In this video Philipp Bagus, Assistant professor of Economics at Madrid’s Universidad Rey Juan Carlos and author of The Tragedy of the Euro and Alasdair Macleod of the GoldMoney Foundation talk about the eurozone facing the problem that is characterised in the “tragedy of the commons” analogy. Bagus explains this phenomenon by way of an example of overfished and over-exploited oceans due to a lack of property rights on oceans. In Europe, governments run larger deficits than their “competitors” in order to externalise the costs to all users of the currency. Knowing these incentives, the Stability and Growth Pact was put in place as per the early 1990s Maastricht Treaty, capping budget deficits at 3% of GDP and the debt to GDP level at 60%. However there was no enforcement of these rules which is why there have already been more than 80 infringements to this stability pact without any repercussions.
They talk about possible solutions to the euro crisis. Bagus points out that there are basically three different ways to go about it. Firstly, governments could make drastic cuts in public spending and privatise public assets in order to balance their budgets. However, there will be – and is – strong political resistance to such proposals. Secondly, the eurozone could disintegrate, driven by a reluctance of German citizens to pay for other countries’ expenditures. And lastly, central banks and governments could decide to print their way out of the crisis, leading to high inflation.
Bagus says that as long as the incentive for running deficits exists there won’t be an increase in countries’ savings rates. Macleod points out that there is great institutional resistance to breaking up the euro. Bagus explains that the official opinion towards the euro is positive in Germany; however the sentiment on the streets looks quiet different. But as long as there is no political party devoted to this issue this mood is not likely to gain traction at least as long as inflation remains moderate.
Amid the ongoing expansion of the money supply and persistent deficits, Bagus can’t see the dollar gaining in value over the medium to long term. He also says that ECB policies are a lot more pragmatic than the ones undertaken by the US Federal Reserve. Talking about sound money, Bagus explains different ways to go about its introduction. One way would be to back all the money in existence by gold, adjusting the price of gold accordingly. Another would be to take away legal tender laws and have competing currencies. However this would require the governments to impose dramatic reforms, which is partly why they will oppose such measures.
This interview was recorded on November 15 2011 in Madrid.
The markets are telling us that there is a painful abscess in Europe, with the Euro at its core, writes Paul Tustain, founder and director of BullionVault.
We believe it is driving Germany and France a little mad, and that they are abusing their European partners as a result. They are about to commit an injustice which will strip away the profound goodwill which they have built up over 50 years, and they risk tearing Europe apart.
All our European friends are today irritated by Britain’s refusal to come with them. Not for the first time we are the odd man out, and being pointed at by the shallowest politicians in Europe. It’s OK. We can live with a little name-calling for the moment, and we look forward to quietly rebuilding our friendships with every one of you in the future. We hope it will be soon, although we fear it may not be.
You are right. Our British financial system contributed – in part – to the mess we are in. But you are wrong as to the reason and the solution.
What really happened is that over a period of years the political classes in New York and Europe (including the British) worked together to hold down the cost of credit. Ever since 2001 western politicians suppressed the will of the market to enter into a mild recession. What is this ‘market will’? It is the combined message from a thousand million transactions a day, expressing the free choices of 400 million people. Looming recession is the evidence that free people think it sensible to cut back a bit.
In 2001/2 that’s what western people chose to do. But the politicians wanted them to go on spending. “Put off recession to ensure re-election” said their advisors. How? By making central bank money available cheaply to the banks.
Of course we agree that bankers’ bonuses are a problem which badly needs addressing. But politicians, not bankers, created the febrile and ultimately ruinous deal-making atmosphere of 2004-2006. They skewed the economic landscape by continually releasing funny money from the central banks, and opposing the tendency to mild recession which was the judgement of the market; that means our judgement.
Politicians created a world where the only bankers who could keep their jobs were credit addicts. The villages around London are full of redundant and cautious 60 year old bankers who lost their jobs when their natural risk-aversion allowed credit-fuelled junior banks to win all the business, take them over, and clean out the old guard. Easy, state-sponsored credit found its home under the control of inexperienced and overenthusiastic bankers. They thrived only because politicians had skewed the economic landscape in their favour.
Yes, we can blame ‘the free market’ because those who acquired credit got it freely in trade with a supplier of credit. But to take this line is to wilfully misunderstand what the market is. The market is your freedom to choose. The marketplace is what you get when one billion purchasing decisions are made every day by 400 million individuals who are exercising free choice. The problems occur when people exercise those choices unwisely, which they will certainly do if they are being pushed and shoved into purchasing decisions which suit politicians seeking re-election.
Ever since 2007 the market – that is everyone who has made a choice about it – has been waking up to the deep contradictions within the Euro. Gordon Brown (let’s give him some rare credit) was one of the first. He had understood that no-one was asking the key question of how the Euro could hold together when the weaker nations were bound into union with the extra-ordinary productivity of Germany.
In Europe nothing so simple as an awkward question is allowed to get in the way of government progress. They marched forward regardless, and now the pesky market is expressing the opinion of a billion votes a day that the Euro is going to fail. Why? What went wrong?
This did. The false market in borrowed money which the politicians created back in 2002 made money accessible mostly to people who were a good risk to lenders – which means mostly older, richer people. To begin with they bought houses, which dragged the price up to impossible levels for first time buyers. The money continued to be pumped in by the central banks. Next to bubble was investment assets, and once again it suited those who were already wealthy. Poorer people got to keep their jobs, but investment assets, the bedrock of a retirement income, were becoming ever more expensive, making nice capital profits for richer people but yielding less and less in income. So it was again profiting those who already had money, and condemning hard-working people to a lifetime of slog, crowned with a tiny pension.
Yet whenever the government looked at the numbers there always seemed a risk that if they took their foot of the monetary accelerator the economy would stall; and it would have. So still the money was pumped in, and now bond yields descended to 1.5% as their values bubbled (a bubble which remains un-pricked) and hundreds of billions started accumulating at the banks.
Houses and a comfortable retirement were by now out of reach of hard-working, deserving and particularly younger people. But the enemy was not the free market, still the only practical embodiment of their freedom; the problem was the corruption of the market by monetary politics.
It was the irresponsible and self-serving policy of elected representatives – seeking re-election all over the western world – which is without any doubt the root cause of the explosion of credit which we now have to pay for. Politicians have hoodwinked you if you believe ‘the market’ or ‘the bankers’ are at fault, and you should not be taken in. The market is not a thing you can meaningfully blame. It is simply an expression of a billion private votes cast every day in what appears to both buyer and seller to be sensible and private trade, under the prevailing conditions set by the politicians. The problem was the prevailing conditions set by the politicians, not the mechanism of the market which was, as it always is, simply an expression of the judgement of free people.
But still easy money aggregates to richer people, not poorer ones, and we had ended up with an enormous pile of their savings. It had already bought houses, and investments, and still more kept on coming. Eventually vast quantities accumulated at banks, and for want of remaining opportunities it was lent to underfunded governments. As it turned out this was extremely unwise, because those governments are now threatened by default. That always looked possible, because none of them could keep up with German economic growth.
Bad lending happens from time to time. Usually it means the creditors lose their money, and gain some wisdom. Only this time some of the creditors – particularly Germany and France – don’t want to lose their money. Rather than see their banks suffer they want to force two or three generations of Greeks, Irish, Portuguese, Italians, Spanish and Belgians to pay, pay, pay. Germany and France lent stupidly to your father, yet you become the indentured slave.
That should never be how bad money-lending is resolved. The lender should take the hit when the borrower cannot repay; it helps to focus his mind before he lends. In Britain we got rid of inter-generational debt servitude 200 years ago, and it is not progress to return to it.
But default now would be particularly bad for German and French banks, so our European friends are deluding themselves that what is at fault here is ‘the market’, which is why they are trying to devise ways to tame it. What they want to do is to stop it from making its judgement against the Euro, so that they can follow on with their agenda, controlling first one market, then the other, and always with the officers of Brussels making the decisions which are ordinarily made by people exercising their free market choices. The current European plan is to disenfranchise your judgement upon them by making the financial marketplace somewhere which is too expensive for you to cast a vote, because it will be taxed by them.
Right now they have the financial services market in their sights. If – they reason – they can stop those votes being cast in the marketplace then they can carry on doing what they do (which obviously must be right) and no-one and nothing will hold them to account.
To be fair that is not their conscious intention. They are simply trying to repair a difficult situation of massive debt. But they are failing to make the intellectual connection between free choice and markets. That is a common weakness in governments, and this is what caused David Cameron to be hauled before his Franco-German counterparts and be instructed to accept a tax on financial services.
As it happens in Britain we made the same policy errors as Europe, we created the same mountain of money, we have a similarly bust government, and so we have in one country a microcosm of the entire European mess. But we are going to resolve it in a very different way. We are not going to turn into slaves the subordinates and the children of people who borrowed our money. Nor are we going to take the money explicitly from those who lent it (though perhaps we should). That won’t happen because that would mean our government would go into default, which it will not do while it controls the issue of money. So, instead, we will use a third way.
Our government is going to live with a profound devaluation of Sterling, which will eliminate the government’s own debt without explicit default. In this way it will share the pain of default across all creditors. All savers – even those whose debtors are perfectly solvent – are going to share in setting this thing back on a sustainable course.
At different stages through this process of adjustment we will experience interest rate hikes, currency crises, and sharp inflation, which will continue until twenty five years of savings, and twenty five years of a credit-fuelled house price bubble, have been removed from the system by devaluation. By the time it ends the creditors – taken collectively – will have paid. By then houses will be again affordable by anyone with a half decent job, the bond market bubble will have burst, long standing pension savings will be near worthless, equities will again yield sensible dividends, student loans will have inflated to irrelevance, our freedom to choose our private actions in our marketplace will have been preserved, and Britain will again be a great deal fairer than it currently is. It’s going to be a very unpleasant journey and it looks like we are making it alone.
In Europe many will doubtless laugh quietly as all this happens to us. But they will have no reason to hate us for our problems, which will be wholly independent of theirs. Besides, they will probably be too busy hating each other. The creation of the Euro has caused 1,000 years of carefully constructed and often hard fought mutual independence to be sacrificed on the altar of monetary union. We think that Europe’s political class is making a monumental error in holding on to it because it carries all their political credibility. Their resulting policy is to enslave half of Europe, and to kill the messenger – the financial market. This happens to be the section of the European economy which we in the UK have specialised in, while we have been buying German cars, and French aeroplanes. So let’s be clear, David Cameron did not have much of a choice.
In summary then, the proposed Franco-German policy is built on the lie that it is the market which is the cause of the problem. We think their policy is dangerously brutal to European debtors, that it is unfair to Britain, and that it transgresses the existing treaties whose laws were designed to stop governments doing exactly what the leaders of France and Germany now want – which is to suppress the rest of Europe into servitude. We think it will end in deep loathing of Franco-German power, and destroy the one part of Europe which we wanted to join, and which can be saved if we stick to the existing treaties. That is the single market. To us it is a single market of free choices which guarantees the freedom and the prosperity of our continent, yet that is what is being destroyed in an effort to cling on to the Euro.
Contrary to popular belief most of the British love Europe and the Europeans. But we also love our free market and the way it exposes the vanities of overreaching politicians. Last week Germany and France forced David Cameron to choose between the two, and he chose well.
“In my several decades as a financial and economics commentator – covering banking crises dating back to the early 1970s and the Latin American debt catastrophes of the early 1980s – I have never heard a sitting [Bank of England] governor talk in such apocalyptic terms about the parlous state of the global financial system.”
- Alex Brummer, The Daily Mail.
So what precisely did our inflation-fighter-in-chief actually say?
Well, that euro zone instability had created
an exceptionally threatening environment
as falling government debt prices, softening confidence and distressed asset sales threaten to
spiral
into a systemic financial crisis. Also, the UK financial system was encouraged to continue building up capital to bolster against an
extraordinarily serious
situation not of its own making and which it could not resolve. Also,
The crisis in the euro area is one of solvency not liquidity. And the interconnectedness of major banks means the banking systems and economies around the world are all affected. Only the governments directly involved can find a way out of this crisis.
And
If debt is not to [continue] exploding to ever more unsustainable levels, transfers will be required together with the plan to restore the competitiveness within the euro area. There comes a point where the creditors need to realise that the scale of the debt owed to them is so large that they may have to be part of the solution.
Strong stuff from a fellow who looks like the hamster in “Danger Mouse”. It is all a waste of time, of course, more than a day late and more than a trillion short in whichever currency you care to proffer.
Perhaps things are not quite as bad as they seem. Last week in London we had the pleasure of hearing Gordon Corrigan speaking at Owen James’s always stimulating “Meeting of Minds” investment seminar. The intention of his speech was to put to rest a few myths about Britain’s role in the Great War. There was undeniable tragedy during those dreadful four years, but could there be a chance, asked the ex-Gurkha Major, that the Brits have tended to mythologise the whole World War One experience, magnify the national role, and accentuate the negative – a process that hardens with every passing year?
The late Alan Clark once quoted a conversation between a German general and one of his men that has not just entered the national psyche but become firmly embedded there. These British fight like lions, observed the soldier. Yes they do, replied the general: lions led by donkeys. But apparently Alan Clark made it up. No such conversation ever took place.
And there are evidently plenty of other established “facts” about the Great War that turn out to be somewhat detached from the actualité.
The popular British view of the Great War is of a useless slaughter of hundreds of thousands of patriotic volunteers, flung against barbed wire and machine guns by stupid generals who never went anywhere near the front line. When these young men could do no more, they were hauled before kangaroo courts, given no opportunity to defend themselves, and then taken out and shot at dawn. The facts are that over 200 British generals were killed, wounded or captured in the war, and that of the five million men who passed through the British Army 2,300 were sentenced to death by military courts, of whom ninety per cent were pardoned
The popular conception is that nearly every family in Britain had somebody killed in it. But according to the official census reports, there were approximately 9,800,000 households in Britain in 1914. The British lost 704,208 dead in the Great War. So statistically, only one family in 14 lost a member. Although there were undoubtedly certain parts of the country where fatalities were concentrated due to the way in which British infantry were recruited back then, there were large swathes of the country from where no one was killed. Corrigan has spoken of his own family, and his own black-clad Great Aunt, who never married – perhaps because all of her boyfriends and potential boyfriends met their end at the front ? “Nonsense,” suggests an uncle – his Great Aunt never married because she was “simply too damned ugly”.
By Gordon Corrigan’s account, British soldiers actually spent more time playing football than facing the enemy. By regularly rotating the soldiery and never keeping men in maximum danger for more than relatively short periods of time, the British army was alone among the major forces on the Western Front in never suffering a collapse of morale leading to mutiny.
One in 65 of the British population was killed in the war; for the French, the figure was one in 28. One in every 12 men mobilised in Britain was killed; for the French, one in six. For the Germans, one in 31 of the population was killed, one in every seven mobilised, as shown in the table below:
Country
Population in 1914
Men mobilised
Men killed
Percentage of soldiers killed
Percentage of population killed
France
39,000,000
8,500,000
1,391,000
16.4
3.7
United Kingdom
45,750,000
8,375,000
702,410
8.4
1.5
Germany
60,300,000
13,250,000
1,950,000
14.7
3.2
Source: Mud, Blood and Poppycock: Britain and the Great War
France, with a population six and a half million less than that of the UK, mobilised more men and suffered nearly twice as many deaths. Unlike in the UK, the demographic effect on France was enormous.
The perception of soldiering in the Great War has the young patriot enlisting in 1914 to do his bit and then being shipped off to France.
Arriving at one of the Channel Ports he marches all the way up the front, singing ‘Tipperary’ and smoking his pipe, forage cap on the back of his head. Reaching the firing line, he is put into a filthy hole in the ground and stays there until 1918. If he survives, he is fed a tasteless and meagre diet of bully beef and biscuits. Most days, if he is not being shelled or bombed, he goes “over the top” and attacks a German in a similar position a few yards away across no man’s land. He never sees a general and rarely changes his lice-infested clothes, while rats gnaw the dead bodies of his comrades.
Just on the topic of transportation, many soldiers were moved by train until a few miles from the front, and as the war went on, motor lorries and even London buses were used as troop carriers. And as Corrigan has already pointed out, the rotation of troops alone ensured that conditions were altogether more bearable than the popular conception would have it.
But back to the present. The war then may have been ultimately much less bleak for the British, for example, than the media and propaganda have portrayed. That does not mean that the peace now is any less bad for any of us than Mervyn King suggests. As investors we remain trapped in a surreal nightmare in which clueless politicians and desperate central bankers can see nothing other than money printing as a way out of the gloom. In the euro zone the problem is worse to the extent that the currency crisis is not merely severe but existential. Tragically, former voices of sanity such as The Telegraph’s Ambrose Evans-Pritchard seem to have now taken leave of their senses and joined with the inflationists, as this recent mad piece indicates.
This crisis can be stopped very easily by monetary policy.. to expand the quantity of money..
Oh, really? I am indebted to Tony Deden for the following quotation, from Alasdair Macleod in excerpts from a speech given to the Committee for Monetary Research and Education, given in New York on 20 October 2011:
I support sound money for two very good reasons. Firstly, it is a basic human right to choose to save, without our savings being debased by the tax of monetary inflation. Those who are worst affected by this inflation tax are not the rich, they benefit; but the poor and the barely well-off, which is why monetary inflation undermines society and why the right to sound money should be respected. If government gives itself a monopoly over money, it has a duty to protect the property rights vested in it.
Secondly, it is a basic right for us to own our own money rather than have it owned by the banks. For them to take our money and expand credit on the back of it debases it. It is an abuse of an individual‟s property rights and a banking licence is a government licence to do so. If anyone else was to do this, they would be guilty of fraud. Banks should be custodians of our money, and it should not appear in their balance sheets as their property..
Sound money guarantees a stable yet progressive economy where people are truly equal. It allows people to save properly for their retirement so that they will not become a burden on the state. It leads to democracy voting for small governments. It encourages peaceful trade and discourages war. It is the only path, after this mess, that leads us to long-lasting and peaceful prosperity. We really need everyone to understand this for the sake of our future.
Are you listening in the chancellories of Europe? Here in Britain we may not have had lions led by donkeys, but we now have liars throughout finance being led by junkies addicted to the printing of money. As democracies throughout the continent now topple to be replaced by technocrat stooges, and as the monetary and social chaos accelerates, we must hope that we at least manage to avoid the devastating political mistakes our forebears throughout Europe committed almost a century ago.
Everyone seems to be searching for a roadmap for the Euro-crisis. A precedent to guide policymaking and financial decisions would give some assurance that feasible outcomes are available. I have argued elsewhere (here, here and here) that there are examples for individual countries to follow. But what of the eurozone as a whole?
With luck, precedent for the precarious situation the 17 members of the euro-club face is available. Across the pond, the United States of America once faced a similar challenge.
After the revolutionary War, the US was faced with a band of individual member states (emphasis placed on the “States” aspect of the USA). The Articles of Confederation allowed each state the exclusive right to tax its population. The Continental Congress was given the right to issue paper money – “Continentals”, as they were known.
Individual states refused to give the Continental Congress the ability to tax, nor did they consent to sharing their tax revenue with it. With no ability to raise funds through taxation, the Continental Congress turned to the only fund-raising means available – issuing new Continentals. The phrase “Not worth a Continental” predictably resulted, as hyperinflation set in.
This course of events prompted Alexander Hamilton and his Federalists to argue for a stronger central government, with the ability to both tax and issue debt. The ratification of the U.S. Constitution in 1789 was the culmination of this drive.
This is the situation roughly analogous to what the eurozone faces today.
Each of the 17 member states has the ability to tax but not to issue currency. The European Central Bank has the ability to issue currency, but not to tax. Some countries can no longer remain solvent through increasing taxes alone. Two solutions result:
Allow individual states the right to issue money.
Allow for a centralized fiscal agency to collect taxes for redistribution within the eurozone.
Option 1 amounts to a breakup of the currency union. Option 2 is currently the more popular option. By having a fiscal union with one tax-collecting agency, transfer payments can solve country specific insolvencies. (Of course, longer-term issues remain, but that is for another article.)
Is such a solution as efficient, or equitable, as we are led to believe?
The longevity of the United States suggests that fiscal union is not such a bad idea for a currency union. But important differences exist between the eurozone’s future and the US.
First, with no central fiscal agent for the eurozone there is no central spending required, unlike with the Continental Congress. Each eurozone member state funds its own activities. For example, there is no joint military that requires funding, as is the case with the United States. Hence, there is no threat that the ECB would hyperinflate the euro to fund its fiscal activities (as it has none). This was decidedly not the case with the Continental Congress.
Second, has the centralization of fiscal power been beneficial to the US? The longevity argument is not as strong as one might think. America has, after all, defaulted explicitly on its debt four times in its history. It has evaded insolvency numerous times by inflating its liabilities away. But such an action is default by another means. It has taken from the citizens in the form of an inflation tax to pay for its excesses.
Third, with a central fiscal agency, the US Congress has continually seen a strengthening of its role and scope. New agencies to displace the rights of the individual states have become the norm. The bill to fund the increase in federal activities has risen commensurately. The cost of a centralized fiscal agency in the US has been paid with increasing taxes – whether explicitly through the income tax, or implicitly through the inflation tax.
If the eurozone finds itself amidst a crisis set off by too much government spending (an insolvency crisis) does anyone seriously think the solution is a centralized fiscal agency with the incentive to increase its own indebtedness?
As the United States’ own history demonstrates, calls for a centralized fiscal agency to complete a currency union are misplaced at best and damaging at worst. If history is any guide, fiscal consolidation will result in increased indebtedness on a supranational level. This indebtedness is solved in one of two ways: increased taxes on the member states, or increased inflation. Neither of these seems like a welcome option.
Talks of contagion risk, despite having a brief respite earlier this year, are back stronger than ever. With Italy dominating the news, the new risk is that a new European domino is threatening to topple the others over.
The authors find that over 80 percent of the total variance in the Eurozone CDS market can be explained by general Eurozone risk. This is a sharp increase from less than 60 percent at the beginning of the year. Their conclusion: “once again markets are bundling EZ members as one in terms of risk.”
Despite an earlier uncoupling of country-specific risks – especially those of Greece, Portugal and Ireland – the markets are once again pricing in a convergence of these countries´ risks relative to general CDS spreads. Stated differently, over the summer months these countries accounted for only small statistical portions of total CDS spreads. The tides have turned of late, with the result that these countries are increasingly affecting the general risk of the Eurozone market. Their conclusion: the risk of systemic contagion is increasing.
Finally, the two authors look at the correlation between the new contagion culprit de jour – Italy – and other Eurozone member states. The bilateral correlation between Italy and all countries (save Germany) is between 0.99 and 1. In other words, 5-year CDS spreads are moving in almost perfect lockstep between the affected European countries. The authors’ conclusion: little diversification can be achieved by investing in different Eurozone countries.
By all three measures the authors make the claim or allude to the conclusion that because markets are moving with high degrees of correlation, the risk of contagion is high. Such an analysis ignores the definition of what “contagion” means.
As I pointed out previously, contagion in the general sense (and also the financial sense) only occurs when one event affects an otherwise innocent bystander. Two questions arise. How do we know that the innocent bystander was actually affected by the “contagious” party? What would it take to be considered fully “innocent”?
The two authors in question actually answer the first question, at least as it pertains to Italy, claiming “Italy’s problems are homemade – contagion is a sideshow.” Indeed, Italy’s problems are more the result of unsustainable domestic policies coupled with weak growth then they have to do with contagion from Greece (or elsewhere). This in part explains why markets gave only the weakest rally with the exit of Berlusconi. The problems are largely already sunk, and it is now difficult to quickly revive growth or limit promised expenditures.
On the other hand, what does it take for one to be innocent, and thus susceptible to contagion. If I walk down the street, and someone with a contagious disease sneezes on me, I am surely the object of contagion. I had no connection to the individual prior to the event. Indeed, there was no way that I could have known that they were to sneeze on me (perhaps they did so only accidentally, but it would make no difference). But what if my friend with a communicable disease is bed-ridden at home, and so I decide to pay him a visit. By entering his sickly house I knowingly place myself at risk. When I return home and get sick there is no use in blaming my sick friend for my unfortunate health. I did it to myself.
The countries of Europe are sick, and the Eurozone as a whole is highly contagious. But there is no way that we can say that those parties inside the system are innocent. Holding Greek debt, or Italian debt, or bonds of a bank that holds these debts, these are all acts that remove your supposed ¨innocence¨. These are all activities that put you at risk because of the connection between the risky activity that you are undertaking, and the party that you are undertaking it with.
If I don’t want to get sick, I don’t enter my sick friend’s house. If I don’t want to be affected by the Eurozone’s sickness, I don’t invest in the guilty parties’ bonds. I also don’t associate with people who do so – banks, insurance companies, or investment funds.
By labeling the crisis as one of contagion, attention is drawn away from the real causes. Highly risky financing activities fueled by an easy-money credit policy over the last decade are now bearing their rotten fruits. Profligate European governments now find their revenues unable to cover their promised expenditures. There are specific causes to this crisis, and specific culpable parties. Chalking market misfortunes up to “contagion” risk obfuscates the true causes, and hinders meaningful analysis of workable solutions.
I recently wrote about the inconsistency of the economic arguments for the formation of the Eurozone. The conclusion that the euro was oversold at inception leads us to conclude that calls to save it are also oversold. If the economic considerations for the Eurozone are misguided at best, let’s see if the political arguments fare any better.
The European monetary system existed in various forms for decades prior to the euro. It bred its own instabilities across the continent throughout these decades. Existing as a complex web of fixed exchange rates, continual readjustments caused an uncertainty as to what values one could expect their cross-border costs and benefits to be worth in the future. Germany, the largest and most fiscally conservative country in Europe, was long seen as overemphasized under these conditions – smaller and less fiscally and monetarily responsible countries were under constant subordination to a highly valued Deutschmark.
The creation of the Eurozone would serve four political ends:
The single currency would offer greater integration.
The increased mobility of capital removed most of the gains from pegging exchange rates (and that brought about many losses if these pegs were abandoned).
The Maastricht Treaty, that key Treaty governing debts and deficits, would promote political stability
Germany would no longer be overemphasized as an economy, and political rivalries of the past would be diminished.
It is difficult to see any of these political goals being achieved.
While the single currency may have promoted greater integration among goods transfers within Europe, there is no real evidence that this has resulted in greater integration where it really matters for most Europeans – in the labour market. Further goods market integration does not transfer immediately to labour market integration, and as this recession makes clear, the labour market is what the unemployed masses are most concerned with. (Indeed, as I made clear in my last article, labour market integration is a criterion for forming a currency union, not an expected result thereof.)
The Maastricht Treaty originally set limits on debts and deficits that European governments could incur – 60% of GDP for the former, and 3% of GDP for the latter. It also set strict inflation and exchange rate criteria for potential member countries to maintain prior to admission to the Eurozone. While these rules create political stability in the sense that they constrain the fiscal policies of the member countries, they have famously been abandoned. Indeed, Germany – the role model for European financial conservatism – was the first country to break the Maastricht Treaty. It has since become laughable. Ireland ran a budget deficit of over 30% of GDP last year. Several member states run public debt-to-GDP ratios of more than 100%. Only Finland continues to abide by these rules (with the Netherlands coming very close).
When rules are thrown out the window, discretion reigns. When discretion reigns – especially 17 different types of discretion, one for each country using the euro – the uncertainty inherent for the euro-using community soars. In a similar application, Bob Higgs famously argued that “regime uncertainty” prolonged America’s Great Depression. Many entrepreneurs and investors sat on the sidelines, unsure of the future state of the regulatory and tax environment of Depression-era America.
A similar atmosphere exists in the Eurozone today, except in a more extreme form. It is not only the business community that is hesitant to undertake new ventures; it is anyone using the euro as a currency. This includes not only European entrepreneurs, but also European consumers and interested foreign parties. Instead of providing the political stability promised by the euro promoters, we are now witnessing one of the most extreme periods of instability and uncertainty of the modern era.
Finally, the shift from the Exchange Rate Mechanism to the euro was supposed to end a period of German dominance. European countries – especially Southern European countries – were continually constrained in their fiscal and monetary policies under the ERM. As the continent was linked via a complex of fixed exchange rates, disparate inflation rates vis-à-vis the largest economy – Germany – resulted in continual strain on the individual central banks. Readjustments, commonly in the form of devaluations, became the norm. Germany implicitly set the interest rate and fiscal policy for Europe. If a European country veered from these norms, its exchange rate would come under pressure, and would have to be reset when the central bank was unable to defend it.
The European Central Bank was set up as an attempt to remove this German dominance. Now instead of being subordinate to the Bundesbank, European governments would have an equal say in how monetary affairs were to be run. For a period this was true. Indeed, one could argue that Germany became subordinate to the rest of Europe under the monetary regime of the ECB (as Philipp Bagus argues in his book The Tragedy of the Euro).
It is increasingly becoming clear that few member states are equals to Germany in the Eurozone. No good deed goes unpunished. The heavily German-funded bailouts of several Eurozone economies to date have been met with indignation. As the saying goes in Ireland, “We serve neither King nor Kaiser.”
To briefly recap, none of the four pre-euro arguments for the common currency stand the test of time. Two of them (greater capital and labour mobility, and increased integration) were actually criteria to be met prior to forming a currency union, not results to expect after. The other two – increased political stability and decreased German dominance – are being reversed with every passing day.
The great European experiment of currency integration has failed to meet any of the economic and political goals set prior to its formation. Perhaps it is time to admit the error, and stop trying to salvage a broken system.
European monetary integration relies on the theory of the optimal currency area (OCA). Successful currency unions generally meet four criteria:
A high degree of economic integration exists within the region
Prices (and wages) are sufficiently flexible
Places within the region are exposed to symmetric shocks
There exists a risk-sharing agreement (i.e., directed fiscal policy) for the region
A region fulfilling these four criteria makes a prime candidate because one monetary policy will be able to combat the root shock affecting the economy, with factor mobility and price flexibility reallocating resources to where they can be more fully utilized. The cost of joining is the sacrifice of an independent monetary policy. Instead of the Bank of Spain or the Bundesbank directing monetary policy for Spain or Germany, the European Central Bank does so for all included countries. As long as all included countries face the same shock, or provided that factor mobility is sufficiently high to easily reallocate resources, this unique monetary policy should be (according to the theory) adequate to combat any ensuing crisis.
While the effectiveness of monetary policy in mitigating adverse shocks is certainly not without its own controversy, for our purposes we will take the theory on its own merits and judge its outcomes accordingly. Importantly, the fourth criterion becomes a caveat on the others – only in circumstances of low factor mobility, price rigidity or asymmetric shocks will fiscal agreements and transfers payments be necessary to stave off recession. Hence, OCA theory states that targeting fiscal policy will only be necessary if these criteria are not met. In other words, if a country is not an optimal currency area.
The euro was originally sold as an economic enhancement to certain European countries. The costs of trade (through direct exchange costs and uncertainties) of having multiple currencies across the continent made at least some European countries candidates for currency union inclusion. While this cost reduction would be beneficial, inclusion in the currency union would only be net beneficial if the cost of joining a currency union was lower than the resultant benefits.
Against these criteria, how does the Eurozone fare?
Cross-border trade is quite high within Europe, so capital mobility is consequently high. The Treaty of Rome was passed in 1957 to liberate the mobility of goods, services, labour and financial capital across European borders. One would consequently believe that capital flows within the European continent are high, and by and large they are.
Labour mobility is a different issue. While freedom to movement is a key principle of European integration, there are inherent features of the labour market that make it quite rigid. Language differences are the most obvious difficulty to labour reallocations, but cultural differences also abound. An unemployed Spaniard does not just move to the Netherlands to find work (an unemployed Spaniard might not even move from his home province to another region of Spain to find work, but that is another question).
Is the Eurozone exposed to similar shocks? In a broad sense one can say that today’s crisis has homogeneous roots across the continent. Yet with the Dutch economy still performing well with the PIIGS in full depression, it is difficult to say that this is the case. One significant factor is the euro itself. One currency for the zone implies one currency value for the whole zone. The euro trades for the same price in Germany as it does in Greece. This would not be problem if prices were flexible. If Greek prices (and especially wages) were sufficiently downward flexible, an overvalued euro would see real prices equilibrated with the rest of the zone through nominal Greek price declines. This is not the case.
Southern European economies famously suffer from an overvalued euro, inhibiting their abilities to create export growth to escape the crisis. Germany, in contrast, is quite possibly exposed to an undervalued euro, resulting in a large net export position. While the euro may be more or less fairly valued for the whole region – net exports for the euro zone are about zero – for any specific component country this may not be the case.
Having a risk-sharing agreement for a currency area is effectively a caveat for when asymmetric shocks occur. In the Eurozone, fiscal agreements were only loosely defined at the euro’s inception. While transfer payments from high to low income European countries were fairly noncontroversial during the boom, as budgets are strained during this recession there is considerably more animosity towards the idea. Indeed, given the perverse incentives facing transfer payment recipients, it is not clear that increased risk-sharing is a desirable alternative. Indeed, Germany pushed for the Stability and Growth Pact to diminish reliance on fiscal transfers for this very reason.
Lacking flexible prices and labor or symmetric shocks, it is difficult to make the case that Europe is an optimal currency area. While this is becoming apparent in this recession, a proper reassessment of the “optimality” of the currency union is hard to come by. In other words, maybe we should be asking if the Eurozone was oversold to us.
In response, calls for fiscal consolidation are becoming increasingly common. If Europe’s woes cannot be solved by one blanket monetary policy, and some countries lack the resources to enact appropriate fiscal responses to stave off recession, other member states should chip in to save their less-fortunate neighbours.
This approach confuses what the criteria for a currency union are with whether it should exist in its present form or not.
If the criteria for the currency union were correctly met, such targeted fiscal policy would be unnecessary. Resources would be automatically reallocated as prices adjust to make this possible. Fiscal consolidation within Europe does nothing to promote such reallocations. Indeed, it could well inhibit it. German transfer payments to Greece in the current crisis remove the incentive Greeks have to reduce their prices downward to regain competitiveness. It also removes the incentives for Greeks to migrate to other Eurozone areas to find employment.
As this current recession progresses, instead of focusing attention on how to save the existing currency union, perhaps time would be better spent reviewing the initial arguments for its formation. The Eurozone was oversold at inception, the painful economic results of which are now all too obvious.
In the next article of this two-part series, we will look at the political arguments for currency integration, and see if they have fared any better than these economic arguments.
“Clearly, Field Marshal Haig is about to make yet another gargantuan effort to move his drinks cabinet six inches closer to Berlin.”
- Captain Blackadder [Rowan Atkinson], from ‘Blackadder Goes Forth’, written by Richard Curtis and Ben Elton.
By some accounts, the general populace in Europe during July 1914 was largely unaware of the imminence of war until the end of the month. “Enjoying the warmth of a golden summer, Europe’s citizens turned their attention chiefly to news of more local importance.” And then a network of alliances, and events, exerted their inexorable gravitational pull, drawing what would become millions into a pan-Continental mincing machine. Archduke Franz Ferdinand had been assassinated on 28 June. Austria-Hungary issued an ultimatum to Serbia on 23 July, and issued a formal declaration of war on 28 July. Russia and Austria-Hungary mobilised on 30 July. Germany demanded that Russia demobilise on 31 July. Germany and France ordered mobilisation on 1 August. By way of response, “Stock exchanges panicked and many were closed.” But it was a bit late by then. As the saying goes, if you’re going to panic, panic early.
The definitive text that addresses this human frailty is Irving Janis’ ‘Groupthink’ (Houghton Mifflin, 2nd revised edition 1982). Janis examined a number of US foreign policy disasters, including failure to anticipate the Japanese attack on Pearl Harbour; the Bay of Pigs fiasco; the decision to escalate the Vietnam War, and concluded that all of these decisions had incorporated groupthink, “a mode of thinking that people engage in when they are deeply involved in a cohesive ingroup, when the members’ strivings for unanimity override their motivation to realistically appraise alternative courses of action”. William H. Whyte apparently first used the term in 1952:
Groupthink being a coinage – and, admittedly, a loaded one – a working definition is in order. We are not talking about mere instinctive conformity – it is, after all, a perennial failing of mankind. What we are talking about is a rationalized conformity – an open, articulate philosophy which holds that group values are not only expedient but right and good as well.
Janis went on to develop the theory, stating that
The more amiability and esprit de corps there is among the members of a policy-making ingroup, the greater the danger that independent critical thinking will be replaced by groupthink, which is likely to result in irrational and dehumanizing actions against outgroups.
Here are some suggestions. The great euro project itself was a creation of groupthink (sparked by “illusions of invulnerability creating excessive optimism and encouraging risk-taking”). It was reinforced by “unquestioned belief in the morality [primacy in political and economic theory] of the group [primarily and initially France and Germany], causing members [other, later euro adopters] to ignore the consequences of their actions.”
As tensions and obvious fault-lines started to develop in the common currency zone, groupthink was there to ignore them. Closed-mindedness on the part of the euro zone’s political leaders “rationalized warnings that might challenge the group’s assumptions” and “stereotyped those opposed to the group [not least among which, the UK] as weak, evil, spiteful, impotent or stupid.”
Groupthink continued to exert its pressure toward uniformity, incorporating the “Self-censorship of ideas that deviate from the apparent group consensus”, together with “illusions of unanimity among group members, where silence is viewed as agreement”. There was “direct pressure to conform placed on any member [of the EU] who questions the group, couched in terms of ‘disloyalty’.” And there were “mind guards – self-appointed members [the European Commission among them] who shield the group from dissenting information.”
Consensus-driven decisions [the adoption of a common currency without a common Treasury or unified tax-raising authority and the abandonment of rigorous selection criteria for the adopters] caused the establishment of a unified currency bloc destined for failure, fuelled by the groupthink practices of
Incomplete survey of alternatives
Incomplete survey of objectives
Failure to examine risks of preferred choice
Failure to reevaluate previously rejected alternatives Poor information search
Selection bias in collecting information
..and not least,
Failure to work out contingency plans.
Another suggestion: just as they lost the plot in the run-up to war in 1914, the stock markets have been largely absent without leave of their senses as the euro zone moves inexorably toward explosion in 2011. Groupthinkers – Keynesians, more or less to a man – continue to believe that this is a problem that can be solved by the ‘big bazooka’ deployment of yet more money, more taxpayer milk dispensed from the giant teat of government. The reality is more prosaic, and more worrisome. Last week, the BBC’s Sarah Montague interviewed Kyle Bass, one of the relatively few investors who not only identified the sovereign debt crisis ahead of time but was able to profit from it. She resorted to the standard, lazy canard of citing speculation for the downfall of governments when the reality is that if governments don’t like the message they’re hearing from the bond markets, then they shouldn’t borrow more than they can afford from them. Or in Kyle Bass’ terms, “don’t hate the mirror because you’re ugly”.
The problem is two-fold but not distinctly so in that the culprits – ill-disciplined, over-indebted governments; and ill-disciplined, under-capitalised banks – are really joined at the hip,
two spent swimmers, that do cling together
And choke their art..
Forget bail-outs (although the euro zone authorities are unlikely to). The only ultimate resolution can be, in Bass’ words, massive debt restructurings and write-downs. Countries that have “sailed into a zone of insolvency” cannot be ‘resolved’. Their debts have to be written down. He also points out the inconvenient fact that only the UK and the US have made any progress in recapitalising their banks. But before we get to the fun of the debt restructuring endgame, we are likely to have to endure more fatuous money-printing at the behest of economically illiterate politicians and policy-makers. So there are two actionable conclusions: one is to maintain a defensive posture with regard to both debt and equity investments, especially in a European context. The second is to take advantage of any sell-offs to rebuild exposure to the one asset that is being fundamentally supported in this environment, namely monetary metal (gold and silver – and the mining companies represent arguably an even more attractive method than the physical of gaining inflation and currency insurance, given the unfolding macro outlook).
Or you could pin your hopes on wishful thinking. The eurocrats certainly are.
In explaining the conventional thinking behind ‘Why there could never be a war’, Captain Blackadder explains to Private Baldrick that
..in order to prevent war in Europe, two superblocs developed: us, the French and the Russians on one side, and the Germans and Austro-Hungary on the other. The idea was to have two vast, opposing armies, each acting as each other’s deterrent. That way there could never be a war.. [but] You see, there was a tiny flaw in the plan.. It was bollocks.
Before what came to be known as the Great War, Britain was the leading power in Europe. Many expected her to wait on the sidelines as the various power blocs clashed. Britain finally entered the war on 4 August 1914 on the back of a guarantee to maintain Belgian neutrality dating back to the 1839 Treaty of London. By 1945 and after two world wars and over a million of its servicemen and servicewomen dead, Britain had passed on the baton to the United States, and was inevitably diminished on the global stage. A policy of splendid isolation did not prevent her entry into hostilities in 1914. One can only hope that its equivalent today, in the form of our non-participation in the euro zone, will lead to a somewhat better relative and absolute outcome. It is quite clear that our current entente with the French is not entirely cordiale. Somebody should gently suggest to M. Sarkozy (and Frau Merkel for that matter) that when it comes to Europe, Britain has already done enough. If you break it, you pay for it.
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.
