By Marshall Auerback, a portfolio strategist and hedge fund manager. Cross posted from New Deal 2.0
The Iceberg Cometh: An economic and financial crisis will soon be brought about by the collapse of the European Monetary Union. And everyone goes down with the ship!
In the past, I have called the euro zone a “roach motel”. But as usual, I’ve been outdone in the metaphor design department by the Italians: Guilio Tremonti, the Italian Finance Minister, last week compared Germany and its small-minded Chancellor Angela Merkel to a first-class passenger on the Titanic. The underlying message is the same: You can be sailing in coach or you can be in the 1st class compartment. But when the ship hits the iceberg, everybody goes down together — Germans, Italians, Greeks, Irish and French alike. All euro zone members have an institutional wide problem of not being able to fund deficits, given that the countries of the euro zone have all acceded to impose gold standard conditions on themselves by forfeiting their fiscal freedom.
To repeat: this is not a problem confined to the periphery. The sovereign risk problem applies to the central core countries, such as Germany and France, as it does to the Mediterranean “profligates”. Once a run on the currency starts and moves into the banking sector, then none of the governments will be able to do anything other than to oversee financial and economic collapse while the fiddlers in Brussels and Frankfurt try to spin some line about “special circumstances” or something without admitting the whole system they imposed on the area is the cause of this crisis.
The risk for the fiscal authorities of any member country is that the ‘dismal arithmetic’ of the budget constraint leaves few palatable alternatives. If the yield on government securities demanded by markets exceeds a country’s nominal income growth, then interest expense on the outstanding debt must become a relatively larger burden (Jordan, 1997: 3).
In a country like the United States, this should never cause financial stress; the U.S. government can always meet any dollar-denominated commitment as it comes due. But markets clearly recognize that things work differently in the Eurozone, where governments are no longer able to ‘print money.’ As a result, the bonds issued by member governments now resemble those issued by state and local governments in the United States (or bonds issued by provinces in Canada or Australia), where yields often differ by a sizable amount.
The European Monetary Union has hitherto only survived because whenever push comes to shove, the ECB has stepped in as the “missing” fiscal agent and has kept the bond markets at bay. It continues to “write the check” whenever the markets seek to shut down the individual markets on the grounds of looming insolvency.
But Finance Minister Tremonti is right: the underlying logic of the monetary system will continue to ensure these on-going crises will spread across the union. Each successive “resolution” is merely a place-holding operation. The EU bosses are just buying time and kicking the can down the road. Ultimately, to survive the system has to add a unified fiscal authority and abandon the fiscal rules embodied in the Stability and Growth Pact or accept the experiment has failed and dissolve the union. The constant stop-gap measures being introduced on a seemingly ad hoc basis are leading toward a very unpleasant dissolution, the end result for which could be Europe’s “Lehman” event. Meanwhile, the iceberg is approaching rapidly.
Europe’s brokered marriage is in deep trouble. The partners have not grown together. For a long time, countries such as Greece and Portugal benefited from the illusion of economic convergence through the lower interest rates and stable currency that the euro brought with it. When the European economy was growing, the markets indulged the fantasy that there was little to choose between Greek and German debt. But that has now changed — and Greece has to pay a significant premium on its borrowing, as does Portugal and now Spain and Italy.
It is also now obvious that countries such as Greece, Spain, Italy, Ireland and Portugal are struggling to compete with the much more productive German economy. In a currency union they cannot devalue their way out of trouble. The only alternative solution on offer is a long and painful period of austerity to reduce their costs through cuts in wages and living standards, the so-called “internal devaluation” — in reality, a one-off coordinated reduction of wages and prices across the board. It is, as I have argued before, more like an “infernal devaluation.” It amounts to a domestic income deflation — as wages are crushed — in order to get the prices of tradable goods down enough so the current account balance increases sufficiently enough to carry the next wave of growth.
This lack of economic convergence has revealed the lack of political convergence around a shared European identity. There is a striking lack of sympathy for the Greeks or Italians from Germany. Berlin continues to fiddle while Rome and Athens burn. The German position seems to be that the weaker European economies are paying the price for not being as hard-working and skilled as Germans — and must now shape up or ultimately leave the euro.
Any suggestion that German under-consumption and export-addiction might have something to do with the crisis in the euro-area is brushed aside. Some Greek politicians have responded to German pressure with angry references to the Nazis’ brutal occupation of their country during the Second World War. So much for European solidarity.
In this context, it is interesting to see that former German Chancellor Helmut Kohl is now apparently speaking out against current Chancellor Merkel, who has proven herself to be a small-minded burger who should not be entrusted with the leadership of a great nation like Germany.
Merkel, of course, claims to be safeguarding the interests of German taxpayers. It is amusing to hear the Germans talk about the “cost” to them of staying in the euro zone as a result of “funding” so-called “profligates” such as Greece or Italy. First of all, the “funding” comes from the ECB which creates new net financial euro denominated assets at will, not the Germans.
In fact, there has been zero cost to the Germans. They’ve locked their export competitors into the European Monetary Union at hopelessly uncompetitive exchange rates. German taxes haven’t gone up, they haven’t had their generous social welfare provisions cut (which are much larger than Greece’s, contrary to popular perception). At the same time, the periphery countries have had their economies destroyed by enforced austerity, in exchange for which they get ongoing ECB funding which (wait for it) helps them to buy yet more German imports.
So the ECB keeps the game on the road to facilitate the continued expansion of German exports to the rest of Europe (although that strategy is, as Mr Tremonti amongst others, has started to notice, is becoming a touch self-defeating), and the Germans pay nothing for this privilege. No increased taxes, no austerity and no competitive threat to Berlin’s export base so long as the PIIGS are locked into the euro straitjacket.
A further sad irony is that if Greece, Spain or the other periphery nations genuinely succeeded in implementing a successful “internal devaluation” a number of German businesses would relocate, or force further downward pressure on German domestic wages.
Guilio Tremonti is right: Germany is in the first class cabin of the Titanic. Another way of looking at it is that figures like Chancellor Merkel are leading the PIIGS to slaughter in the abattoir, not realizing that they are on the same conveyor belt. The tragedy ushered in by the current crisis is entering into its critical phase, and the small mindedness of the policy response could well spell the death of not just a currency but also a vision for a unified Europe. The essential problem is that the EU was founded as a political venture but quickly grew into a (promising) economic venture. The irony is that the lack of a true political union — which would have permitted a unified fiscal policy — is precisely what will kill the whole idea.