By Arturo O’Connell, formerly an official in the Argentine Central Bank in various capacities from 1959 to 2015 who has He also held offices related to economics and international finance both in other government spheres and in academia in Argentina and Chile. Originally published at the Institute for New Economic Thinking website
Most discussion of the Eurozone crisis has revolved around the alleged profligacy of the heavily indebted “peripheral” countries. In fact, however, the desperate position of these countries mainly results from reckless lending by banks located in the “center” countries. As such, the crisis is just one more case of the well-known financial cycle that, in an era of financial deregulation, arises from cross-border financial flows dominated by “push” factors, i.e., by circumstances in the economic and financial systems of those center countries. Lending is always nothing more than the provision of purchasing power, and in the case of the southern European periphery was mainly funded outside the euro area. In this specific instance, therefore, it is patently clear — beyond conceptual considerations — that contrary to the narrative of northern European political debate, southern Europe’s debt hardly represented a transfer of savings from the Eurozone’s more advanced nations to its periphery.
Additionally, repayment crises (the “bust”) are not only the end result of the upside phase of the capital flow cycle (the “boom”) but by themselves also create serious problems such as distortions in the recipient economy and the very obvious overexposure of creditor institutions, to which as much attention should have been paid as to the “sudden stop”.
The Eurozone lacked institutional structures to cope with such dangers. Its institutions, and the limits imposed on fiscal deficits and government debt, were designed on the premise that the only potential source of problems would be the misbehavior of governments. In accord with the policy consensus of previous decades, though, no provisions were introduced to cope with a financial crisis originating from the misbehavior of big private financial institutions headquartered in the center countries, and their supervisors.
We can hardly afford to repeat this disastrous omission. Changes are needed both in the architecture of the institutions and also in the vision that informs their supervisory authorities. The best full-employment and growth oriented macroeconomic policies can do little to handle the massive waves of finance and cross-border flows from financial institutions in the center countries. Unless strong regulations are introduced to manage those financial flows — if not cancel them out — even the most carefully crafted policies will be powerless.
Of course, future adoption of such policies does nothing to cope with the legacy of the accumulated stock of bad credits/debts. In the past, peripheral countries have in such situations resorted to nominal devaluations that with dampened exchange rates pass through turned into real ones – and to economic expansion. A few have obtained significant reductions of their debts or restructuring of maturities at moderate rates of interest.
But not in the Eurozone. There, policies have concentrated almost exclusively on an enforcement of accumulated obligations by achieving real devaluations through domestic deflation and imposing drastic reductions in ‘absorption’ — both public and private — to make room for debt repayments. These strategies have not resulted in renewed growth nor in a significant present-day or near-future reduction of Debt/GDP ratios. So, while “structural reforms” that weakened or abolished hard-won social rights and the paradoxically labeled “expansive fiscal consolidations” were requested, they predictably failed to bring back economic growth and consequently decrease indebtedness.
As with countries in the global periphery, official lending from the center — and from the IMF — was made conditional not only on the implementation of those policies, but by demanding the recycling towards private creditors of the bulk of official credits made available, so as to combine with the recipients’ own resources to ensure a punctual repayment of accumulated debt. This fatal combination led to a “revolving door” or “triangular bailout” strategy that disguised public intervention by governments in the center to relieve the creditors. Additionally, one gets the impression that the other component of the strategy applied to the EMEs, the “muddling-through” strategy — or stumbling from one crisis to another — has also been employed in the Euro area periphery, generating its own instability that jeopardized recovery.
The opposite, however — an upfront wholesale all-round reduction in the debt/credit overhang — looks like the only way out that would have ensured growth and employment. There is no dearth of proposals in that direction. But, to my knowledge, in almost all cases these relief schemes start from the wrong point, i.e., they place responsibility for the crisis squarely on the countries receiving the financial flows rather than on the institutions in the core countries “pushing” them and their supervisors, as well as the deregulated environment in which those financial institutions operate.
Moreover, and in a language that should be avoided because of the danger of feeding old feuds and xenophobia, there has been too much loose talk about overcoming “German” opposition to an alternative way out. The matter has been framed as if creditors were disciplined, high-saving German people and not a narrow — if powerful — group of financial institutions merely providing finance and not necessarily transferring savings. Consequently, the issue has been framed as a conflict between different euro area nations, hardly a helpful way to strengthen the integration process.
What is in crisis, therefore, as it was the case back in the 1980s and 1990s for Emerging Market Economies like those in Latin America, is the strategy of “triangular bailouts” of large creditor center banks through the wrong means, i.e. via further compression of economic activity in the peripheral countries and transfers of a sizable portion of those credits to official institutions — so that debtors can keep up to date with servicing the “toxic” loans on the balance sheets of “Too-Big-To-Fail” banks in the ‘core’ countries.
Oddly enough, it could be proved that these schemes also imply that the center countries also lose in terms of GDP and employment.
Already back in the 1980s, “debt relief” by the center countries’ governments was shown to be a global positive force for growth that boosted their own domestic economies. That was the conclusion of simulations done by the Research Department of the IMF with their world economy model of those days. It was presented to a meeting of what was then called the Interim Committee as an Appendix to the WEO of March 1988 (in mimeo form in that pre-digital era) that was inexplicably struck out from the printed version made available to the general public.
Therefore, taking the narrow side of the banks, governments in the center countries, besides victimizing peripheral countries, had to force other sectors of their own societies — the legendary poor carpenters and plumbers as well as middle class taxpayers — to pay for the adventurous behavior of those institutions.
A different diagnosis and the corresponding policies are urgently needed not only for the sake of growth and employment but also to avoid dangerous and avoidable nationalistic divisions in Europe.
“Most discussion of the Eurozone crisis has revolved around the alleged profligacy of the heavily indebted “peripheral” countries. In fact, however, the desperate position of these countries mainly results from reckless lending by banks located in the “center” countries.”
Doesn’t the debtor/creditor relationship originate from trade imbalances between countries?
If one countries trade surplus is another countries trade deficit than someone has to go on a credit binge. Europe’s economic issues have always struck me as a case of creditor/surplus countries wanting their cake and eating it too. They want to maintain a trade surplus and they want to squeeze the debtors that enable the surplus.
This is an interesting if true, but I’d like to see what data its based upon. My understanding (if memory serves me right it was in a Michael Pettis blog, but I may be wrong on this) is that it is narrowly true that most of the funding for excess lending in southern Europe came from outside the Eurozone, but that in a broader sense this money originated in Germany and the north, it just may have taken a few different transactions to get from a creditor account in a bank in Frankfurt to a loan account in a bank in Madrid. So far as I’m aware, in Ireland it was more or less a direct result of Irish banks selling bonds to German banks to fund the property bubble. I’d be interested to hear what those more expert than I have to say on this.
Buy our Bimmers.
Which are made in South Carolina and exported worldwide. Link:
And don’t forget our Buicks.
In other words, this is class warfare, pure and simple. So is this “austerity”, which hurts the economy a lot more than the spending reductions initially.
The big banks ought to be force to take a big haircut and in some cases, the executives should be locked up. Isn’t it obvious that banks are going to do some pretty dangerous actions in their pursuit of profit?
That should prevent future recklessness and greed.
… in my dreams no doubt
I have been waiting for the banks to get spanked since 2008……..
BTW, I am still waiting
When we played monopoly at Christmas many many years ago, the game always stopped when my eldest brother owned everything, so then our mother would give out free money from the ‘bank’ that she always took care to control in every game and the fun would start again. When will it all begin again?
you’re lucky you had a mother 10 times smarter than the average big bank CEO… i’m sure it was a phenomenon so ubiquitous that nobody noticed….
EU looks like toast from here. A common currency is a very difficult matter to make palatable for so many different economies. Keeping a bridle on so many banksters is almost as daunting. Who ever seriously believed that a bunch of old men were qualified to plan such a complicated situation?
As I travel around London I see a forest of cranes building residential and office properties. Reports of residential price softening post-Brexit vote, particularly at the higher end. The likely job losses represent millions of pounds of lost income with ripple multiplier effects hurting many more. Not all are Polish or Slovak carpenters with cheap flats and exit strategies in their home countries.
it would be instructive to know which lenders are on the hook for potential losses on the financed property side, and which developers are sovereign wealth funds and hedge funds or university endowment funds on the equity funded side.
This is a wonderful and honest and clear analysis. Why doesn’t this guy have a microphone, Arturo O’ Connell? He jeopardizes all the bigs, that’s why. Those nitwits, profligate lenders all. Besides which we don’t even need their buckets of bank sewage, aka “private” money. Nations have their own clean means. If the big center banks want to be paid back they need to participate fully in society. But, but… they became big behemoths in order to escape society. Well then, let them starve.
Depository institutions (banks, credit unions, etc.) are arranged in a cartel such that, in the private sector*, ONLY liabilities AMONG cartel members are entirely real. Wrt the rest of us, the cartel’s liabilities are almost entirely a sham and will be ENTIRELY a sham if/when physical fiat is abolished since it will then be impossible for a non-cartel member in the private sector to redeem a bank’s liability for fiat.
So tell me, ye lovers of accounting, how can anything good be expected with sham liabilities?
Bu, bu, but the system works!
Does it now?
*including State and local governments, i.e., not the monetary sovereign.
this is like a country western song
Reckless lending Reckless Spending
Now our troubles are unending
banks are broke and Lordy so are we!
We’re not sure now who has our money
all we know’s it just aint funny
Europe is a mess for all to see.
Can’t spend a franc cause we don’t have one
lira’s gone, the deutchmark’s all done
if you want a loan, go ask the ECB!
Germans are mean, the Greeks are lazy
England’s cold, the French are crazy
man oh man do we need MMT!
(What’s MMT doing in a country western song? It’s in Kansas City, that’s the answer).
Saving’s for a man with money
being broke it just ain’t funny
Let’s crank it up with a new currency!
Whoa that’s a bad song! Whoa. it’s bad. Even if Johnny Cash himself sang it in baritone it would be bad.
But . . . it’s a bad situation. Reckless lending Reckless spending, ya need some love with fences mending, ya can’t get there from here it’s plain to see. (whoa that’s still bad. sorry.) It’s easier to copy somebody else’s good song than make up one.
but Reckless lending, Reckless spending — I could see Dolly Parton belting out that line somehow back in the day. It might have been a song on Hee Haw.
It’s a totally erroneous system not some minor faults in its functioning. A big artificial bubble did burst, it wasn’t an overextended real economy that popped. There was no excessive inflation in EU bubble countries. No serious shortage of labor, bricks, mortgage, lumber and so on in the housing boom countries. And there probably was a real need for modern housing in Ireland, Spain and so on. Europe’s productive capacity wasn’t overextended in any way. A fictitious artificial organization of the economy (finance capitalism running amok on privatized money creation) decoupled from the real economy did implode.
The situation before the Euro:
”historically the German D-Mark had been strengthening since its introduction in 1948 against the currencies of its neighbours, and this reflected – and compensated for – increased German competitiveness. Their weakening currencies allowed German trade partners to keep their export industries in business and their workers employed. By introducing a single currency, future revaluations of the German currency were disallowed.“ Professor Werner
An elite group of free market fundamentalists came up with a plan to roll out across the world based on the neo-liberal ideology and neoclassical economics.
In the early days, before this ideology had flagged up its obvious problems, plans were put in place for the Euro.
A single currency area without barriers would naturally lead to a stable equilibrium.
This is just an assumption based on this ideology.
In 2010, Raghuram G. Rajan (who later headed up India’s Central Bank), wrote a book “Fault Lines” going into all the fault lines that had developed in the global economy and nowhere does he expect these fault lines to naturally resolve themselves as the free market fundamentalists would expect.
To me, it seems the economies are still diverging and the imposition of a single currency did nothing to stop the divergence process that has been seen since 1948.
The Club-med nations go from bad to worse and their banking systems are collapsing.
The weakest nation, Greece, has now collapsed and Wolfgang Schäuble wants to kick Greece out of the Euro-zone.
He doesn’t think this is just part of the natural underlying divergence of the Euro-zone and other Club-Med nations will soon be following in Greece’s footsteps as the Euro naturally destroys itself through the divergence of national economies.
We all have a ring side seat to watch what happens, but if this old divergence trend is still operating decisions will have to be made on how to modify the Euro or abandon it altogether.
As the situation gets worse in the Club-Med nations, the higher the cost will be to the surplus nations in trying to save it.
The banking systems in Greece, Italy, Portugal and Spain are in a bad way and the future costs of saving the Euro rise by the day.
Time is not on the Euro’s side but there is a way out:
“This can be done by simply reversing the procedures of introducing the euro.
By abandoning the euro, each country would regain control over monetary policy and could thus solve their own particular predicament. Some, such as Greece, may default, but its central bank could limit the damage by purchasing the dud bonds from banks at face value and keeping them on its balance sheet without marking to market (central banks have this option, as the Fed showed again in October 2008). Banks would then have stronger balance sheets than ever, they could create credit again, and in exchange for this costless bailout central banks could insist that bank credit – which creates new money – is only allowed for transactions that contribute to GDP in a sustainable way. Growth without crises and large-scale unemployment could then be arranged.“ Professor Werner
The Euro, just another bad neoliberal idea where debt is used to paper over the cracks until max. debt is reached.
How about a sub-prime mortgage, sub-prime auto loan or a payday loan?
Papering over the cracks until max. debt is reached.
The fundamental neoliberal flaw.
The gist of the article on the whole is clear enough if not remarkable or informative at this late date, but this is some really hopeless writing. The quoted portion above is close to gibberish so loaded is it with unnecessary qualification and litotes.
Reading the quoted portion, first I am startled, as commenter PlutoniumKun was above, by the assertion, “Lending . . . in the case of the southern European periphery was mainly funded outside the euro area.” This may be true, but I’d like to know some particular referent, so I can understand what is meant by this. Instead I am treated to a following sentence that appears to treat this assertion of outside funding as an important premise for an argument. What that argument is, beyond the negation of an unspecified narrative, I could not begin to guess. Nothing in the remainder of the article that I can see resolves into a clearly spelled out syllogism where funding from outside the eurozone assumes the place of a premise.