As I discussed recently, the costs and risks of maintaining the eurozone system are already immense and rising. So is an exit possible? Intuitively, the exit from the euro should be as easy as the entrance. Joining and leaving the club should be equally simple. Leaving is just undoing what was done before. Indeed, many popular articles discuss the prospects of an exit of countries such as Greece or Germany.[1] However, other voices have rightly argued that there are important exit problems. Some authors even argue that these problems would make an exit from the euro virtually impossible. Thus, Eichengreen (2010) states, “The decision to join the euro area is effectively irreversible.” Similarly, Porter (2010) argues that the large costs of an exit would make it highly unlikely. In the following we address the alleged exit problems.
Legal Problems
The Maastricht Treaty does not provide for a mechanism to exit the European Monetary Union (EMU). Thus, several authors maintain that an exit from the euro would constitute a breach of the treaties (Cotterill 2011, Procter and Thieffry 1998, Thieffry 2011, Anthanassiou 2009).[2] In an ECB working paper from 2009 Anthanassiou claims that a country that exits the EMU would have to leave the EU as well. As the Lisbon Treaty allows for secession from the EU, withdrawal from the EU would be the only way to get rid of the euro.
The solution to this legal problem could be an exit from both the EMU and EU with an immediate reentering of the EU. This procedure could be negotiated beforehand. In the case of a net contributor to the EU budget such as Germany, the country would probably not face any problem getting immediately readmitted to the EU.
In any case, the referral to the Maastricht Treaty when discussing the legal possibility of exit is intriguing, because the Maastricht Treaty, especially the “no-bailout clause,” has been violated through the bailouts of Greece, Ireland, and Portugal. The European Financial Stability Facility effectively serves to guarantee debts of other nations, not to mention the plans to introduce eurobonds.
In addition, the European Central Bank has violated the spirit of the Maastricht Treaty by purchasing debt of troubled nations. It seems to be a justification, if not an obligation, to leave the euro after the conditions for its existence have been violated.[3] Indeed, the German Constitutional Court ruled in 1993 that Germany could leave the euro if the goals of monetary stability were not attained (Scott 1998, p. 215). After the last couple of years, it is clear that the eurozone and the euro are far from stable. Apart from these considerations it should be noted that a sovereign state can repudiate the treaty (Deo, Donovan, and Hatheway 2011).
Another legal problem results from the possible redenomination of contracts in the wake of an exit from the euro. A government may redenominate euro contracts into the new currency (applying lex monetae — the state determines its own currency). It may do so without problems if the contracts were contracted in its territory or under its law. But what about private and public bonds issued in foreign countries? How would foreign courts rule (Scott 1998, p. 224)?
Imagine a German company that sold a bond in Paris. Will the bond be paid back in euros or in the new currency if Germany leaves the euro? The French court would probably decide that it can or must be paid back in euros.[4] Possibly also the European Court of Justice would rule on such issues. Thus, in the case of an exit, there would be some uncertainty caused by court settlements. There may be one-time losses or profits for the involved parties. However, it is hard to see why these court rulings would constitute important disturbances or insurmountable obstacles for a euro exit.[5]
Introduction Costs
An exit from the euro may imply the issuing of a new national currency. This involves the costs of printing new notes, melting new coins, exchanging vendor machines, etc. There are also logistic costs exchanging the new currency against the old one. These costs are not higher than the costs of introducing the euro. The costs for introducing the euro in Austria have been estimated at €1.45 billion euros or around 0.5 percent of GDP.[6]
Wage Inflation and Higher Interest Rates
Sometimes it is argued that peripheral countries with uncompetitive wages could just exit the euro and magically solve all their problems. Greece, for instance, suffers from too-high wages mainly because there is no free labor market. Labor unions have caused wages to be too high. The resulting unemployment had been attenuated by government deficit spending and debt accumulation made possible by the Eurosystem. The Greek government employed people at high wages, paid unemployment benefits and retired people early with high pensions.
As strong labor unions prevent wages from falling to recuperate competitiveness, some people recommend that Greece exit the euro, depreciate the currency, and thereby increase competitiveness. This argument contains a problem. If labor unions remain strong, they may simply demand wage increases to compensate for higher import prices (Eichengreen 2010, p. 8). Such a compensatory increase in wages would eliminate all advantages from depreciation.[7] The exit would have to be accompanied by a reform of the labor market in order to improve competitiveness. In any case, after an exit from the EMU, the Greek government could no longer use EMU monetary redistribution and deficit spending to push up wages artificially.
Similarly, an exit without further reforms could lead to a repudiation of government debt. This would imply higher interest rates for the government in the future (Eichengreen 2008, p. 10). An accompanying reform of fiscal institutions such a constitutional limits for budget deficits could alleviate this problem.
The End of Monetary Redistribution between Countries
Some countries benefit from the monetary setup of the EMU. They pay lower interest rates on their debts than they otherwise would. If a country like Greece exits the euro and repays its debts with a devalued new currency, it will have to pay higher interest rates for its debts.
In addition, countries such as Greece could no longer benefit from the monetary redistribution. The Greek government, and indirectly part of the Greek population, benefits from the high Greek deficits and the flow of new money into the country. This process allowed Greece to finance an import surplus and standard of living it would not have achieved otherwise. At least in the short term, an exit from the euro would, ceteris paribus, mean a deterioration of artificially high living standards. In other words, after an exit from the EMU, the size of its public sector and standard of living would likely fall as the EMU subsidies end. These redistribution costs only apply to countries that have been on the receiving end of the redistribution. For fiscally sounder countries, the opposite reasoning applies.
Trade Losses
Some authors argue that European trade would collapse in the wake of a euro exit. Trade barriers would be re-erected. In any case there could be an appreciation of the new currency like a new deutschemark (DM). In a UBS research paper, Flury and Wacker (2010, p. 3) estimate that the new DM would appreciate about 25 percent.
In contrast to another UBS research paper (Deo, Donovan and Hatheway 2011) that comes up with horrific costs of a euro break up,[8] we do not regard such trade barriers as very likely for several reasons. First, such barriers would be an economic disaster for all involved parties and would lead to a severe and long depression and a reduction of living standards. Second, net contributors to the EU, such as Germany, could still use their contributions to the EU budget as a negotiating card to prevent such barriers. Third, trade barriers are a blatant violation of EU treaties. Fourth, tariffs could provoke severe tensions between nations, possibly leading to war.
Political Costs
Sometimes it is maintained that an exit implies high political costs. Most importantly, an exit could trigger the dissolution of the euro.[9] The disintegration of the EMU could endanger the development of a federal European state. At least, it would mean an important blow to the “European project.” It could mean the end of the EU as we know today. The EU could “degenerate” into a free-trade zone.
Politicians of the exiting country would lose influence on the policies of other EMU countries. The politicians of the exiting country would also lose appreciation of other EMU politicians and in the mainstream media that has supported the euro staunchly. However, for supporters of a free-trade zone in Europe, these political costs imply immense benefits. The danger of a federal European state would disappear for now.
Procedural Costs and Capital Flows
An exiting nation has to print new notes, mint new coins, reprogram automatic teller machines, and rewrite computer code (Eichengreen 2008, p. 17).[10] This takes time. The case of machines may not be tragic, because, during the transition period, old machines may be in use without chaos. A public parking place using euro coins will not bring the economy down.
The notes-and-coins problem has a fast solution, because on both the country’s origin is visible. Coins have a country-specific image and notes bear a country-specific letter. In a German exit from the euro, all German coins and notes would be redenominated into the new currency and later gradually exchanged into the new notes and coins.[11] Of course, the transition period would involve some checking costs as people have to look at the symbols when transacting in cash.
The most severe problem of a euro exit — one that according to Eichengreen (2010) would pose “insurmountable” barriers — is capital flows when the option of exiting is discussed.[12] Such a discussion takes time in democracies. During this time there may be important capital inflows and outflows.[13]
Let us first discuss the problem of capital outflow such as in the case of an exit of Greece with no accompanying reforms. If Greek senior politicians seriously discuss an exit from the euro, Greek citizens will expect a depreciation of the new currency, a new drachma. Greek citizens will transfer their euros held at Greek banks to accounts in other EMU countries. They will probably not turn in their euro notes to be exchanged for the new drachmas voluntarily.
Greek citizens may also acquire other currencies such as Swiss francs, US dollars, or gold to protect themselves from depreciation. In this way Greece could practically be immunized against the new drachma even before its introduction. As a consequence, the Greek banking system may get into liquidity and solvency problems. Meanwhile, Greek citizens would continue to transact in euros held outside Greek jurisdiction.
This is the so-called “problem” of capital outflows. Yet these outflows are not a problem for ordinary Greek citizens. For them these outflows are a solution to the problem of an inflationary national currency. Moreover, capital outflows are already occurring. The discussion in parliament of a Greek exit would only speed up what is happening already.
The opposite reasoning applies when a more solvent country like Germany discusses an exit from the eurozone. If people expect an appreciation of a newly introduced currency, there would be capital inflows into Germany. The money supply of euros within Germany, which would later be converted into a new currency, would increase. Prices of German assets (e.g., housing and stocks) would increase in advance of the actual German exit, benefitting the current owners of such assets.
A Systemic Banking Crisis
Finally, there may be negative feedback for the banking system as there will most likely be losses for banks both domestic and foreign.[14],[15] Eichengreen (2010) fears the “mother of all financial crises.” Due to connectivity, it does not matter if Germany or Greece leaves the euro. If Greece leaves the euro and pays back its government bonds in a depreciated new currency or defaults outright, there will be losses for European banks that could get into solvency problems. Similarly, if Germany leaves the euro, the implicit guarantee and support to the Eurosystem will disappear. The result may be a banking crisis in Greece and other countries. The banking crisis might negatively affect German banks.[16] The banking crisis would also negatively affect sovereigns, due to possible bank recapitalizations. Other countries may be regarded as possible defaulters or exit candidates leading to higher interest rates on public debts. A systemic financial crisis infecting weak governments would be likely (Boone and Johnson 2011).
Recently, the IMF suggested that European banks face €300 billion in potential losses and urged the banks to raise capital.[17] We should emphasize that the problem of bank undercapitalization and bad assets (most importantly, peripheral government bonds) does already exist in the EMU and will deteriorate without an exit.
It is almost impossible to leave the euro without already-unstable structures collapsing. Yet this collapse would have the beneficial effect of quickly purging unsustainable structures. Even if there are no exits from the euro, the banking problem exists and will have to be solved sooner or later. Potential bank insolvency should therefore be no argument against an exit.[18] In the EMU taxpayers (mostly German) and inflationary measures by the ECB are momentarily containing the situation. An exit would speed up a restructuring of the European banking system.
At this point I would like to give the following recommendation for a solution of the banking crisis. There are important free-market solutions to bank-solvency problems.[19]
Banks with nonviable business models should be allowed to fail, liberating capital and resources for other business projects.
A debt-to-equity conversion may put many banks on a healthy basis.[20]
Banks may collect private capital by issuing equity, as they are already doing.
A free-market reform has important advantages:
Taxpayers are not hurt.
Unsustainable banking projects are resolved. As the banking sector is oversized, it would shrink to a more healthy and sustainable level.
No inflationary policies are used to sustain the banking system.
Moral hazard is avoided. Banks will not be bailed out.
The Problem of Disentangling the European Central Bank
The Eurosystem consists of the ECB and national central banks. The task of disentangling is facilitated because national central banks still possess their own reserves and have their own balance sheets. Scott (1998) argues that this setup may have been intentional. Countries wanted to retain the possibility of leaving the euro if necessary.
On January 1, 1999, the ECB started with capital of €5 billion. In December 2010 the capital was increased from €5.76 billion to €10.76 billion.[21]
Only part of all EMU reserve assets have been pooled in the ECB, making a disentangling easier. On January 1, 1999, national central banks provided €50 billion in reserve assets pro rata to their capital contribution (Procter and Thieffrey 1998, p. 6). National central banks retained the “ownership” of these foreign reserve assets and transferred the management of the reserves to the ECB. (Scott 1998, p. 217). In the case of an exit, both the return of the contribution to the ECB’s capital and the foreign assets transferred to the Eurosystem had to be negotiated (Anthanassiou 2009).
Similarly, there is the problem of TARGET2 claims and liabilities. If Germany had left the EMU in March 2012, the Bundesbank would have found TARGET2 claims denominated in euros of more than €616 billion on its balance sheet. If the euro depreciated against the new DM, important losses for the Bundesbank would result.[22] As a consequence, the German government may have to recapitalize the Bundesbank. Take into account, however, that these losses would only acknowledge the risk and losses that the Bundesbank and the German treasury are facing within the EMU. This risk is rising every day the Bundesbank stays within the EMU.
If, in contrast, Greece leaves the EMU, it would be less problematic for the departing country. Greece would simply pay its credits to the ECB with the new drachmas, involving losses for the ECB. Depositors would move their accounts from Greek banks to German banks leading to TARGET2 claims for the Bundesbank. As the credit risk of the Bundesbank would keep increasing due to TARGET2 surpluses, the Bundesbank might well want to pull the plug on the euro itself (Brookes 1998).[23]
Intellectual honesty requires us to admit that there are important costs to exiting the euro, such as legal problems or the disentangling of the ECB. However, these costs can be mitigated by reforms or clever handling. Some of the alleged costs are actually benefits from the point of liberty, such as political costs or liberating capital flows. Indeed, other costs may be seen as an opportunity, such as a banking crisis that is used to reform the financial system and finally put it on a sound basis. In any case, these costs have to be compared with the enormous benefits of exiting the system, consisting in the possible implosion of the Eurosystem. Exiting the euro implies ending being part of an inflationary, self-destructing monetary system with growing welfare states, falling competitiveness, bailouts, subsidies, transfers, moral hazard, conflicts between nations, centralization, and in general a loss of liberty.
Notes
[1] Reiermann (2011) discusses rumors of a possible Greek exit. Desmond Lachman (2011) maintains that Greece exit from the eurozone is inevitable. Feldstein (2010) recommends that Greece take a “holiday” from the euro. Johnson (2011) and Roubini (2011) recommend that Greece leave the euro and default. Alexandre (2011) and Knowles (2011) wonder how a Greek exit could be achieved. Edmund Conway (2011), on the contrary, thinks that Germany should leave the eurozone. David Champion (2011) also considers the possibility of a German exit.
[2] Smits (2005, p. 464) writes, “There is no legal way for a separate exit from the eurozone. So, an intention to give up the single currency can only be realized by negotiating an exit agreement, or, failing successful conclusion thereof, leaving [the EU altogether] after the two-year notice period.”
[3] Anthanassiou (2009, p. 19), in contrast, argues that no country can leave the eurozone in protest.
[4] Mann (1960) maintains that if it is unclear which currency should be applied, the courts should use the law specified in the contract. So if the bond of the German company is sold in Paris under French law, the contract would be paid in euros. Porter (2010, p. 4) reaches the same conclusion.
[5] Thieffry (2011, p. 104) fears a “serious legal dislocation of government bond markets and a long period of uncertainty.” Problems for irresponsible governments to finance deficit spending might actually be seen as advantageous.
[7] The argument of increased competitiveness via depreciation has more fundamental problems (Rallo 2011, p.158). While it is important to lower some prices vis-à-vis the foreign world (e.g., wages in some sectors), depreciation lowers all prices to the same extent. Moreover, it makes imports more expensive. If a country has to import commodities and goods that are later exported, the depreciation may not increase competitiveness at all.
[8] The authors estimate the costs for “weak” countries to leave between €9,500 and €11,500 per person and €6,000 to €8,000 per person for “strong” countries. The authors contrast these numbers with the relatively small cost of €1,000 per German in the case of a 50 percent haircut on Greek government debt. These estimations neglect some important benefits of exit and exaggerate the costs. For instance, they do not take into account the long-term costs of a fiscal union, nor the higher inflation. Moreover, they assume that the “strong” leaving country would have to “write off its export industry” and civil disorder in weak countries, while the possibility of such disorder it actually higher staying within the eurozone.
[9] On the history of the political project of the euro as a means toward a central European state see Bagus (2010).
[10] Flury and Wacker (2010) estimate one year of transition to fully establish the new currency.
[11] An alternative solution would be to stamp all notes in the exiting country within a short period of time. Yet, there is the problem of massive inflow of notes or a population that does not bring in their notes to be stamped due to fear of future depreciation. Thus, we regard the exchange of notes bearing the national letter more practical, even though some of the notes are circulating in other EMU countries.
[12] Smith (2005, p. 465) points to the instability caused by speculations about an exit: “even the threat of withdrawal will affect the euro stability and may lead to speculation against the single currency.” Scott (1998, p. 211) argues that speculation on which country is to leave may lead to a breakup of the eurozone.
[13] Porter (2010, p.6 ) depicts the following scenario: If Germany is expected to introduce a strong currency. banks will transfer deposits to Germany. They could lend at the marginal lending rate of their central banks and deposit at the Bundesbank. The Bundesbank balance sheet would expand substantially. Porter suggests a surprise shut down of the TARGET2 system.
[14] Another alleged problem is contagion. If one country leaves the eurozone, investors may sell the debt of other weak EMU governments and their banks triggering more exits. The contagion problem does not concern us here, because we want to discuss the possibility of exit. If exit is possible and desirable, contagion is no insurmountable problem but may even be recommendable.
[15] As Porter (2010, p. 5) points out, an exit would result in a currency mismatch of many companies and banks. Suddenly they would have assets or debts denominated in a foreign currency with a changing value resulting in windfall profits or losses. As Germany has a net foreign-asset position and an exit would likely lead to an appreciation of the new German currency, losses would result. The losses would damage balance sheets.
[16] Flury and Wacker (2010) discuss this and other problems related to a German exit from the euro.
[18] One may also ask whether a country should have rejected the possibility of secession from the Soviet Union in fear of banking problems.
[19] For a detailed plan and critique of the 2008 bailouts, see Bagus and Rallo (2011).
[20] Ideally, this conversion would be voluntary. If bank creditors are unwilling to convert their investments into equity, the bank would have to be liquidated with high losses due to fire sales. Thus, there is an incentive for creditors to convert bank debts into equity, if the business model is be viable. Doing so they can prevent the higher losses from a liquidation. On the contrary, Buiter (2008) has suggested an involuntary, across-the-board debt-equity conversion. This measure is unnecessary if we allow for bank failures.
[21] The Bundesbank capital share is 27.1 percent. The paid up capital is €1.4 billion. (The Bundesbank’s capital share is 18.93 percent including both eurozone and noneurozone members.)
[22] A depreciation of the euro implies a loss of almost €100 billion.
[23] Note that the claims or liabilities in the TARGET2 system are not against other national central banks, but a single net bilateral position is established vis-á-vis the ECB only (Whittaker 2011). See also Bundesbank (2011b, p. 34).
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On Tuesday, March 26, 2012, I was invited by Ron Paul and his staff to assist a meeting of the Domestic Monetary Policy and Technology Subcommittee of the House Committee on Financial Services. The title of the hearing was “Federal Reserve Aid to the Eurozone: Its Impact on the U.S. and the Dollar.”
Unfortunately, Ben Bernanke had not come to the hearing, being busy with propaganda lectures in favor of the Fed. Instead, two of his colleagues, Mr. William C. Dudley (president and chief executive officer, Federal Reserve Bank of New York) and Dr. Steven B. Kamin (director, Division of International Finance, Board of Governors of the Federal Reserve System), showed up to answer the committee’s questions on currency swaps with other central banks.
But why did European banks need help from the Fed in the first place? European banks had borrowed dollars short term in international wholesale markets and lent these dollars for the long term to US companies or households. The maturity mismatch is highly risky, because once a bank cannot renew its short-term debts it becomes illiquid.
We approached such a situation last year. European banks had been pressured by their governments to buy their governments’ debts. Italian banks are loaded with Italian government bonds, Spanish banks with Spanish bonds and so on. As the sovereign-debt crisis increased once again in the summer of 2011 with governments short of collapsing, European banks had increasing difficulties renewing their short-term dollar loans. As the ECB can only print euros, not dollars, European banks got nervous. While US banks did not want to lend to European banks anymore, in September 2011, the Fed stepped in and bailed out European banks through currency swaps. Through the swaps, the Fed assumed its role as the international lender of last resort.
During the financial crisis between 2007 and 2009, the Fed had bailed out European banks mainly through direct loans to subsidiaries in the United States. In order to conceal the bailouts, the Fed now uses mainly currency swaps. In the swap, the Fed sells dollars to the ECB and buys them back later at the same price, receiving interests. This construction resembles a dollar loan to the ECB at about 0.6 percent (0.5 percent above the federal-funds rate). The ECB can then use these dollars to lend them to troubled European banks.
At the hearing the Fed officials did not deny the obvious: the bailout of European banks by the Fed. Rather, they claimed that the bailout was basically a free lunch for US taxpayers, as they would get an almost-risk-free benefit in the form of the interest on the swap.
Further, the Fed officials maintained that the bailout was necessary because a default of European banks would cause stress in financial markets. Through the interconnectivity of financial markets, US banks would get into problems; lending to US households and companies would be affected negatively.
Lastly, they made assurances that the Fed will end the swap-bailout policy once it becomes imprudent and the costs and risks of such a policy exceed the benefits for the US public.
Let’s have a look at these startling arguments.
First, there ain’t no such a thing as a free lunch; not even for the Fed, the ultimate money producer. Just remember that US banks did not want to lend to European banks, because they regarded it as too risky. Even the central-bank swap is not risk free. It is true that the Fed has locked in the exchange rate and expects to get back the same amount of dollars plus interest. Yet there remains counterparty risk: what if the ECB, goes bust? Then the creditors, including the Fed, will take over the ECB’s assets. Creditors would receive assets such as Greek government bonds, or loans to Portuguese banks. These banks depend on ECB liquidity lines and are collateralized by bonds issued by the Portuguese government, which also depends on the ECB to support it.
In the end, the ECB balance sheet is backed to a large extent by bonds from insolvent governments that are only kept afloat thanks to the ECB’s promises to keep printing money and the pledged support of German taxpayers.
While an ECB bankruptcy does not seem imminent, the ECB has increased its capital to make good for potential losses already back in 2010, and the Bundesbank increased its provisions for losses in 2011. In the mean time, the ECB has bought even more Greek government debt. The ECB is probably one of the most highly leveraged banks in history.
Of course, the Fed hopes that eurozone governments will always recapitalize the ECB if it is necessary, so that ultimately taxpayers return the dollars to the Fed. But what if Germany leaves the eurozone? While this is unlikely in the short term, the possibility exists for the long run. Then southern European governments will default on their debts — and take their banks and the ECB down with them. Then who will pay back dollar swaps to the Fed?
The swap is also no free lunch as opportunity costs are involved. By abstaining from producing dollars and lending them to the ECB, the US-dollar money supply would be smaller and backed by better-quality assets (not indirectly by Greek government bonds). The dollar production also implies a redistribution toward the first receivers of the new dollars, the ECB, European banks, and their borrowers (mainly irresponsible and insolvent governments) to the detriments of the last receivers, mainly US citizens, who are confronted with a debased dollar.
There are other opportunity costs. The Fed could have produced the same amount of dollars and not invested in the central-bank swaps. These swaps earn very low interest. Instead of the swaps, the Fed could have purchased other assets, like stocks of Apple or gold, which may rise more in value.
One cost of the swap operation acknowledged by the officials in the hearing is the moral hazard created. Banks and governments worldwide may expect that the Fed will come to save them, too, especially if they are well connected with the US financial system. So why be prudent?
The highest cost of the swaps, though, may be something else. Through the swaps, the Fed is helping the ECB to bail out European banks that finance insolvent and irresponsible governments. The Fed is indirectly bailing out countries like Greece, Portugal, and Spain, debasing the dollar. Thanks to the bailouts, the political project of the euro continues. Without the swaps, some European banks might have failed, and with them their sovereigns. Thanks to the swaps, the eurozone stays intact.
The project of the euro leads to an ever-increasing rescue fund, and gradually toward a fiscal union and more centralization. A European financial government and the European super state, which would most likely abolish tax competition in Europe, are on the horizon. The highest cost of the Fed policy, therefore, may be liberty in Europe.
The Fed officials also made clear that they think the swap arrangement benefits the US public by keeping stress away from US banks and financial markets. The Fed does not want stock markets to fall or interest rates to increase. For them, low interest rates are the panacea for all economic ills. However, having artificially low interest rates climb back to more normal levels is no disaster. Sustainable investments are always restricted by real savings. Lowering interest rates does not increase the amount of real savings at all. Moreover, an important feature of a market economy is that people take responsibility for their actions. If US banks have granted loans to European banks and governments, they should assume the losses from their risky behaviour.
Finally, the Fed claims to be prudent. But how can the Fed know the point at which it is no longer prudent to bail out foreign banks? How can it know when the costs of the bailouts start to exceed the benefits to the US public? How can they know what is best for the United States? Interpersonal-utility comparisons are arbitrary. Thanks to the bailouts, some banks may win, some stock owners may win, but at the cost of liberty in Europe and to the detriment of dollar users. Moreover, bailouts produce moral hazards, crises, and losses for individuals in the future. Yet the Fed claims to know what to do: social engineering at its best — or, as Hayek would put it, a fatal conceit on the part of central (banking) planners.
In sum, the Fed has assumed the task of bailing out the financial industry and governments worldwide by debasing the dollar. Fed officials claim to know that the bailout-swaps are basically a free lunch for US taxpayers and a prudent thing to do. Thank God the world is in such good hands.
This article was previously published at mises.org.
On Thursday, October 28, 2011, prices of European stocks soared. Big banks like Société Générale (+22.54%), BNP Paribas (+19.92%), Commerzbank (+16.49%) or Deutsche Bank (+15.35%) experienced fantastic one-day gains. What happened?
Today’s banks are not free-market institutions. They live in a symbiosis with governments that they are financing. The banks’ survival depends on privileges and government interventions. Such an intervention explains the unusual stock gains. On Wednesday night, an EU summit had limited the losses that European banks will take for financing the irresponsible Greek government to 50 percent. Moreover, the summit showed that the European political elite is willing to keep the game going and continue to bail out the government of Greece and other peripheral countries. Everyone who receives money from the Greek government benefits from the bailout: Greek public employees, pensioners, unemployed, subsidized sectors, Greek banks — but also French and German banks.
Europeans politicians want the euro to survive. For it to do so, they think that they have to rescue irresponsible governments with public money. Banks are the main creditors of such governments. Thus, bank stocks soared.
The spending mess goes in a circle. Banks have financed irresponsible governments such as that of Greece. Now the Greek government partially defaults. As a consequence, European governments rescue banks by bailing them out directly or by giving loans to the Greek government. Banks can then continue to finance governments (the loans to the Greek government and others). But who, in the end, is really paying for this whole mess? That is the end of our story. Let us begin with the origin that coincides with beneficiaries of the last EU summit: the banking system.
The Origin of the Calamity: Credit Expansion
When fractional-reserve banks expand credit, malinvestments result. Entrepreneurs induced by artificially low interest rates engage in new investment projects that the lower interest rates suddenly make look profitable. Many of these investments are not financed by real savings but just by money created out of thin air by the banking system. The new investments absorb important resources from other sectors that are not affected so much by the inflow of the new money. There results a real distortion in the productive structure of the economy. In the last cycle, malinvestments in the booming housing markets contrasted with important bottlenecks such as in the commodity sector.
The Real Distortions Trigger a Financial Crisis
In 2008, the crisis of the real economy triggered a banking or financial crisis. Artificially low interest rates had facilitated excessive debt accumulation to finance bubble activities. When the malinvestments became apparent, the market value of these investments dropped sharply. Part of these assets (malinvestments) was property of the banking system or financed by it.
As malinvestments got liquidated, companies went bust and people lost their bubble jobs. Individuals started to default on their mortgage and other credit payments. Bankrupt companies stopped paying their loans to banks. Asset prices such as stock prices collapsed. As a consequence, the value of bank assets evaporated, reducing their equity. Bank liquidity was affected negatively too as borrowers defaulted on their bank loans.
As a consequence of the reduced bank solvency, a problem originating from the distortions in the real economy, financial institutions almost stopped lending to each other in the autumn of 2008. Interbank liquidity dried up. Add to this the fact that fractional-reserve banks are inherently illiquid, and it is not surprising that a financial meltdown was only stopped by massive interventions by central banks and governments worldwide. The real crisis had caused a financial crisis.
Conditions for Economic Recovery
Economic recovery requires that the structure of production adapt to consumer wishes. Malinvestments must be liquidated to free up resources for new, more urgently demanded projects. This process requires several adjustments.
First, relative prices must adjust. For instances, housing prices had to fall, which made other projects look relatively more profitable. If relative housing prices do not fall, ever more houses will be built, adding to existing distortions.
Second, savings must be available to finance investments in the hitherto neglected sectors, such as the commodity sector. Additional savings hasten the process as the new processes need savings.
Lastly, factor markets must be flexible to allow the factors of production to shift from the bubble sectors to the more urgently demanded projects. Workers must stop building additional houses and instead engage in more-urgent projects, such as the production of oil.
Bankruptcies are an institution that can speed up the process of relative price adjustments, transferring savings and factors of production. They favor a rapid sale of malinvestments, setting free savings and factors of production. Bankruptcies are thus essential for a fast recovery.
A Fast Liquidation Is Inhibited at High Costs
All three aforementioned adjustments (relative prices changes, increase in private savings, and factor-market flexibility) were inhibited. Many bankruptcies that should have happened were not allowed to occur. Both in the real economy and the financial sector, governments intervened. They support struggling companies via subsidized loans, programs such as cash for clunkers, or via public works.
Governments also supported and rescued banks by buying problematic assets or injecting capital into them. As bankruptcies are not allowed to happen, the liquidation of malinvestments was slowed down.
Governments also inhibited factor markets from being flexible and subsidized unemployment by paying unemployment benefits. Bubble prices were not allowed to adjust quickly but were to some extent propped up by government interventions. Government sucked up private savings by taxes and squandered them maintaining an obsolete structure of production. Banks financed the government spending by buying government bonds. By putting money into the public sector, banks had fewer funds available to lend to the private sector.
Factors of production were not shifted quickly into new projects because the old ones were not liquidated. They remained stuck in what essentially were malinvestments, especially in an overblown financial sector. Factor mobility was slowed down by unemployment benefits, union privileges, and other labor market regulations.
Real and Financial Crisis Trigger a Sovereign-Debt Crisis
All these efforts to prevent a fast restructuring implied an enormous increase in public spending. Government spending had already increased in the years previous to the crisis thanks to the artificial boom. The credit-induced boom had caused bubble profits in several sectors, such as housing or the stock market. Tax revenues had soared and had been readily spent by governments’ introducing new spending programs. These revenues now just disappeared. Government revenue from income taxes and social security also dropped.
With government expenditures that prolong the crisis soaring and revenues plummeting, public debts and deficits skyrocketed.[1] The crisis of the real and financial economy led to a sovereign-debt crisis. Malinvestment had not been restructured, and losses had not disappeared, because government intervention inhibited their liquidation. The ownership of malinvestments and the losses resulting from them were to a great part socialized.
Sovereign-Debt Crisis Triggers Currency Crisis
The next step in the logic of monetary interventionism is a currency crisis. The value of fiat currencies is ultimately supported by their governments and central banks. The balance sheets of central banks deteriorated considerably during the crisis and with them the banks’ capacity to defend the value of the currencies they issue. During the crisis, central banks accumulated bad assets: loans to zombie banks, overvalued asset-backed securities, bonds of troubled governments, etc.
In order to support the banking system during the crisis and to limit the number of bankruptcies, central banks had to keep interest rates at historically low levels. They thereby facilitated the accumulation of government debts. Consequently, the pressure on central banks to print the governments’ way out of their debt crisis is building up. Indeed, we have already seen quantitative easing I and quantitative easing II enacted by the Fed. The European Central Bank also started buying government bonds and accepting collateral of low quality (such as Greek government bonds) as did the Bank of England.
Central banks are producing more base money and reducing the quality of their assets.
Governments, in turn, are in bad shape to recapitalize them. They need further money production to stay afloat. Due to their overindebtedness, there are several ways out for governments negatively affecting the value of the currencies they issue.
Governments may default on debts directly by ceasing to pay their bonds. Alternatively, they can do so indirectly through high inflation (another form of default). Here we face a possible feedback loop to the banking crisis. If governments default on their debts, banks holding these debts are affected negatively. Then another government’s bailout may be necessary to save the banks. This rescue would likely be financed by even more debts calling for more money production and dilution. All this reduces the confidence in fiat currencies.
Conclusion
After crises of the real economy, the financial sector and government debts, the logic of interventionism leads us to a currency crisis. The currency crisis is just unfolding before our eyes. The crisis has been partially concealed as the euro and the dollar are depreciating almost at the same pace. The currency crisis manifests itself, however, in the exchange rate to the Swiss franc or the price of gold.
When currencies collapse, price inflation usually picks up. More units of the currency must be offered to acquire goods and services. What had started with credit expansion and distortions in the real economy, then, may well end up with high price inflation rates and currency reform.
It is now easy to answer our initial question: Who is paying for the mutual bailouts of governments and banks in the eurozone? All holders of euros, via a loss of purchasing power.
Instead of allowing the market to react to credit expansion, governments increased their debts and sacrificed the value of the currencies we are using. The remedy to the distortions caused by credit expansion would have been the fast liquidation of malinvestments, banks, and governments. As the innocent users of the currencies are paying for the bailouts, it is difficult not to be a liquidationist.
[1] The tremendous increase in public debts after a banking crisis is typical. Carmen Reinhardt and Kenneth Rogoff write in This Time Is Different (2009), p. xxxi: “On average government debt rises by 86 percent during the three years following a banking crisis.”
This article was previously published at Mises.org.
In this essay we evaluate the alleged costs of a euro exit and propose practical steps to make a withdrawal from the euro as smooth as possible.
The costs of remaining within the euro are very high. These costs do not only include the costs of the open bailouts and guarantees for the rescue funds. The euro is a misconstruction as several independent governments can finance their deficits through one (central) banking system. The incentive is to run higher deficits than other states of the EMU. The setup of the Eurosystem made interest rates converge and enabled monetary redistribution. Due to its incentives there is a tendency for price inflation.
To save the euro the ECB will have to be highly inflationary in the future. The ECB will have to keep accepting or buying governments bonds and finance the rescue funds. Within the EMU the incentives to reduce deficit spending are diminished. There is a general tendency for the size of government to increase due to this inflationary deficit spending. Most likely, only a centralization of some sort (fiscal union) will be able to save the euro at this point with its current members. The growing size of government and the centralization imply a loss for individual liberty for citizens of governments that remain within the euro. Lastly, the redistribution may cause conflicts between nations and disturb the harmonious cooperation in Europe.
The problems of a euro exit have been largely exaggerated. Introduction costs, wage inflation, trade losses, political costs, legal problems, procedural costs, banking crisis, costs of disentangling of the ECB, pose important but no insurmountable problems. With accompanying measures and careful negotiation these problems are all solvable.
We found three ways to exit.
First, redenomination of all contracts and deposits into a new national currency. Coins and notes bearing the national symbol are exchanged gradually into the new currency preferably at a 1:1 exchange rate. In order to prevent disturbing flows of capital a “provisional” redenomination allowing for democratic discussion is found as the most elegant way.
Second, issue of a parallel national currency. This national currency may be backed by government or central bank assets preferably gold and would compete with the euro.
Third, currency competition. All legal tender laws are abolished. Gradually, citizens will start using more stable currencies and possibly adopt commodity based means of payment.
It is essential to accompany an exit from the euro with supporting reforms to alleviate transition costs. The sovereign debt and euro crisis is foremost a crisis of the state that has grown to a dimension that threatens the stability of the euro currency. Accompanying measures must roll back the state. In order to introduce a new currency with success it is essential that the new currency is expected to be less inflationary than the euro.
As a banking reform will be necessary in any case, an exit from the euro should be used to thoroughly reform the banking and monetary system putting them finally on a sound basis. Moreover, the public deficits should be eliminated, old public debt restructured, public assets privatized, markets deregulated and made flexible, and taxes lowered.
I recently presented these ideas to the European Parliament in a conference sponsored by the EFD group (starting from 41:20):
There are basically three scenarios for the future of the European Monetary Union as I argue in my book The Tragedy of the Euro.
First, the Stability and Growth Pact (SGP) is reformed and enforced with automatic sanctions for countries not complying with its conditions. This requires harsh austerity measures, privatizations, labor market reforms and reduction of living standards in the periphery. The case of Greece shows that this option may just not be viable considering political structures and socialist voters resisting a reduction of the state’s size. Indeed, for 2011 the Greek deficit is expected to be at 9.5% of GDP, far above of the 3% limit established by the SGP and the 7.4% target established by the European Commission.
The second scenario is a break-up of the monetary union. The periphery has no interest in exiting the Eurozone. Periphery governments are benefitting from guarantees by the core and from monetary redistribution. An exit would imply a substantial reduction of living standards in the periphery. But why are core countries not leaving the Euro? While a euro exit would be in the interest of the common population, the political elite and their financiers from the banking sector want to continue the Euro project. As we have seen in the summit on the second Greek bailout, German Chancellor Merkel not only defied the “no-bailout clause” of the Maastricht Treaty but also a resolution of the German parliament against purchasing commonly-guaranteed bonds from February 2011. This leads us to the third scenario, which we are approaching fast: a transfer union and a European superstate. The EU summit of Thursday, 21st of July 2011 marks a big step in this direction.
The Greek government will get an additional €109 bn. bailout loan until 2014. Maturities for Greek bonds from the first bailout were raised from 7.5 to 15 years (originally it was 3 years). Interest rates were reduced from 4.2 % (originally at 5.2 %) to 3.5 %. Likewise, interest rates on loans to Portugal and Ireland were reduced.
The day brought also another bailout of banks. Banks, insurance companies and other private investors can swap their old Greek government bonds against new ones with a longer maturity. Joseph Ackermann, CEO of Deutsche Bank, estimates write-downs for banks around 21%. Politicians sell the so-called “participation of private investors” in the bailout as a great success. However, it is just another bailout for the banking system, limiting losses to 21% and putting taxpayers’ money on the hook. Old bonds are swapped into new bonds that are guaranteed by the EFSF and such by European taxpayers. Without the second bailout the Greek government would have had to default. Banks would have had to take much higher losses in a restructuring. Estimates of losses range between 50-70%. After the swap, banks are effectively protected. The financial industry, the governments’ main financier, can be very happy about this covert bailout.
The most important consequence of 21st of July was the official establishment of a transfer union by granting more powers to the EFSF (the European bailout fund). In the Eurozone, there have always been transfers through monetary redistribution: The ECB accepts bonds from the periphery as collateral thereby monetizing deficits indirectly. Last year, the ECB even started to buy government bonds from the periphery outright, spreading the burden of the bailout to all users of the currency. Yet, from now on, direct purchases by the ECB may become unnecessary. The burden of the bailouts will be more concentrated. Not all currency users will pay in form of a dilution of the Euro but rather taxpayers in countries that effectively guarantee the EFSF.
The EFSF now can give credit lines to countries that are expected to have financing problems. In addition, the EFSF may purchase government bonds on the secondary market. The role of the ECB is thereby partially taken over by the EFSF.
The possibility of financing through the EFSF reduces the pressure for countries to eliminate deficits and reduce government debts. Why introduce harsh austerity measures, reform labor markets and privatize the public sector if there are loans available from the EFSF at ridiculously low interest rates? If you want to win elections, you should not reform but spend. Only through deficit spending one can maintain the artificially high living standards in the periphery. Indeed, debts are still on the rise. Deficits are huge and far from being eliminated. Most probably, Greece, Ireland, Portugal and soon Spain, Italy and even Belgium will borrow exclusively from the EFSF. To be effective, the size of the EFSF will have to be extended. The main guarantor will be Germany. Considering peripheral funding needs, a report from Bernsteincalculates:
As the guarantees of the periphery including Italy are worthless, the guarantee Germany would have to provide rises to €790bn or 32% of GDP.
If France is downgraded, the German share increases to €1.385 trillion — 56% of GDP.
The transfer union implies a transfer of power to the European Commission. We get ever closer to a European superstate. Incentives to reduce deficits will be reduced both in the periphery and in the core. Germans will start to resist cuts in public spending. Why save if the savings flow to the periphery? Instead of reducing German pensions to guarantee Greek pensions, German voters will push for more public spending. To pay for welfare states and transfers, more taxes (maybe a European tax) and money production will become necessary. The centralization of power allows for harmonization of regulations and taxes. Once tax competition ends, there will be a tendency towards ever higher taxes. With the transfers, the power of Brussels will continue to rise. There seems to be only one bold, albeit costly way, to stop the process towards a EUSSR: withdrawal from the transfer union. With an exit from the Euro, Germany could bring down the whole Euro project and save Europe.
In the past, The Tragedy of the Euro could only bought in the U.S. This implied long shipping to Europe and high shipping costs. Now, a second, improved edition has been published in Europe. With free shipping at Terra Libertas. You can also order from Amazon.co.uk.
In this article recently published in the Quarterly Journal of Austrian Economics, David Howden and I discuss the theoretical problems of fractional reserve free banking. Find the article here: http://mises.org/journals/qjae/pdf/qjae13_4_2.pdf
The heroes of Europe are to be found in Slovakia. The Slovak government is the only Eurozone government that did not participate in the €110 bn. bailout of Greece. While all other governments of the Eurozone work toward further centralization, an economic government and Euro bonds, only the Slovaks resist this trend toward inter-european transfers via bailout funds.
While the Slovak parliament had rejected the specific Greek bailout, it gave in to the creation of the “rescue fund”. However, it was only after massive pressure and the threat of “political sanctions” that they assented to the foundation of the European Financial Stability Facility (EFSF) of €750bn.
Prime Minister Iveta Radicova explained in August the Slovak resistance to European bailouts:
We had a difficult time with fundamental reforms between 1998 and 2002.And no one helped us. We did not get a cent. Nothing. It was our citizens who had to carry the burden and it was not easy. But we got through this phase with very unpopular, painful reforms. How should I tell our citizens that we should now help those who are not prepared to do something themselves.
Radicova shows more common sense than can be expected from European politicians. Indeed, Slovakia did commit to necessary structural reforms and cut public spending, against resistance on part of the population. Note: the Slovaks did this without the need for the EU commission or Germany to “impose” reforms, as is now the case in Greece, Spain or Portugal.
Finally, Greece is also undertaking unpopular reforms. Why does Greece get a reward in the form of a bailout while Slovakia did not? Not only did Greece defer the necessary reforms, but the Greek government lived beyond its means by borrowing and indirectly monetizing its debts. Thereby, it made all users of the common currency pay for its extravagancies. This was facilitated by the perverse setup of the monetary union. The Eurosystem allows for the monetary redistribution in favor of government with the highest deficits. Several independent governments can use one (central) banking system to finance their deficit spending (I explain the mechanism in detail in my book The Tragedy of the Euro).
By living beyond its means, the Greek government subsidized an uncompetitive Greek economy. Wage rates could remain artificially high as the Greek government paid generously for a large public sector, public employees, pensioners, and unemployed. At the same time, the Slovak government forced through unpopular reforms, reducing the public sector and making its economy more competitive and productive.
It is understandable that Slovaks feel uneasy about paying for the artificially high living standard of the Greek population via direct transfers. As a Slovak one might well think: “How have we been so stupid to do these reforms? If we’d waited a little bit longer and lived beyond our means, we might well have gotten the reward of a bail out like the Greeks.” One must take into account, however, that Slovak reforms were before the entry into the monetary union. Once you have entered, the incentives for reforms drop dramatically, as a bailout can be expected.
An intriguing fact is that GDP per capita in Greece is almost 50% higher than in Slovakia ($29,400 vs. $21,200). Hard working poorer Slovaks are expected to bailout lazy Greek bureaucrats? Unelected EU commissioner Olli Rehn was not embarrassed to accuse Slovakia of a “lack of solidarity” and criticize the decision of the democratically elected Slovakian parliament.
Recently, Ivan Miklos, Slovak Finance Minister, stated that Greece should restructure its debt. Such an acknowledgment of reality is not found often among politicians. Politicians must know that a restructuring will be necessary sooner or later. But they do not dare to say so. Miklos also stated that the EFSF was a mistake.
It is honourable that Slovak politicians call the EFSF for what it is, and that Slovakia resists the redistribution and tendency toward centralization in the EU. Unfortunately, Slovakia is not big enough to really matter in the fight for the future of Europe. Its contribution to the Greek bailout would have been less than 1% of the total (€ 800 million). Thus, Greece was bailed out anyway.
Unfortunately, politicians of countries that would make a difference do not resist the advancement on the fast track toward a transfer union. German chancellor Angela Merkel, by just saying that Greece should restructure and that the EFSF was a mistake, could bring down several governments in peripheral countries by causing a surge in their bond yields and their eventual default. This could stop the process toward centralization of power in Europe and the prospects of a transfer union. Yet, Merkel fails to defend the interest of the common man in Germany and in Europe. She should look to Slovakia for inspiration.
January 14th 2011 is the day on which the Greek government ultimately would have failed. Only extreme interventions by the ECB, breaking former promises, are holding the Greek government afloat. On January 14th, Fitch downgraded Greece from BBB- to BB, a rating considered junk status. Fitch was the last of the big three rating agencies after S&P and Moody’s that had rated Greece above junk.
The ratings are essential for governments because of the collateral rules of the European Central Bank (ECB). When governments spend more than they receive as tax revenue, they issue government bonds. These government bonds are bought by the banking system because banks can use government bonds as collateral for new loans from the ECB. This mechanism is explained in detail in my book The Tragedy of the Euro. The ECB does not accept just any kind of security or government bond as collateral for its valuable loans. The ECB wants some quality, and requires a minimum rating by one of the three rating agencies for these securities.
During the financial crisis the ECB had lowered the required minimum rating for its open market operations from A- to BBB- in order to help out banks because the rating of securities, especially mortgage backed securities, were falling. The reduction was supposed to be an exception and was to expire at the end of 2010.
The uncertainty of Greece’s rating triggered the sovereign debt crisis in 2010. Due to budgetary problems, Greece was in danger of losing the minimum A- rating. What would happen in 2011 when the minimum rating would be raised back to A- and Greece’s rating would not meet this requirement?
The market started to have doubts about Greece’s being able to repay its debts. And it was feared that the ECB would stop financing the Greek deficit indirectly. If the ECB would stop accepting Greek bonds as collateral for loans, no one would buy Greek bonds. The government would have to default on its obligations.
In January 2010 Jean-Claude Trichet, ECB president, still maintained a hard money rhetoric: “We will not change our collateral framework for the sake of any particular country. Our collateral framework applies to all countries concerned.”
Market participants interpreted this statement as a pledge that the ECB would not extend the exceptional reduction of the required minimum rating to BBB- just to save the Greek government. Along the same line, chief economist of the ECB, Jürgen Stark, stated in January that markets were wrong in believing that other member states would bail Greece out.
As Greek problems intensified in March 2010, Trichet, in contrast to his January statement, announced that emergency collateral rules would be extended through 2011. Greek bonds regained the potential to serve as collateral.
Yet, the Greek situation was worse than central bankers had expected. Markets started to believe that Greece would even fail to meet the BBB- rating in 2011, an expectation that finally became reality on January 14th with the downgrade by Fitch. They continued to sell Greek bonds.
In May 2010 at the height of the debt crisis, the independence of the ECB began evaporating when it announced it would drop all rating requirements for Greek government bonds. The ECB would accept Greek bonds as collateral no matter what. Only by this measure does the ECB continue to accept junk rated Greek bonds as collateral.
By contradicting its previous approach and becoming an executor of politics, the ECB lost its credibility. The ECB presented itself more and more as the inflationary machine—in service of high politics—that had been intended by French and other Latin politicians.
From the beginning, the Euro has been a political project. In order to save the project, the ECB disregarded its mandate of price stability and changed its collateral rules to accommodate the bailout of Greece. Far from being a copy of the Bundesbank that during its history repeatedly dismissed inflationary wishes of politicians, the ECB proved to be an instrument of politicians toward a centralization of power in Europe.
In 2011 we are at a decisive moment regarding the future of the European Union. Either the EU takes a leap forward toward a strong centralized European state, or we will move towards more freedom as competition is fostered. The ECB has shown on which side it stands.
