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Germany is a first class passenger on the Euro Titanic

I was on RT’s Capital Account on Monday afternoon, talking about the euro crisis yet again. The video is below but I have a few comments before you watch it.

In the video, I say Europe can continue dithering for quite a while. There is no sense in making predictions about imminent euro zone destruction because Europe has a lot of tools in its arsenal to continue its Great Dither. But while my comments on RT were less strident than recent predictions from George Soros about Europe’s predicament, I respect his analysis and am still alarmed by the situation. Let me tell you why.

Europe’s political leaders are now in a policy cul-de-sac that ends in disorderly breakup. Europe is too far along the path of fiscal consolidation and bailouts to turn quickly enough to forestall the debt deflation now taking hold in Europe. Germany too will eventually succumb as a result of this debt deflationary path.

The expansionary fiscal consolidation myth

When the crisis started in early 2010, Germany took a hard no-bailout line to Greece. But as the situation in Greece worsened, it became clear that a sovereign default would be likely without a bailout. Rather than risk the fallout from a Greek bankruptcy on global markets and Greek creditors, Germany relented and bailed Greece out.

But there was a cost: austerity. You see, the German people, who never voted for the euro, were apoplectic that Germany would bail out Greece. This, they rightly saw, was the hidden cost of the euro. Greece was widely considered to be a fiscal profligate and had been revealed to be a fiscal cheat to boot. So, for the German government to bail out Greece and save German banks and global capital markets from the contagion a Greek default would create, it had to attach strings, conditionality, to the funds Europe gave.

This has led to the internally inconsistent policy path of repeated bailouts and austerity. Unfortunately, austerity doesn’t work as advertised. Fiscal consolidation is never expansionary. Austerity is always contractionary as the word ‘consolidation’ implies. Now, let’s remember that even the UK government tried to sell us on expansionary fiscal consolidation in 2011, claiming an imaginary confidence fairy would permit growth. Predictably, the UK is now in recession as a result. Last October a leaked Greek bailout document demonstrated that the EU knew expansionary fiscal consolidation had failed in Greece too.

My point: As I predicted when the crisis erupted in 2010, Europe’s policy path has led to a double dip recession.

Throughout this crisis, Europe’s approach has been bailouts and austerity. In the periphery this has led directly to missed fiscal targets again and again. The mantra as I put last October is:

continue fiscal austerity until you reduce your deficits significantly. If the depression this creates causes you to miss your fiscal targets, redouble your efforts under the watchful eye of the Troika.

And yet, those who favour austerity keep trying to put forward some example of where and how austerity actually works. Latvia is the latest example. The whole line of argument is false. As I put it in 2011 when the UK was pushing the confidence fairy line:

People like Hugh Hendry get it. He is not advocating fiscal contraction because he believes it will immediately be expansionary. Instead, he argues there is no policy remedy for debt deflation. Rather than allow the government’s debt levels to climb and fill in the missing private sector demand as Richard Koo advocates, Hendry recommends just letting aggregate demand fall and starting anew. That leads to Depression of course.

And that’s where Europe’s periphery is right now.

The policy cul-de-sac

Can Europe change tack though? Should they? And if they were to do so, how would they do it?

My view: Europe should change tack but it won’t. The risk of a global Great Depression is too large to continue on the current path. I understand the argument that Hugh Hendry makes about debt deflation but I believe there are policy remedies for debt deflation: credit writedowns, bank shareholder losses and subordinated debt haircuts, bank recapitalisation without fiscal targets at a minimum. In Europe, to stop the debt deflation, we would also have to see ECB sovereign backstops.

The problem is that Europe is doing none of this. And so it would be forced to change tack completely. I don’t see this as a likely scenario because changing policy responses that much is simply not credible. I tried to get at why political leaders can get trapped inside their own rhetoric last May in a post entitled "Consistency". My basic point there was that:

most people – once they have taken a decision, publicly committed to it and taken action to reinforce that commitment- most people will defend that decision come hell or high water, regardless of whether it is advantageous to do so.

I look at recent statements Angela Merkel is alleged to have made about Eurobonds happening only over her "dead body" as emblematic of this type of commitment to previous public policy statements. So what I expect to happen in Europe is that we will go from bailouts and austerity to bigger bailouts and austerity lite, buying some more sovereign bonds and pushing back fiscal targets but not changing the basic approach.

As we have witnessed, bailouts and austerity lead to economic contraction, missed targets and contagion and renewed crisis. And with each new crisis, Europe has been forced into more extreme policy measures and larger bailouts without making any amendment to the basic bailout in exchange for austerity approach to the crisis. After the Italian crisis, my thinking was that "Europe gets it", that European leaders finally understood that the dithering approach would fail and eventually take down the euro and the global economy with it. But I was wrong. Europe doesn’t get it and I now believe they will never get it. The debt deflation in Europe will move too quickly for European policy makers like Angela Merkel to change tack.

Bailouts and austerity will fail

This is how austerity in Europe works. National governments in the euro zone are not currency creators. They have to ‘get’ euros because they cannot create them. If they cannot ‘get’ that money, they are rendered insolvent. So, in a debt deflationary crisis like this one:

currency users are necessarily pro-cyclical. The economy is shrinking, so for currency users in general, revenue is shrinking. And since they have to ‘get’ euros, they cut back their outlays to deal with this or risk insolvency.

Now, this pro-cyclicality is always the case for national governments because a shrinking economy means shrinking tax revenue. Moreover, in the case of governments with automatic stabilisers to pay for, outlays are also increasing. So a worsening of the government’s budget is automatic in a recession. As currency users, the euro zone’s national governments must also be worried about insolvency as we now see. They too must act pro-cyclically then.

Procyclicality is one of the structural flaws of the euro zone; there is no federal agent to add any net financial assets counter cyclically during a recession. Thus, the euro zone business cycle will always have to be more volatile as every economic agent must act pro-cyclically. That makes current account imbalances a lightening rod for intra-European recrimination.

Against this backdrop, national governments are then forced to cut spending, reducing net financial assets in the private sector. Reducing net financial assets means sucking money out of the private sector. And that will reduce consumption demand and harm credit. if private sector debt levels are high and banking systems are leveraged, as they now are in the euro system, this reduction of credit leads to financial distress, bankruptcies, bank failures and potentially systemic failure. That’s what austerity means in an environment of high debt and excessive financial sector leverage.

Germany cannot save the euro because it doesn’t have the financial resources to do so. The German government is already in violation of the Maastricht Treaty government debt to GDP limit as a result of the US-centric crisis. And as the Germans increase their commitments to the bailout/austerity approach, one has to question Germany’s credit rating as Egan-Jones rating agency has done, downgrading the country to A+. The euro crisis is a rolling crisis that will damage the euro zone closer and closer to the core until we get defaults, breakup or monetisation.

For now, the Great Dither continues – and it can continue for quite a while. But eventually, events on the ground will become too dire and the Great Dither will fail. At that point anything can happen. A disorderly euro zone breakup must then move from being considered an outlier outcome to one of the main expected scenarios or even a base case.

RT video below

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

15 Comments

  1. David_Lazarus says:

    Over the last few days I have been giving thought to the German position. The creation of Eurobonds will be a disaster. All they are doing is impaling european tax payers on the bail out hook.

    All along I have contested that this is a banking crisis. By maintaining the banks debt levels you maintain asset prices at elevated levels when the work force are being forced to take the full impact of deflation, which increases the debt burden and asset burden. This could in future be seen as a massive policy mistake as it prices millions more out of the housing market and lead to a split in society which as we should know always ends badly. Not only are the young priced out of housing but so are small businesses priced out of the market, as they lack the funds to get started. This is great for incumbent businesses but very bad for job creation.

    Edwards position of this being a balance of payments issue is part of the problem. I do think that the excessive lending by the banks enabled the balance of payment problems to be avoided.

    Months ago I said that Greece may have to default on every loan to have a chance and today I heard that opinion echoed on the BBC. If the euro is to be saved the banks will have to pay the price. When the Euro was created the central banks had responsibility as lender of last resort but that role should have been eliminated when the Euro was created. Banks should not have had state backing. This would have reduced the risks they could take.

    The other policy that should be implemented is deposit protection for savers with modest funds with a cap of €100 000. That will limit bank runs, but not stop them. Much of the bank runs across the periphery is down to fear that they will be pushed out of the euro into a crap currency. That is why the Italians are the latest members of the periphery to start buying assets in London, as a perceived safe haven. So there could be another property bubble in London even as the rest of the UK economy slows down. It also ties in with Germans buying homes in Switzerland as a safe haven.

    One aspect that is problematic is full fiscal union. I seriously doubt whether it will be achievable within the time frame needed. Better to defuse the problems by stopping all pretext that if we save the banks we save the economy. Apart from massive credit write-downs we need massive asset write-downs. In addition we need very tough bank regulations that stop property bubbles, maybe by separating housing finance from banking and only allow mutual organisations to fund housing. With such organisations independent of interbank markets they will not lower interest rates so low as to inflate a Fed type bubble.

    Even so after all this I still think that the euro can survive as long as governments do not bailout banks. So reversing the bailouts would return Ireland to solvency and ease the rest of the problems within the periphery. Though will the core nations accept that as it will destroy their banks as well?

    • Dave Holden says:

      I think Edward’s characterisation of the policy so far as “banking centric” is a good one. I find the motivation for this policy a little unclear however. I suspect it’s a combination of it’s can kicking nature and the protection of the 1% – read political, neoclassical and financial elite. Medium term I find it hard to believe the EZ can survive, I can’t get beyond monetary union means fiscal union means political union. While I think there is enough support in the 1% class for the second and third of those requirements I don’t see there being any chance of that working for the other 99% over a business cycle.

      My best hope at present is a split lead by Germany, a two speed EZ. Although I’m not hopeful that this could be achieved in an orderly fashion since the EU only ever acts out of crisis. I don’t think this is imminent however, not least because I see German politics becoming more aligned with the rest as their economy start to suffer. Ultimately I see this as a epic tragedy resulting from political hubris.

      • David_Lazarus says:

        Many of the 99% want the status quo to continue. Should house prices fall to sustainable levels then the numbers of underwater borrowers will explode. There is no way currently to keep these people in their homes, and that would be disastrous in an election. The majority of economists are numbskulls. They are wedded to an ideology that is clueless.

        I am not so pessimistic that the euro is doomed. Without the pressure to bail out banks and damaging sovereign balance sheets the sovereigns would be in so much better shape. If the banks are wiped out when the bailouts are reversed, then that will restore to an extent the finances of sovereigns. Ending lender of last resort would also protect sovereigns and force banks to re-capitilise. Capital controls and deposit protection would really hit only the 1% as the majority really are living from pay cheque to pay cheque, so are unlikely to be affected by capital controls and losses from funds above the deposit protection ceiling.

  2. ECB Watch says:

    Been thinking along same lines. However, Europe not doing this for a host of reasons one of which is the fear of precipitating a banking crisis. Perhaps the emphasis should be on how to deal with that while forcing losses on creditors.

    • David_Lazarus says:

      I think that a huge element of government capture by the banking system is partly to blame for governments trying to avoid another financial crisis. It is like recessions, yes they are nasty but if you manipulate the economy to avoid small periodic rebalancing of the economy then all you get is a more imbalanced economy and then when it all becomes unsustainable it leads inevitably to depression. Spain, Ireland and Greece are in depressions but because the rest are trying to avoid unwinding their bubbles they are making things worse. Around the world park rangers realised that small forest/park fires cleared out the dead wood and keep the park healthy. By stopping all fires the tinder accumulated until it was impossible to manage. That is where we are now.

      • ECB Watch says:

        Nice analogy, but misleading. A banking crisis is not “a small fire”. Advising credit write downs without giving a modus operandi to deal with banking crisis that ensues is unlikely to overcome the fear factor. ecb-watch.blogspot.com

      • ECB Watch says:

        A banking crisis is not a small park fire, it’s raging fire all across the land. Can’t convince of the worthiness of credit writedowns without explaining how to deal with the banking crisis that ensues.

        • I have commented on this often, especially in the context of the US crisis in 2008-2009. You have to nationalise/recapitalise the banks first by moving up the capital structure chain from equity preferred, sub debt and senior debt, potentially converting some of those to equity instead of wiping them out.

          In dealing with the recaps, the key is to have a robust process of identifying still solvent financial institutions and providing them with enough liquidity to prevent any type of bank run and to get them quickly recapitalised.

          See here as an example:
          http://www.creditwritedowns.com/2009/03/a-few-thoughts-about-the-banking-crisis-response-in-the-united-states.html

          I think the same problems are in Europe and I would recommend the same for their system.

          • David_Lazarus says:

            The problem is that no where is actually fixing their banks. All that is being done is pumping them full of liquidity and hoping that they can trade their way back into solvency.

          • ECB Watch says:

            I think the message would have a better chance of hitting home by providing an actual scenario/case study.

            Say we don’t pump €100Bn in Bankia. Immediate outcome : it’s shunned from money markets. In turn, its leveraged creditors (other banks) suffer credit downgrades etc.

            From here onwards, what is your plan?

            Even as I am sympathetic to putting bond holders where they belong, behind depositors and the taxpayer, that plan, and its cost/benefit analysis, will have to be laid out before my eyes, with precise definitions/modus operandi for ‘liquidated’, ‘recap’, ‘sold’, ‘nationalized’ etc., before I can wholeheartedly adhere to it.

            FYI, I took up Nathan Lewis’ debt-equity-swap case study in my blog (see link below), ‘DES with pie charts’, and raised a few issues.

          • ECB Watch, I have found that’s not a productive use of my time. When the crisis began, I thought the blogosphere had a voice which could influence policy, if only tangentially. I don’t think that now, however. And so my goal here is more in outlining the fundamental issues to predict what will occur and aiding people in making investment and other decisions to meet those predictions.

            So I don’t have a Euro recap plan nor do I intend to make one.
            People who are better-positioned to make actual policy recommendations are academic economists with a wide following like Roubini, Krugman, Whelan or DeLong. Those are the voices you should be pushing to provide an actual scenario/case study

          • ECB Watch says:

            Not even ad honores? Besides, I don’t see how that would be incompatible with your scaled down purpose: if you’re prediction is that the policy is misguided, sooner or later the scenario discussed will become relevant to ‘making investment decisions’.

            Roubini, Krugman etc. represent the consensus on using the ESM as a backstop for banks. I’m posting here because it offers a different perspective.

            Secondly, he who has notoriety is likely to present his views in broad strokes, so as not to expose it to getting nailed on a technicality. The risk/reward trade off is different for lesser known ‘performers’.

          • Maybe one day I can get to something on those lines. Thanks for the show of support.

        • David_Lazarus says:

          No but all the asset bubbles (small fires) beforehand should have been allowed to run their course. Now we have the banking crisis (major forest fire) to show for it. As Edward comments the banks equity should be wiped out and then convert debt to equity and then when they are wiped out the bank should be nationalised temporarily. That is how you force the credit write-downs that are so desperately needed.

          Five years ago we should have followed the Swedish bad bank model and force creditors to take losses. Now we are following the Japanese twenty years of stagnation yet that still did not stop the substantial fall in asset prices.