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THE TROJAN HORSE BATTLE FOR THE EURO

At a recent conference hosted by a major global bank in London I sat on a panel alongside a macro investment strategist who referred to the euro as a ‘Trojan horse’ intended to force fiscal austerity on traditionally profligate countries such as Greece. While that is true, I believe there is also a second euro Trojan horse, this one intended to force through greater fiscal, banking and political integration, enabling the creation of a European ‘superstate’ to rival the US and China in economic and political power. What we are witnessing now is the inevitable battle between the two horses to win over German public opinion, on which the euro’s future most depends. In my opinion the battle will have several national casualties, resulting in a smaller but more competitive euro-area. While this could be negative for European government bonds, it could be supportive of stocks, eventually.

THE FOUNDATION OF EURO MACRO STRATEGY

Although my career in international finance began in New York, in 1995 I moved to Germany. By that time it was generally assumed that European Monetary Union (EMU) would begin, more or less as planned, in 1999. In my role as a macro investment strategist it thus became necessary to develop a methodology for asset valuation and investment strategy in the presumed future single-currency area.

This required first an aggregate economic statistical dataset for the future euro-area taking many months to develop, with the greatest challenge finding ways to harmonise differing national calculation methodologies for key aggregates. But by focusing as we did primarily on the larger prospective members: Germany, France, Italy, Spain and the Netherlands, the goal was nevertheless achievable and in early 1998 we presented our harmonisation methodology, initial dataset, model suite and key investment recommendations on a ‘roadshow’ to major investors in Europe and around the world. (Subsequently I presented regular updates on these data and associated thoughts on European macro investment strategy on a financial television show jointly hosted by the Wall Street Journal and CNBC Europe, The Eurozone Barometer.)

Now it wasn’t exactly easy to get investors’ full attention in early 1998 due to the Asian currency crises unfolding at the time. Nor did it become any easier as the year went on. In August, Russia defaulted. In the fall, the massive hedge-fund Long-Term Capital Management blew up, with the Fed brokering a deal to contain the substantial potential fallout. But there was sufficient interest in EMU as a historic international monetary development that we nevertheless managed to get meetings with senior officials at many major central banks and other financial institutions who would be the amongst the largest future holders of euro-area sovereign debt. They wanted to know how to value and estimate the risks of such debt, issued by sovereign borrowers with the power to tax but lacking a national central bank to set interest rates and serve as a potential ‘lender of last resort’ in a crisis.

This unusual situation required a novel approach to asset valuation and risk estimation. How to determine debt valuations not only for the presumed benchmark issuer, Germany, but also the borrowing spreads to Germany for the other member countries? While it was easy to assume that those economies highly integrated with Germany and with a similar sovereign debt structure, such as the Netherlands, would trade at a minimal liquidity spread to Germany, what about highly-indebted Italy or Greece? At the time, Greece’s debt rating was barely above junk.

And so the process began to find some example or precedent to ground euro-area debt strategy and I found it in Canada, of all places. While in the US much debt is raised at the state and local level, the amount is nevertheless much smaller than the federal debt. Moreover, in the US there are large fiscal transfers to and from the federal to state and local authorities. Canada, however, was structured much more like the euro-area, in that provincial borrowing was large in proportion of the total public debt. Quebec in particular was a useful example as a province with both a large debt and also one at risk of seeking independence from Canada in future. Thus there was both an element of credit and possibly devaluation risk associated with the prospect of Quebecois independence—just what was needed for thinking about the future risks associated with the financially weaker euro-area sovereign borrowers.

As part of my research I travelled to Canada and met with both investors and issuers of central government and provincial bonds. I also had discussions with the ratings agencies to understand their methodology for determining Canadian provincial ratings. What I learned was that there were large perceived variations in provincial credit quality and it was thought unlikely that the federal government would come to the rescue of an overindebted province. This helped to explain the relatively wide spread divergence. My initial conclusions were thus that, following the launch of EMU in 1999, euro-area sovereign spreads for relatively weaker credits would remain wide enough to compensate investors for the risk of a future funding crisis or possible withdrawal and devaluation. For high-quality sovereign credits however, spreads were likely to converge on German Bunds, although the latter would retain a liquidity premium as the benchmark securities providing the basis for euro interest rate risk management.

When asked by a Wall Street Journal reporter to place some numbers on these predictions, I suggested that Dutch government bonds would trade at low double- or even single-digit basis-point (bp) spreads to German Bunds. Italy, however, I suggested would need to pay from 50-100bp above Bunds in 10y borrowing costs. As it happened, while Italy did trade in this range in the first 1-2 years of EMU, spreads subsequently tightened considerably, falling into the low-20s by the mid-2000s. Spanish government bonds traded even tighter. Greece, joining with a delay in 2002, saw spreads tighten inside of 40bp by the mid-2000s.

This spread tightening was primarily due to what appeared to be a material, sustainable improvement in peripheral sovereign finances. Spain in particular achieved a dramatic decline in public deficits and debt by the mid-2000s. The ratings agencies rewarded Spain, Italy, Ireland and Portugal with upgrades. Greece was also rewarded, although we now know that much of the ‘improvement’ in Greek finances was due to opaque swap structures that disguised the true size of the official deficits.

AS THE PERIPHERY LOST COMPETITIVENESS, THE POTENTIAL CRISIS GREW LARGER

At the time I was among those who were sceptical that these peripheral fiscal improvements were sustainable. While regional property and stock markets were booming, reflecting widespread economic optimism, in fact the entire southern periphery of the euro-area was becoming less competitive. Real unit labour costs, while holding stable in most of the euro-core, were rising rapidly in the periphery, harming competitiveness. Indeed, by the mid-2000s, Germany had undergone nearly a 20% real devaluation of wages relative to the periphery. In the past, such large swings in real effective exchange rates between European countries had triggered currency crises, as in 1992 and 1995, for example. The ‘Trojan horse’ of stable money, intended to bolster rather than erode peripheral competitiveness, was failing in its mission.

This, alongside booming, bubble-like peripheral asset prices led me to recommend to clients, beginning in mid-2006, to initiate short positions in Spanish and Italian government bonds. The cost of doing so, either outright or through credit-default swaps (CDS) was so low it was a cheap option.

THE LEHMAN BROTHERS ‘EMU BREAKUP PROBABILITY CALCULATOR’

In order to support this investment recommendation I constructed an ‘EMU breakup probability calculator’, which I presented to the Lehman Brothers Annual European Hedge Fund conference in fall 2006. The idea was the following: In the event that a country withdrew from EMU, reintroduced a national currency and devalued to the point of reversing the entire rise in the real effective exchange rate vis-à-vis Germany, what borrowing spread would fully compensate investors for the devaluation? By then comparing this implied spread to the actual, market spread it was possible to calculate the implied breakup probability.

At the time, due to narrow spreads, the implied probabilities that Italy, Spain, Portugal or Greece would leave EMU within five years were tiny, sub-10%. I then asked the audience if they thought that this was a fair pricing, with only a few hands rising in response. Far more hands went up when I asked if they thought the probability should be higher.

The most interesting part of the ensuing discussion was when I asked those investors who thought the pricing was fair why they held that view. Universally they held that, in the event of a peripheral sovereign debt crisis, some combination of the ECB and EU would come to the rescue. Bailouts would be forthcoming, notwithstanding their explicit prohibition under the 1992 Maastricht treaty. These investors thus had strong faith that, while a crisis might indeed be on the way, the second euro Trojan horse would prevail in any future battle with the first.

It was less than a year before spreads began to widen, slowly at first, then spectacularly as the events of 2008 unfolded to the horror of those who had been riding on and profiting from the euro-area ‘convergence trade’. And yet, as some of those fund managers had predicted correctly, the ECB and EU did come to the rescue, albeit in exchange for varying degrees of ‘austerity’.1 And so the first phase of the Trojan horse battle ended in something of a stalemate.

THE SECOND TROJAN HORSE COUNTERATTACKS, BUT WILL FAIL

The recent Greek elections and subsequent attempts by the new government to substantially renegotiate the terms of the 2010 debt restructuring with their EU counterparts threaten to break the stalemate. While debt forgiveness for hopelessly overindebted Greece is entirely reasonable, to proceed in this way would provide a precedent no doubt highly desirable for other overindebted euro members, present and future. With their support, in time a more formal mechanism of automatic transfers and universal euro-area bank deposit insurance could follow.

Thus those who have always pinned their hopes on a sovereign debt crisis catalysing a major step towards greater political union see a huge opportunity in Greece. But this counterattack by the second euro Trojan horse forces against those of non-inflationary fiscal sustainability is highly risky, because it takes the fight to what is the ultimate support for the euro itself: German public opinion, sharply divided over the issue, which cuts across traditional party lines and is thus difficult to control.

The importance of German public opinion cannot be overstated. Without this support, the euro and possibly even the EU will fail. There is no other large, successful economic anchor for the common market and currency. France has become the elephant in the EU room no one will talk about: It’s economy is in structural decline. One can easily imagine the EU surviving the withdrawal of one or more members but if Germany goes, the EU as we understand it today could well dissolve entirely.

Some fear that Europe would then descend into the perennial nationalism that has plagued Europe for centuries: The German Reformation; the Dutch Revolt; the 30yrs War; 1848; the Napoleonic wars and the dismemberment of the Austrian and German empires post-WWI that would lead to the supremely devastating WWII. In my opinion it is difficult to imagine how, in an age of nuclear weapons and unprecedented economic and social integration, Europe would today choose to take such a suicidal course. Those warning that a German refusal to fund euro bailouts will result in WWIII are scaremongering in my opinion, not to be taken seriously. But the fact remains: The survival of the euro ultimately rests on the support of German public opinion.

To be sure, the new Greek leadership understand this: They launched a clearly well-planned German public relations campaign the moment they assumed office. This included pulling some emotional strings, such as reminding the Germans of the devastation they wrought on occupied Greece in WWII and of Germany’s own devastation and substantial debt forgiveness during and following the war. They are doing all they can to win over an understandably sceptical German public wary of anything that could add to the moral hazard they increasingly suspect was created along with the euro in the first place.

In my opinion, however, the irresistible force of Greece’s demonstrably unserviceable national debt will soon meet the immovable object of German public resistance to further, arguably undemocratic European integration. If so, then in the long battle between the two euro Trojan horses, Greece will default, withdraw and devalue, and those fighting for greater integration will have tried and failed to cross a bridge too far by forcing a common currency on a community of nations that simply did not share a sufficiently common economic and political culture to enable it to succeed. If there is not a retreat soon by a core group of euro members that can close ranks around a defensible position of low public debts and deficits, the entire project is at risk of failure.2

STRATEGIES FOR A EURO RESTRUCTURING

In all probability, the euro-area must therefore either shrink, or dissolve entirely, placing the EU itself at risk. In any variation, this will initiate a series of major macro events not only in Europe but around the world; a cascade of crisis-driven opportunities for those who establish the right positions in advance.

First, if and when Greece faces the music, defaults and/or withdraws and devalues, this will trigger a general peripheral earthquake that will shake loose multiple other member countries, possibly including Spain and even Italy. No, that won’t be the end of the world for either—remember they’ve been through far worse over the past century—but it will lead to substantial losses for those investors directly exposed to their domestic bond markets. Their stock markets should fare somewhat better by comparison, as the devaluations will help to restore competitiveness and profitability. Keep in mind, however, that corporate debt servicing costs will rise along with domestic interest rates generally and leveraged corporations competitive in a low interest rate environment might find they struggle to service debt, much less generate profits amid higher rates. Also of serious concern for these stock markets is that capital controls are imposed for a time. This has been the case in Iceland and Cyprus, for example, and is almost certainly going to be the case with Greece before long.

Second, large German, BeNeLux and French banks are going to take a huge hit, highly exposed as they are to the periphery, if no longer through large holdings of government bonds, then through the interbank or corporate loan markets. In multiple cases I expect banks to be partially if not completely nationalised. This will require increased sovereign debt issuance. But as long as the ECB stands ready to provide the necessary liquidity assistance, as I believe it will, then this need not have a material impact on government bond yields.

Third, the bank recapitalisations within the euro-core will place temporary downward pressure on the euro relative to other major currencies. (The UK may well find its banks need another round of recapitalisations too.) I say temporary because the leaner and meaner euro-core will run a large trade surplus, implying future currency strength.

Fourth, and here I will speculate a bit more freely, I honestly can’t imagine that the above could possibly unfold without multiple large macro hedge funds being caught blindsided in leveraged, positive-carry trades of various kinds. Long-Term Capital Management was taken out by the aftershocks of the Russian debt default of 1998 and, given far higher overall system leverage today and the risks associated with modern financial weapons of mass destruction, including ‘collateral transformation’,3 I would expect the interbank markets in not only euros but also in sterling, dollars and possibly even yen to seize up in varying degrees, with wide-ranging implications for liquidity generally. This nearly occurred in 1998; it did occur in 2008 following the Lehman bankruptcy. While I’m not claiming that a euro restructuring will necessarily trigger something as spectacular as 2008, the possibility certainly exists. In any case no two crises look exactly the same and for all I know things could well be worse, especially in the event that not only Spain but also Italy decide to default and/or withdraw, re-introduce national currencies and devalue.

Regardless of its magnitude, this cascading liquidity shock would infect risky assets across the board. Sure, central banks would respond, pumping reserves into their respective banking systems. But the velocity of these reserves could well be even lower than in 2008. Governments might then step in to provide various forms of direct financial assistance to their financial systems and possibly even large non-financial corporations. But in some countries they would almost certainly meet with some resistance, given how the public in many countries has come to believe—quite rightly in my opinion—that similar actions in 2008-09 favoured the wealthy and well-connected over the working middle-class.

What happens though, when the government in question is broke, as Greece admits? One mooted possibility is to seek financial support from Russia or China, which really opens Pandora’s geopolitical box. Might not only Greece but other euro members in debt trouble seek assistance in Beijing and Moscow, if debt forgiveness is not forthcoming from Brussels or Berlin? As it stands now, the EU is already split over how to deal with the situation in Ukraine, which threatens to escalate into a major military confrontation between NATO and Russia, right on the EU’s doorstep.4 Imagine how it would complicate things were one or more EU members to cozy up to Moscow, in particular those that are also NATO members. The entire European post-WWII settlement and associated institutions could be at risk.

Germany and France appear to have sensed the danger and recently broke ranks with the US, seeking to find a way to de-escalate the situation on their own initiative. The result was the second Minsk accord. Many defence analysts are sceptical that it will hold, and rightly so. Just this week there is yet another dispute over Russian gas supplies to Ukraine, which Moscow threatens to cut off if it is not assured that gas will continue to flow specifically to the breakaway regions of Luhansk and Donetsk.

This context makes it increasingly likely that at a minimum Germany and France and probably other EU member countries will consider it necessary to increase their defence budgets in the coming years, as they sense an urgent need for a strategic deterrent independent of that provided by the US via NATO. But financing larger defence budgets alongside likely bank recapitalisations and other burdens associated with sorting out the mess the euro has become will only serve to increase the debt. Notwithstanding Germany’s prodigal economic and export competitiveness, should rational investors really accept near zero bond yields for the myriad risks associated with the future of the euro: economic, political and even national security?

The better bet is to take a good look at quality European companies trading at what are low valuations when compared to their US or global counterparts. Yes, the German stock market may be at an all time high, but with the euro now somewhat weaker and with the valuations of some peripheral markets clearly distressed, there are almost certainly opportunities. As written above, I consider it highly unlikely that even a general breakup of the EU would result in a return to pre-21st century conditions of rabid nationalism and war. Indeed, one could argue that it would ignite a period of more aggressive competition amongst European countries to attract foreign and retain domestic capital with a general rationalisation of economic policies. The structural reforms associated with austerity seen to date may only be the beginning of a more thorough European economic renaissance.

Am I being too optimistic? Perhaps. But economic competition is without question a good thing. People used to believe the EU promoted it. Many now believe the opposite. Perhaps a good shaking up of European institutions is exactly what is required to unleash some healthy, Schumpeterian creative destruction. As long as it is not of the militaristic variety, investors in European companies would almost certainly benefit from it.

1 In my opinion much of which is presented as ‘austerity’ is really just a slowing or stabilisation of expeditures, rather than real cuts. If you want to know what real austerity looks like, Bulgaria is a prime example. See here for a description.

2 I have long held that were only Germany, the BeNeLux, France, Austria and Finland to have formed the initial monetary union, this would have incentivised the periphery to implement far more thorough structural reforms to improve competitiveness prior to joining at some unspecified point in the future. While this would have resulted in a more sustainable currency union I appreciate that, EU politics being what it is, this idea just couldn’t fly politically in Brussels. It may yet see its day, however.

3 For a discussion of the potentially dangerous financial engineering practice of collateral transformation, see here.

4 George Kennan, arguably the most famous and influential American career diplomat of the 20th century, warned many years ago of the grave danger of expanding NATO eastwards, with a specific warning not to include Ukraine. He claimed this would result in a new Cold War and possibly something even worse. So far he has been spot on. Kennan’s prescient warning can be found here.

Economics

The euro may be riskier than you think

Finance ministers in the Eurozone appear to have had a free lesson in game theory from Professor Yanis Varoufakis, the Greek finance minister.

At the time of writing Greece’s future in the Eurozone is far from secured, but it appears that Greece has achieved something.

He gave his fellow finance ministers a deal they dared not refuse, though it still has to be ratified by some parliaments, including Germany’s today. Varoufakis almost certainly understands that the Eurozone is in a weaker position than the bureaucrats and finance ministers themselves believed. It was important for them to become aware of this reality, which was central to his approach. It appears that under the Lisbon Treaty, Eurozone states cannot expel Greece: she can only leave with everyone’s unanimous agreement, including her own. And they probably didn’t realise that playing hardball against Greece would force the ECB to write off debts approaching ten times her equity capital of only €10.8bn. This would require all member states to increase their capital subscriptions, including the other Eurozone states subject to austerity packages.

Equally, Varoufakis would have known that he could not push his opposite numbers too far because the Brussels establishment also have their national parliaments to consider and the positions of Italy, Spain, Portugal and even Ireland. A revolt against previously-agreed austerity packages by any of these other states would have untold ramifications not only for the future of the Eurozone, but the euro itself.

In the wake of this episode the status of the euro as money is likely to be increasingly questioned, not just in the foreign exchanges, but by its users as well. This should be put into context by referring to Ludwig Von Mises’s regression theorem. Put simply, the theorem states that the validity of any currency as money is based on its history and the basis of the value it had before it was accepted as money. This unfashionable view is demonstrably true of gold and silver, but is it true of paper currencies?

The US dollar and pound sterling have both survived more than one hundred years, having based their original value on extended periods of gold convertibility, and in the case of sterling long before that on silver. This in the minds of the users gives them a pedigree few would question. However, they are very much the exceptions in today’s fiat currencies which are the motley survivors of some 57 hyperinflations, and there are plenty of examples of how a lack of regression coincides with a temporary character. Look no further than the Ukraine, which is suffering its second hyperinflation in 25 years. After Britain gave her African colonies independence in the 1960s, the value of all their currencies fell sharply in black-market dealings (the sole exception being Botswana which didn’t introduce the pula until long after independence).

Logic, if not familiarity, suggests that there is something in the regression theorem, which brings us back to the euro. Like the Kenyan shilling, the Zambian kwacha or the Ukrainian hryvnia, the euro lacked any pedigree on its creation. There was no period when people had a choice of national currencies to aid the transition. While bonds and financial instruments were denominated in euros from January 1999 onwards, notes and coins replaced national notes and coins three years later overnight.

So, if Von Mises’s regression theorem has any validity, holders of euros should be considering their options. It is also unfortunate timing that the ECB is about to embark on its most aggressive bout of monetary expansion to date, which could end up sealing the euro’s fate. If so, the euro will turn out to be the Achilles heel of the global monetary system.

Economics

Cobden Centre’s Gordon Kerr on Bloomberg on the Euro and European banks

The Cobden Centre’s Gordon Kerr can be seen on Bloomberg discussing the Euro and the state of Europe’s banks, which are now in a considerably worse state than they were in 2008.

http://www.bloomberg.com/news/videos/2015-02-20/euro-is-one-of-the-worst-designed-currencies-kerr

Money

Europe’s Move In The Direction Of More Monetary Mischief

The European Central Bank has announced its intention to create out of thin air over one trillion new Euros from March 2015 to September 2016. The rationale, the monetary central planners say, is to prevent price deflation and “stimulate” the European economy into prosperity.

The only problem with their plan is that their concern about “deflation” is a misguided fear, and printing money can never serve as a long-term solution to bring about sustainable economic growth and prosperity.

Europe’s High Unemployment and Economic Stagnation

The European Union (of which the Euro currency zone is a subset) is experiencing staggering levels of unemployment. The EU as a whole has 10 percent of the work force unemployed, and 11.5 percent in the Euro Zone.

But breaking these numbers down to the national levels show just how bad the unemployment levels are in the different member countries. In Greece it is nearly 26 percent of the work force. In Spain, it is 24 percent; Italy and Portugal are both over 13 percent. France has over 10 percent unemployment, with Sweden at 8 percent. Only Germany and Austria have unemployment of 5 percent or less out of the 28-member countries of the European Union.

Youth unemployment (defined as those between 16 and 25 years of age unable to find desired work) is even more catastrophic. For the European Union as a whole it is an average of over 22 percent, and more than 23 percent in the Euro Zone.

In Greece, its almost 60 percent of those under 25; in Spain, it is nearly 55 percent, with Italy at 43 percent, and over 22 percent in both France and Sweden. Only in Norway and Germany is youth unemployment less than 8 percent. Almost all the other EU countries are in the double-digit range.

At the same time, growth in Gross Domestic Product for the European Union as a whole in 2014 was well below one percent. Only in the Czech Republic, Norway, and Poland was it above 2 percent among the EU members.

Consumer prices for the EU averaged 0.4 percent in 2014, with most of the member countries experiencing average consumer price increases between 0.2 and 2 percent for the year. Only in Greece was the average level of prices calculated as having absolutely declined by a minus 1.3 percent. Hardly a measured sign of dramatically suffered price deflation in the EU or the Euro Zone!

Fears of Price Deflation are Misplaced

The monetary central planners who manage the European Central Bank are fearful that the Euro Zone may be plagued by a prolonged period of generally falling prices if they do not act to push measured price inflation towards their desired target of around two percent a year.

(It is worth pointing out that if the Euro Zone monetary central planners were to succeed with their goal and maintain two percent average annual price inflation, this would mean that over a twenty-year period the purchasing power of a Euro would decline by around 50 percent.)

Many commentators inside and outside of the European Union and the Euro Zone have insisted that price deflation needs to be prevented or reversed at all costs. The implicit premise behind their arguments is that deflation equals economic depression or recession, and therefore any such decline in prices in general must not be allowed.

In all these discussions it is often ignored or forgotten that annual falling prices can well be an indication of economic prosperity and rising standards of living. For instance, between 1865 and 1900, prices in general in the United States declined by around 50 percent, with overall standards of living in general estimated to have increased by 100 percent over these 35 years. This period is usually recognized as America’s time of rapid industrialization in the post-Civil War era that set the United States on the path to becoming the world’s economic giant through most of the 20thcentury.

Falling Prices and Improved Standards of Living

A hallmark of an innovative and competitive free market economy is precisely the never-ending attempt by entrepreneurs and enterprisers to devise ways to make new, better and less expensive goods to sell to the consuming public. The stereotypes in modern times have been pocket calculators, mobile phones, DVD players, and flat-screen TVs.

When pocket calculators first came on the market in the 1980s, they were too big to fit in your shirt pocket, basically performed only the most elementary arithmetic functions, and cost hundreds of dollars. Within a few years they fit in your shirt pocket with space to spare, performed increasingly complex mathematical functions, and became so inexpensive that many companies would give them away as advertising gimmicks.

The companies that made them did not proclaim their distress due to the lower and lower prices at which they sold the devices. Cost efficiencies were developed and introduced in their manufacture so they could be sold for less to consumers to expand demand and capture a larger share of a growing market.

In a dynamic, innovative and growing free market economy there normally would be a tendency for one product after another being improved in its quality and offered at lower prices as productivity gains and decreased costs made them less expensive to market and still make a profit.

Looking over a period of time, a statistical averaging of prices in general in the economy would no doubt show a falling price level, or “price deflation,” as one price after another experienced such a decline. This would be an indication of rising standards of living as the real cost of buying desired goods with our money incomes was decreasing.

Draghi as Superman with Paper Money

Europe’s Problems are Due to Anti-Market Burdens

Relatively stagnant economies with high rates of unemployment like in the European Union and the Euro Zone are not signs of deflationary forces preventing growth and job creation. Indeed, since 2008, the European Central Bank has increased its balance sheet through monetary expansion by well over one trillion Euros, and prices in the Euro Zone, in general, have been rising on average between 0.5 and 2 percent throughout this period. Hardly an indication of “deflationary” forces at work.

The European Union’s problems are not caused by a lack of “aggregate demand” in the form of money spending. Its problems are on the “supply-side.” The EU is notorious for rigid labor markets in which trade unions limit worker flexibility and workplace adaptiveness to global market change.

Above market-determined wages and benefits price many who could be gainfully employed out of a possible job, because government policies and union power price these potential employees out of the market. Plus, the difficulty of firing someone once a worker is hired undermines the incentives of European companies to want to expand their work forces.

Even a number of international organizations, usually culprits in fostering anti-free market policies, have pointed out the need for European governments to introduce workplace reforms to free up labor markets in their countries, along with general reductions in regulations on business than hamper entrepreneurial incentives and prevent greater profit-oriented competitiveness.

Creating a Trillion Euros will only Imbalance Europe More

Creating a trillion more Euros cannot overcome or get around anti-competitive regulations, cost-price mismatches and imbalances due to government interventions and union restrictions, or the burdensomeness of taxes that reduce the willingness and ability of businessmen to undertake the enterprising activities that could lift Europe out of its economic malaise.

Furthermore, to the extent to which the European Central Bank succeeds in injecting this trillion Euros into the European economy it will only set in motion the danger of another future economic downturn. Not only may it feed an unsustainable financial and stock market run-up. The very manner in which the new money is introduced into the European-wide economy will inevitably distort the structure of relative prices and wages; wrongly twist the patterns of resource and labor uses; and induce forms of mal-invested capital.

Thus, the attempt to overcome Europe’s stagnant economy through monetary expansion will be the cause of a misdirection of labor, capital and production that will inescapably require readjustments and rebalances of supplies and demands, and price relationships that will mean people living through another recession at some point in the future.

Forced European Bank Lending cartoon

A Market-Based Agenda for Growth and Jobs

What, then might be a “positive” pro-market agenda for economic recovery and job creation in the European Union, and in the United States, as well, for that matter? Among such policies should be:

  • Significantly reduce marginal personal tax rates and corporate taxes, and eliminate inheritance taxes; this would create greater incentives and the financial means for private investment, capital formation and job creation;
  • Cut government spending across the board by at a minimum of 10 percent more than taxes have been cut so to move the government in the direction of a balanced budget without any tax increases; this would take pressure off financial markets to fund government deficits, and end the growth in accumulated government debt, until finally government budgets would have surpluses to start paying down that debt;
  • Reduce and repeal government regulations over the business sector and financial institutions to allow competitive forces to operate and bring about necessary adjustments and corrections for restoring economic balance;
  • Institute real free trade through elimination and radical reduction of remaining financial and regulatory barriers to the competitive free flow of goods among countries;
  • End central bank monetary expansions and manipulation of interest rates; interest rates need to tell the truth about savings availability and investment profitability for long-run growth that is market-based and sustainable. Monetary expansion merely sends out false signals that distort the normal functioning of the market economy.

A market-based set of policies such as these would serve as the foundation for a sound and sustainable real “stimulus” for the European and American economies. It also would be consistent with the limited government and free enterprise principles at the foundation of a free society.

Money

Swiss National Bank Throws Banks, Self Under Bus

In 1985, Arnold Schwarzenegger played John Matrix in the action movie, Commando. One line stands out. While dangling a bad guy over the edge of a cliff Matrix said, “Remember, Sully, when I promised to kill you last?” The frantic man replied, and Matrix added, “I lied.” He let Sully go.

Thomas Jordan, Chairman of the Governing Board of the Swiss National Bank (SNB), must be channeling John Matrix. On December 18, 2014 Jordan said, “The SNB remains committed to purchasing unlimited quantities of foreign currency to enforce the minimum exchange rate with the utmost determination.” Last Thursday, not even a month later—he said, “The Swiss National Bank (SNB) has decided to discontinue the minimum exchange rate…”

Schwarzenegger said it better. Besides, Commando was just a work of fiction. Central bankers toy with people’s livelihoods. Several currency brokers have already failed, only one day after this reversal.

When a central bank attempts to peg its currency, it’s usually trying to stave off collapse. The bank must sell its foreign reserves—typically dollars—to buy its own currency. Recently, the Central Bank of Russia tried this with the ruble. It never lasts long. The market can see the dwindling dollar reserves, and pounces when the bank is vulnerable.

The SNB attempted the opposite, selling its own currency to buy euros. It faced no particular limit on how many francs it could sell. Despite that, the market kept testing its willpower. Here is a graph showing the price of the euro in Switzerland. The SNB’s former line in the sand, is drawn in red, a euro price of 1.2 francs.

Euro Priced in Swiss Francs

 

The price of the euro was falling the whole year. Jordan’s promise caused but a blip. The pressure must have been intense. So he tried one last trick, familiar to any gambler.

Thomas Jordan bluffed.

He said the SNB is committed and tossed around words like unlimited. The market saw his bet, and raised. That forced him to fold.

I wrote about why the SNB pegged the franc. It wasn’t about exporters, but commercial banks. They borrow francs from their depositors, but lend many euros outside Switzerland. This means they have franc liabilities mismatched with euro assets. When the euro falls, they take losses.

The SNB inflicted this same problem on itself with its intervention. It borrowed in francs, creating a franc liability. This borrowing funded its purchase of euros, which are its asset.

As of November, its balance sheet showed 462 billion francs worth of foreign currencies, and it has disclosed that euros represent just under 50% of that. This puts their euro assets around 230B francs (which probably increased after that). The euro has fallen from 1.2 francs to just under 1.0, or 17%.

On Thursday, the SNB lost at least 38B francs, or 6 percent of Swiss GDP.

Why on earth did it choose to take this loss? It threw the commercial banks under the bus, and got tire tracks on its own back too. Without being privy to its internal discussions, we can make an educated guess.

The SNB hit its stop loss.

As traders kept buying francs, the SNB was obliged to keep increasing its bet. Its exposure to euro losses was growing. To continue meant more euro exposure on the same capital base—rising leverage. It chose to realize a big loss now, rather than continue marching towards insolvency.

The market is much bigger than the Swiss National Bank. If the citizens of insolvent states like Greece want to sell their euros for francs to deposit in Swiss banks, and if hedge funds and currency traders want to bet on the franc then the SNB can’t stop that freight train.

Everyone who holds francs is happy, because the franc went up. However, the fallout has just begun. Franc holders will discover that they are creditors. They can’t rejoice for long at their debtors’ pain. Pain will one day morph into defaults. Soon enough the franc will abruptly reverse. Who will bid on a defaulted bond, or a currency backed by it?

The game of floating paper currencies is not zero-sum, but negative-sum. Every move destroys someone’s capital. On Thursday, the SNB admitted it lost 38B francs. How much did commercial banks, pension funds, and other debtors in Switzerland lose in addition?

Economics

As Germany loses battle for ECB, QE goes global

What is Super Mario up to?

First, he gave an unexpectedly dovish speech at the Jackson Hole conference, rather ungallantly upstaging the host, Ms Yellen, who was widely anticipated to be the most noteworthy speaker at the gathering (talking about the labor market, her favorite subject). Having thus single-handedly and without apparent provocation raised expectations for more “stimulus” at last week’s ECB meeting, he then even exceeded those expectations with another round of rate-cuts and confirmation of QE in form of central bank purchases of asset-backed securities.

These events are significant not because they are going to finally kick-start the Eurozone economy (they won’t) but because 1) they look rushed, and panicky, and 2) they must clearly alienate the Germans. The ideological rift that runs through the European Union is wide and deep, and increasingly rips the central bank apart. And the Germans are losing that battle.

As to 1), it was just three months ago that the ECB cut rates and made headlines by being the first major central bank to take a policy rate below zero. Whatever your view is on the unfolding new Eurozone recession and the apparent need for more action (more about this in a minute), the additional 0.1 percent rate reduction will hardly make a massive difference. Yet, implementing such minor rate cuts in fairly short succession looks nervous and anxious, or even headless. This hardly instils confidence.

And regarding the “unconventional” measures so vehemently requested by the economic commentariat, well, the “targeted liquidity injections” that are supposed to direct freshly printed ECB-money to cash-starved corporations, and that were announced in June as well, have not even been implemented yet. Apparently, and not entirely unreasonably, the ECB wanted to wait for the outcome of their “bank asset quality review”. So now, before these measures are even started, let alone their impact could even be assessed, additional measures are being announced. The asset purchases do not come as a complete surprise either. It was known that asset management giant BlackRock had already been hired to help the ECB prepare such a program. Maybe the process has now been accelerated.

This is Eurozone QE

This is, of course, quantitative easing (QE). Many commentators stated that the ECB shied away from full-fledged QE. This view implies that only buying sovereign debt can properly be called QE. This does not make sense. The Fed, as part of its first round of QE in 2008, also bought mortgage-backed securities only. There were no sovereign bonds in its first QE program, and everybody still called it QE. Mortgage-backed securities are, of course, a form of asset-backed security, and the ECB announced purchases of asset-backed securities at the meeting. This is QE, period. The simple fact is that the ECB expands its balance sheet by purchasing selected assets and creating additional bank reserves (for which banks will now pay the ECB a 0.2 percent p.a. “fee”).

As to 2), not only will the ECB decisions have upset the Germans (the Bundesbank’s Mr. Weidmann duly objected but was outvoted) but so will have Mr. Draghi’s new rhetoric. In Jackson Hole he used the F-word, as in “flexibility”, meaning fiscal flexibility, or more fiscal leeway for the big deficit countries. By doing so he adopted the language of the Italian and French governments, whenever they demand to be given more time for structural reform and fiscal consolidation. The German government does not like to hear this (apparently, Merkel and Schäuble both phoned Draghi after Jackson Hole and complained.)

The German strategy has been to keep the pressure on reform-resistant deficit-countries, and on France and Italy in particular, and to not allow them to shift the burden of adjustment to the ECB. Draghi has now undermined the German strategy.

The Germans fear, not quite unjustifiably, that some countries always want more time and will never implement reform. In contrast to those countries that had their backs to the wall in the crisis and had little choice but to change course in some respect, such as Greece, Ireland, and Spain, France and Italy have so far done zilch on the structural reform front. France’s competitiveness has declined ever since it adopted the 35-hour workweek in 2000 but the policy remains pretty much untouchable. In Italy, Renzi wants to loosen the country’s notoriously strict labour regulations but faces stiff opposition from the trade unions and the Left, not least in his own party. He now wants to give his government three years to implement reform, as he announced last week.

Draghi turns away from the Germans

German influence on the ECB is waning. It was this influence that kept alive the prospect of a somewhat different approach to economic challenges than the one adopted in the US, the UK and, interestingly, Japan. Of course, the differences should not be overstated. In the Eurozone, like elsewhere, we observed interest rate suppression, asset price manipulations, and massive liquidity-injections, and worse, even capital controls and arbitrary bans on short-selling. But we also saw a greater willingness to rely on restructuring, belt-tightening, liquidation, and, yes, even default, to rid the system of the deformations and imbalances that are the ultimate root causes of recessions and the impediments to healthy, sustainable growth. In the Eurozone it was not all about “stimulus” and “boosting aggregate demand”. But increasingly, the ECB looks like any other major central bank with a mandate to keep asset prices up, government borrowing costs down, and a generous stream of liquidity flowing to cover the cracks in the system, to sustain a mirage of solvency and sustainability, and to generate some artificial and short-lived headline growth. QE will not only come to the Eurozone, it will become a conventional tool, just like elsewhere.

I believe it is these two points, Draghi’s sudden hyperactivity (1) and his clear rift with the Germans and his departure from the German strategy (2) that may explain why the euro is finally weakening, and why the minor announcements of last Thursday had a more meaningful impact on markets than the similarly minor announcements in June. With German influence on the ECB waning, trashing your currency becomes official strategy more easily, and this is already official policy in Japan and in the US.

Is Draghi scared by the weak growth numbers and the prospect of deflation?

Maybe, but things should be put in perspective.

Europe has a structural growth problem as mentioned above. If the structural impediments to growth are not removed, Europe won’t grow, and no amount of central bank pump priming can fix it.

Nobody should be surprised if parts of Europe fall into technical recessions every now and then. If “no growth” is your default mode then experiencing “negative growth” occasionally, or even regularly, should not surprise anyone. Excited talk about Italy’s shocking “triple-dip” recession is hyperbole. It is simply what one should expect. Having said this, I do suspect that we are already in another broader cyclical downturn, not only in Europe but also in Asia (China, Japan) and the UK.

The deflation debate in the newspapers is bordering on the ridiculous. Here, the impression is conveyed that a drop in official inflation readings from 0.5 to 0.3 has substantial information content, and that if we drop below zero we would suddenly be caught in some dreadful deflation-death-trap, from which we may not escape for many years. This is complete hogwash. There is nothing in economic theory or in economic history that would support this. And, no, this is not what happened in Japan.

The margin of error around these numbers is substantial. For all we know, we may already have a -1 percent inflation rate in the Eurozone. Or still plus 1 percent. Either way, for any real-life economy this is broadly price-stability. To assume that modest reductions in any given price average suddenly mean economic disaster is simply a fairy tale. Many economies have experienced extended periods of deflation (moderately rising purchasing power of money on trend) in excess of what Japan has experienced over the past 20 years and have grown nicely, thank you very much.

As former Bank of Japan governor Masaaki Shirakawa has explained recently, Japan’s deflation has been “very mild” indeed, and may have had many positive effects as well. In a rapidly aging society with many savers and with slow headline growth it helped maintain consumer purchasing power and thus living standards. Japan has an official unemployment rate of below 4 percent. Japan has many problems but deflation may not be one of them.

Furthermore, the absence of inflation in the Eurozone is no surprise either. There has been no money and credit growth in aggregate in recent years as banks are still repairing their balance sheets, as the “asset quality review” is pending, and as other regulations kick in. Banks are reluctant to lend, and the private sector is careful to borrow, and neither are acting unreasonably.

Expecting Eurozone inflation to clock in at the arbitrarily chosen 2 percent is simply unrealistic.

Conclusions

Draghi’s new activism moves the ECB more in the direction of the US Fed and the Bank of Japan. This alienates the Germans and marginally strengthens the position of the Eurozone’s Southern periphery. This monetary policy will not reinvigorate European growth. Only proper structural reform can do this but much of Europe appears unable to reform, at least without another major crisis. Fiscal deficits will grow.

Monetary policy is not about “stimulus” but about maintaining the status quo. Super-low interest rates are meant to sustain structures that would otherwise be revealed to be obsolete, and that would, in a proper free market, be replaced. The European establishment is interested in maintaining the status quo at all cost, and ultra-easy monetary policy and QE are essentially doing just that.

Under the new scheme of buying asset-backed securities, the ECB’s balance sheet will become a dumping ground for unwanted bank assets (the Eurozone’s new “bad” bank). Like almost everything about the Euro-project, this is about shifting responsibility, obscuring accountability, and socializing the costs of bad decisions. Monetary socialism is coming. The market gets corrupted further.

Book Reviews

‘The system has spun out of control’

Book Review: The Death of Money: The Coming Collapse of the International Monetary System by James Rickards

The_Death_of_Money_Cover_ArtThe title will no doubt give Cobden Centre readers a feeling of déjà vu, but James Rickards’ new book (The Death of Money: The Coming Collapse of the International Monetary System) deals with more than just the fate of paper money – and in particular, the US dollar. Terrorism, financial warfare and world government are discussed, as is the future of the European Union.

Though he quotes F.A. Hayek a few times, the Austrian School gets only one mildly disparaging mention in the entire book. This seems odd for an author who devotes a whole chapter to the benefits of the gold standard. His first bestselling book, Currency Wars, argues that currency wars are not just an economic or monetary concern, but a national security concern for the USA.

Rickards relies on emerging Chaos theories of economics and markets (1) to buttress his arguments in favour of sound money and prudent – limited – government. He uses the same insights, twinned with years of Wall Street experience, to explain why the “coming collapse of the dollar and the international monetary system is entirely foreseeable.”

One of Rickards’ key arguments is that exponential increases in the total size of credit markets mean exponential increases in risk. The gross size of derivative markets is the problem, irrespective of false assurances about netting, he claims. Politicians and central bankers have by and large learnt nothing from recent crises, and are still “in thrall to bank political contributions.”

He makes the case for the US federal government to reinstate Depression-era restrictions on banking activities and for most derivatives to be banned. As a former Federal Reserve Chairman, Paul Volcker, said in 2009, “the only useful thing banks have invented in 20 years is the ATM” – a sentiment Rickards would probably be sympathetic to.

The chapter dealing with the Fed’s hubris and what investment writer James Grant calls our “PhD Standard” of macroeconomic management will be familiar territory for readers of this site. The Fed is trapped between the rock of natural deflationary forces of excessive debt, an ageing population and cheap imports frustrating its efforts to generate a self-sustaining economic recovery and the hard place of annualised inflation of 2%. Rickards quotes extensively from eminent economist and Ben Bernanke mentor Frederic Mishkin, who noted in a 2013 paper titled Crunch Time: Fiscal Crises and the Role of Monetary Policy that “ultimately, the central bank is without power to avoid the consequences of an unsustainable fiscal policy.”

More interesting is the author’s attempt to map out what-happens-next scenarios. The chapter about the on-going transformation of the International Monetary Fund into the world’s central bank, and Special Drawing Rights (SDRs) into a global currency, is particularly insightful. Though Rickards doesn’t say it, Barack Obama’s former chief of staff (and current Mayor of Chicago) Rahm Emanuel’s dictum about never letting a crisis go to waste seems to apply here: hostile acts of financial warfare would lead to calls for more international regulation, and to more government intervention and monitoring of markets. Observers of the EU’s crab-like advance over the last half century will be familiar with the process.

Indeed, my only quibble with this book is Rickards’ starry-eyed take on the EU – soon to be “the world’s economic superpower” in his view. Though he makes a good argument – similar to Jesús Huerta de Soto’s – that relatively-tight European Central Bank monetary policy is forcing effective structural adjustments in the eurozone periphery, as well as in eastern states that wish to join the euro, his endorsement of other aspects of the EU seem too sweeping.

The author talks of the benefits of “efficiencies for the greater good” in supranational government, and how subsidiarity makes allowances for “local custom and practice”. But, as the regulatory débacle surrounding the Somerset floods has shown recently, EU rule frequently licenses bureaucratic idiocies that destroy effective, established national laws. Regulatory central planning for an entire continent is, I’d say, just as suspect as monetary central planning for one country.

The continent’s demographic problems are probably containable in the short-term, as Rickards says. But mass immigration is driving increasing numbers of white Europeans to far-right parties. And while there is consistently strong public support for the euro in the PIIGS (Portugal, Ireland, Italy, Greece and Spain), he’s silent on the broader question of the EU’s democratic legitimacy. No mention of those pesky ‘No’ votes in European Constitution, Maastricht and Lisbon Treaty referendums – or of the Commission’s own Eurobarometer polls, which show more and more Europeans losing faith in “the project”.

No matter I suppose: the eurocrats will rumble on regardless. But what was that quote about democracy being the worst form of government apart from all the others?

All in all though, this is a great book – even for someone like me who’s not exactly new to the economic doom ‘n’ gloom genre. As Rickards says at the end of his intro: “The system has spun out of control.”

References:
(1) For example Juárez, Fernando (2011). “Applying the theory of chaos and a complex model of health to establish relations among financial indicators”. Procedia Computer Science 3: 982–986.

Economics

Currency war means currency suicide

What the media calls a “currency war,” whereby nations engage in competitive currency devaluations in order to increase exports, is really “currency suicide.” National governments persist in the fallacious belief that weakening one’s own currency will improve domestically-produced products’ competitiveness in world markets and lead to an export driven recovery. As it intervenes to give more of its own currency in exchange for the currency of foreign buyers, a country expects that its export industries will benefit with increased sales, which will stimulate the rest of the economy. So we often read that a country is trying to “export its way to prosperity.”

Mainstream economists everywhere believe that this tactic also exports unemployment to its trading partners by showering them with cheap goods and destroying domestic production and jobs. Therefore, they call for their own countries to engage in reciprocal measures. Recently Martin Wolf in the Financial Times of London and Paul Krugman of the New York Times both accuse their countries’ trading partners of engaging in this “beggar-thy-neighbour” policy and recommend that England and the US respectively enter this so-called “currency war” with full monetary ammunition to further weaken the pound and the dollar.

I am struck by the similarity of this currency-war argument in favour of monetary inflation to that of the need for reciprocal trade agreements. This argument supposes that trade barriers against foreign goods are a boon to a country’s domestic manufacturers at the expense of foreign manufacturers. Therefore, reciprocal trade barrier reductions need to be negotiated, otherwise the country that refuses to lower them will benefit. It will increase exports to countries that do lower their trade barriers without accepting an increase in imports that could threaten domestic industries and jobs. This fallacious mercantilist theory never dies because there are always industries and workers who seek special favours from government at the expense of the rest of society. Economists call this “rent seeking.”

A Transfer of Wealth and a Subsidy to Foreigners

As I explained in Value in Devaluation?, inflating one’s currency simply transfers wealth within the country from non-export related sectors to export related sectors and gives subsidies to foreign purchasers.

It is impossible to make foreigners pay against their will for the economic recovery of another nation. On the contrary, devaluing one’s currency gives a windfall to foreigners who buy goods cheaper. Foreigners will get more of their trading partner’s money in exchange for their own currency, making previously expensive goods a real bargain, at least until prices rise.

Over time the nation which weakens its own currency will find that it has “imported inflation” rather than exported unemployment, the beggar-thy-neighbour claim of Wolf and Krugman. At the inception of monetary debasement the export sector will be able to purchase factors of production at existing prices, so expect its members to favour cheapening the currency. Eventually the increase in currency will work its way through the economy and cause prices to rise. At that point the export sector will be forced to raise its prices. Expect it to call for another round of monetary intervention in foreign currency markets to drive money to another new low against that of its trading partners.

Of course, if one country can intervene to lower its currency’s value, other countries can do the same. So the European Central Bank wants to drive the euro’s value lower against the dollar, since the US Fed has engaged in multiple programs of quantitative easing. The self-reliant Swiss succumbed to the monetary debasement Kool-Aid last summer when its sound currency was in great demand, driving its value higher and making exports more expensive. Lately the head of the Australian central bank hinted that the country’s mining sector needs a cheaper Aussie dollar to boost exports. Welcome to the modern version of currency wars, AKA currency suicide.

There is one country that is speaking out against this madness: Germany. But Germany does not have control of its own currency. It gave up its beloved Deutsche Mark for the euro, supposedly a condition demanded by the French to gain their approval for German reunification after the fall of the Berlin Wall. German concerns over the consequences of inflation are well justified. Germany’s great hyperinflation in the early 1920’s destroyed the middle class and is seen as a major contributor to the rise of fascism.

As a sovereign country Germany has every right to leave the European Monetary Union and reinstate the Deutsche Mark. I would prefer that it go one step further and tie the new DM to its very substantial gold reserves. Should it do so, the monetary world would change very rapidly for the better. Other EMU countries would likely adopt the Deutsche Mark as legal tender, rather than reinstating their own currencies, thus increasing the DM’s appeal as a reserve currency.

As demand for the Deutsche Mark increased, demand for the dollar and the euro as reserve currencies would decrease. The US Fed and the ECB would be forced to abandon their inflationist policies in order to prevent massive repatriation of the dollar and the euro, which would cause unacceptable price increases.

In other words, a sound Deutsche Mark would start a cascade of virtuous actions by all currency producers. This Golden Opportunity should not be squandered. It may be the only non-coercive means to prevent the total collapse of the world’s major currencies through competitive debasements called a currency war, but which is better and more accurately named currency suicide.

This article was previously published at Mises.org.

Economics

In Defense of the Euro (An Austrian Perspective)

Professor Jesus Huerta De Soto sent me a copy of his new film called “In Defense of the Euro (An Austrian Perspective)”. You can watch it here.

For those truly interested in the Gold Standard as a potential solution to our monetary crises, whilst the Euro is a very weak imitation of it, it does force governments in the euro area, in the absence of any ability to mint up money out of nowhere, to confront their profligate over-expenditure and move towards being honest with their citizens over it.

We who sit in nations that can mint up new money from nowhere – the UK, USA, and Japan – can seemingly avoid the pain of confronting our profligacy, but we wither on the vine; the pain is required to and grow and prosper again. The eurozone area will be on a stronger footing, with governments living within their means, much quicker than in the nations where monetary nationalism rules the day.

To all those who trash the Euro and Euro-style solutions, you should listen to what the Professor has to say, reflect on this contrary view, and challenge your perspective. You may find that, surprisingly, the Euro could lead to smaller governments and more honest money.

Economics

France’s cul-de-sac

Over a year ago, in the midst of an ongoing economic crisis, François Hollande celebrated his victory over Nicolas Sarkozy in France’s presidential elections. Hollande became the leader of a country in economic turmoil. In the past year, he has had relatively free rein to carry out his economic agenda, since the Socialist Party he leads has a majority in the French Parliament.

France has a history of grandiose government spending, even among European countries. Public spending accounts for 57 percent of national output, and public debt accounts for over 90 percent of GDP. While austerity has been the buzzword in the rest of Europe since 2009, resulting in a modest decline in government spending as a percentage of GDP, France is not part of that trend.

The public sector now accounts for almost two-thirds of all direct economic activity, and more if indirect activity is counted. This large and growing dependence on government is disastrous because it is funded by ever higher taxes. These high taxes drain the private sector (while simultaneously giving the public sector an aura of impotence) and deficit spending obliges future generations of French citizens to pay off the largesse of today’s government.

Deep within the French psyche is the idea that cuts to the gargantuan public sector would cause undue harm to everyone. This inability to envision a French economy where the private sector picks up the slack when fewer public services are provided has reinforced the reluctance of politicians, and in particular, François Hollande, to use austerity measures to overcome the crisis. Instead, the current solution is to increase government spending and create more jobs in the public sector. For this reason, Hollande’s administration has pledged to increase the minimum wage for all employees, public and private, and create 60,000 new public teaching jobs.

In addition to the present increases in public expenditures, Hollande has committed to future increases in public spending. His decision to roll back Sarkozy’s initiative to raise the retirement age from 60 to 62 obliges taxpayers not only to support the burgeoning ranks of public employees “working” today, but the growing number of public retirees supported by generous social security payments.

In a bid to combat rising interest rates on its bonds, the French government has recently commenced a campaign to raise taxes to fund the country’s ballooning expenditures. Indeed, one of Hollande’s primary electoral promises was a top tax rate of 75 percent on the so-called riche (income earners above 1 million euros).

France has one of the highest corporate tax rates in the European Union, exceeding even the famous high rates of Sweden. While the European Union’s average tax rate has been decreasing (from about 50 percent in 2005 to about 44 percent in 2012), France’s tax rate has remained constantly high (over 65 percent from 2005 to 2012).

In addition to high tax rates, French businesses are faced with the highest social charges in the European Union, as well as oppressive government regulation. These factors make for an unattractive business environment. Recently several large companies closed their doors rather than deal with the difficult business conditions, resulting in thousands losing their jobs. New companies are slow to appear in such a climate.

In response to the threat of higher French taxes, British Prime Minister David Cameron, offered to “roll out the red carpet” for any high-income earning Frenchmen who wanted to avoid paying French taxes. Of course, we would be remiss to think that Cameron was motivated by anything other than to attract tax dollars into his own strained coffers. The result, however, was tax competition between states.

Before the advent of the European Monetary Union, highly indebted countries sought to cure their fiscal woes through inflationary policies. France removed this option from the table when it adopted the euro. Indeed, as Philipp Bagus demonstrates in his book The Tragedy of the Euro, it was the French who aggressively pushed for monetary integration within Europe. They must now adhere to the results of this decision.

The monetary union functions somewhat as a modern gold standard. Just as gold once kept states from running prolonged deficits, today the loss of an independent monetary policy constrains European member states in a similar way.

With no recourse to an inflationary monetary policy, the French government is at the mercy of the bond market. As lenders worry about the French government’s ability to repay their debts, now and in the future, interest rates will rise (as they have already). The French government will have to rein in its deficit spending either through spending cuts or tax increases as the cost of borrowing goes up. The private sector is already a heavily burdened minority, and given the current exodus of French companies and entrepreneurs to other countries, any further taxes would be coming from an already shrinking tax-paying base.

Like many of his counterparts, François Hollande realizes that the beleaguered French economy needs change. What he must do is focus on the areas that he can change. He must decrease public spending and lower taxes in order to increase employment. In addition, the private sector must be allowed to heal and recover, instead of treating it as a goose to be plucked. This is the only way the French government can continue to function, and more importantly, the only way to get France out of its economic cul-de-sac.

This article was co-authored with  and previously published at Mises.org.