ridden countries and Germany. Once again, notice how Spain has the lowest debt to GDP ratio, even after a remarkable deterioration in its fiscal position over the last two years.

I would also add that Germany’s fiscal record is significantly worse than Spain’s over the last decade. … In short, it is total nonsense for people to act like Spain’s government has been reckless and irresponsible in managing its finances. The numbers tell a completely different story.

If you pointed to Portugal, Greece or Italy, you might have a point.  But Spain had been a paragon of fiscal virtue. We are witnessing historical revisionism due to the unprecedented downturn in that country.

What happened?  The Euro happened – and that has been a decidedly mixed blessing. I have been pointing this out for two years on this blog. … we got was an unbalanced Euroland in which Germany and the Netherlands exported and Spain, Portugal and Greece imported, running up enormous current account imbalances in the process.

These imbalances are a direct result of a monetary policy that was geared to slow-growth core Europe. The result was an enormous property bubble in Spain and Ireland in particular.  It’s not as if a robust regulatory environment could have overridden these forces either; the Banco de España, Spain’s central bank, is widely credited as having run one of the more solid regulatory regimes in Euroland.  Yet, this did not stop a runaway property bubble from forming and imploding.

Moreover, what these two charts also point out is that, in Spain and Ireland, enormous property busts turned what were fairly large government budget surpluses in 2006 – the largest in the euro zone except for Finland –  into an enormous government budget deficit by 2009. …

(b)  “The political economy of the European sovereign debt crisis“, Edward Harrison, 30 June 2011 — Excerpt:

As I indicated on BNN, Nicolas Sarkozy has been deft in getting a French person installed at the ECB as a quid pro quo for allowing Mario Draghi to become its head. And he has been equally effective in getting Christine Lagarde, his finance minister installed at the head of the IMF. In that sense, France now has greater input throughout the Troika institutions, the ECB, the EU, and the IMF, now dictating terms on bailouts, restructurings and defaults in Europe. And clearly, as the French banks are very exposed to potential defaults in the periphery, there will be enormous pressure on the Troika through their French representation to accede to the interests of the French banks. Again, I am not advocating a position here. I am trying to forecast likely scenarios.

… The French plan is another example of Europe’s extend and pretend strategy. … I would go further and say that the extend and pretend strategy is inevitable because that’s how large hierarchical systems respond to crisis. Seeing this, I also understand this is the template we are likely to see going forward for Ireland and Portugal as well.  Eventually, the extend and pretend approach will fail after successive rounds of the same policy response in Greece, Ireland and Portugal. Eventually, a combination of four things will occur:

  • the people in the periphery countries rise up and overthrow the existing order forcing a default;
  • the poor economy that austerity entails forces leaders to move to the hard restructuring route as fiscal consolidation fails
  • markets become skittish about Spain or Italy, which cannot be bailed out. So EU leaders will cut Greece loose
  • popular unrest in core countries against bailouts grows so severe that they force a hard restructuring or default

The point for policy makers is to socialise enough of the bank losses onto taxpayers in order to recapitalise the banks, survive the crisis and maintain the status quo. Taxpayers will accept this if the economy is robust enough. As an investor, you should see this as an uncertain political situation. more than most. That means avoiding periphery sovereign debt until the situation stabilizes.

(c)  “On Greek Haircuts“, 28 September 2011 — “Now it seems that Europe is moving to a hard restructuring for Greece and recapitalisation for bank creditors. The word is the haircut will be 50%”

(5)  For more information

  1. Can the European Monetary Union survive the next recession?, 11 July 2008
  2. The periphery of Europe – a flashpoint to the global economy, 8 February 2010
  3. Our government’s finances are broken. How do we compare with our peers?, 8 April 2010
  4. Governments cannot go bankrupt, 2 April 2010
  5. The EU does Kabuki for Greece. Is it the next domino to fall?, 14 April 2010
  6. About the Euro crisis: the experts are wrong; the German people are right., 7 May 2010
  7. Former Central Bank Head Karl Otto Pöhl says bailout plan is all about ‘rescuing banks and rich Greeks’, 20 May 2010
  8. The Fate of Europe, nearing the point of decision, 13 September 2011
  9. Europe drifts towards the brink of a cataclysm, 26 September 2011

7 thoughts on “Delusions about easy fixes for Europe, dreaming during the calm before the storm”

  1. So…because Spain ran its economy for a decade based on a delusional construction boom that was based on nothing but greed and the Spanish government has to pick up the bill for this development at some point in time, the Euro-bogeyman is to blame. It seems to me, that Harrison is intentionally confusing two aspects, namely the export-import-imbalance between Eurozone members, which to me rather seems a consequence rather than the cause of the current troubles, and very doubtful national economic policies, which greatly contributed to the current disaster in the first place.

    About the only thing, where I agree with Harrison, is, that the “PIIGS” (a ridiculously populist term in its own right) cannot be painted with the same brush and their woes do have different origins. For Greece, this is blatantly obvious to just about anyone, who has actually spent some time in the country and talked to the people there, which is to say, one significant issue there has been a combination of inefficient and non-productive government spending on one hand and an apalling amount of tax evasion on the other hand. If a taxi driver in Athens shouts angrily, that he pays 5% income tax and considers this a terrible punishment, you might consider this an anecdote. Combined with the angry masses marching in protest of – “well, something” – I see it as an indicator of how broken their system really is.

    1. I suggest reading Kash Mansori’s article (link in the first section), explaining the systemic causes of Europ’s macroeconomic crisis (the political crisis results from gambling on a currency union before a political union).

      More broadly — It is fun to tell ourselves morality tales, “just so stories” with satisfying lesson for children. Medicine became a useful profession only when doctors moved beyond this natural impulse. By 2000 it seemed that economics also had reached this level of development. Current events — including what Krugman calls the “great forgetting” — prove this to be false. Like a plague can hlep a society regain lost knowledge about public health, a depression can educate a society about economics. if we choose to learn.

  2. So what is the end game scenario? Economic Collapse? Death of the Euro? It gets confusing what the outcome could be.

    1. There are only two choices (broadly speaking): unification or divorce. Both have high transition costs. Which will they choose? They don’t know, so therefore we don’t know either.

      Of course, massive policy failure is always an option, like 1929 – 1945. But more likely they will muddle through, somehow.

      Economic collapse?

      Our long prosperity in America since WW2 (and in a sense, since 1865) makes us like little girls. Every little thing and we scream “It’s the end of civilization!”. Buck up, people!

      Economic events are not like atomic war or invasion of the Mongels. Afterwards the foundations of society — our physical and human infrastructure — remain. Which is why society almost always bounces back. We had frequent depressions in the late 19th century, and they don’t even bother mentioning then in grade school history books.

  3. Causality incoming:
    Writing from Lisbon, it is clear that the causality of the crisis ran from the external CAB imbalances, fed by the avalanche of loose cross-border lending, to the domestic fiscal imbalances. Portugal and Greece both bought German submarines, plus lots of shiny new cars and electronic equipment, not to mention all the Chinese “stuff” that wiped out the local textile industry. (By the way, the submarine “purchases” are the subject of corruption investigations in Germany).

    Mansoori, Krugman and Whitney are certainly on the right track.
    In fact, the external surplus/deficits positions of the trading partners are likely to diverge as long as foreign creditors (ex. surplus country banks) are willing to finance them, especially when the surplus countries enjoy huge economies of scale.

    Looking out over the Tagus, it appears that the big mistake may have been to allow the huge external debt accumulation when the Single Currency and Single Market had done away with the principal external adjustment mechanisms (import tariffs, FX rates and interest rates), fed by loose lending by foolish German, British and French banks looking for a few extra basis points. This represents a failure of prudential regulation by the national central banks which were lulled into complacency more by Basel than by the Euro.

    The way out will certainly have to include debt restructuring, but with special protection for the critical local savers, considering the risks arsing from the freedom of capital movement.
    Mariana Abrantes de Sousa, PPP Lusofonia

  4. Munchau: "Eurozone fix a con trick for the desperate"

    Eurozone fix a con trick for the desperate“, Wolfgang Münchau, Financial Times, 2 October 2011 — Opening (bold emphasis added):

    We are now in the stage of the crisis where people get truly desperate. The latest crazy idea, which is being pursued by officials, is to turn the eurozone’s rescue fund into an insurance company, or worse, a collateralised debt obligation, the financial instrument of choice during the credit bubble. This is the equivalent of putting explosives into a can, before kicking it down the road.

  5. Robert Reich: "Behind Europe's debt crisis lurks another Wall Street bailout"

    Behind Europe’s debt crisis lurks another Wall Street bailout“, Robert Reich,CHristian Science Monitor, 5 October 2011 — “A Greek (or Irish or Spanish or Italian or Portuguese) default would have roughly the same effect on our financial system as the implosion of Lehman Brothers in 2008.” Excerpt:

    The Street has lent only about $7 billion to Greece, as of the end of last year, according to the Bank for International Settlements. That’s no big deal. But a default by Greece or any other of Europe’s debt-burdened nations could easily pummel German and French banks, which have lent Greece (and the other wobbly European countries) far more.

    Big Wall Street banks have lent German and French banks a bundle. The Street’s total exposure to the euro zone totals about $2.7 trillion. Its exposure to to France and Germany accounts for nearly half the total.

    And it’s not just Wall Street’s loans to German and French banks that are worrisome. Wall Street has also insured or bet on all sorts of derivatives emanating from Europe – on energy, currency, interest rates, and foreign exchange swaps. If a German or French bank goes down, the ripple effects are incalculable.

    Get it? Follow the money: If Greece goes down, investors start fleeing Ireland, Spain, Italy, and Portugal as well. All of this sends big French and German banks reeling. If one of these banks collapses, or show signs of major strain, Wall Street is in big trouble. Possibly even bigger trouble than it was in after Lehman Brothers went down.

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