21 July 2011

Eurozone Defense

Skeptics and the common currency

This piece was originally published on June 1, 2010.

If you believe the papers, a lot of people think there’s going to be another Lehman. Only this time, it will come not from the recklessness of American finance, but from a sovereign debt default, the result of the infamous profligacy of the European welfare state. And given all the headlines—“The End of the Euro,” “The Death of the European Dream”—you would think these were the end times for the Eurozone itself. 

The gloomy chorus has been building for months now: it is the leitmotif of the hyper-powered fund managers who are, as I write this, wagering on the demise of the euro, or profiting off the fear of its demise, or even, perversely enough, the fear of that fear. A February piece in the Wall Street Journal, “Hedge Funds Try ‘Career Trade’ Against Euro,” summed up the fervid atmosphere. The piece covered a private lunch in a Manhattan townhouse, hosted by a “boutique investment bank,” where elite managers huddled together over an “idea dinner” to share their views on the state of the euro. Their forecasts were extremely dour—which, for alert speculators, always means a potential windfall: “This is an opportunity . . . to make a lot of money,” said one manager present.

You bet it is. And when major financial institutions can disappear overnight, and the Dow can “flash-crash” 1000 points for no well-explained reason, dire predictions seem more plausible than modest ones. Fear of contagion can itself become a contagion. We accept the assertions of experts with vested interests without asking for the details, and blithe predictions begin to masquerade as anxious questions. How exactly is Greece going to hit US companies? How is it going to undermine confidence in the US treasury?

In the case of Greece, fear of contagion has allowed a debt crisis in an economic backwater to swell into a major liquidity crisis across Europe. Investors have punished the euro, while ignoring the positive, longer-term effects that a cheaper euro implies. In response, the finance ministers of Europe produced a massive bailout package, with new facilities meant to address the currency’s institutional weaknesses. There are even signs of a new willingness among member states to address the structural inadequacies that have been present since the launch of the European currency. Yet euro-skeptical fund managers continue to press their bets, and commentators peddle their ideological agendas as necessary reforms, as if the unprecedented nature of the euro were evidence enough of its ultimate failure.


Is there an actual crisis of the euro? Ever since the Greek government’s surprise upward revision of its budget deficit to 12.7 percent of GDP last winter, the focus has been on Greece’s ability to service its Olympian debt. Of chief concern was the rollover of $25 billion euros worth of Greek bonds coming due this spring. The yield on Greek sovereign credit default swaps shot up; by April, Greece had rolled over $15 billion worth of its paper at successively higher and higher rates of interest, until the costs became prohibitive. European finance ministers were thrust into the role of lenders of last resort.

The perennially indecisive character of European politics, which makes it nearly impossible for European policymakers to hold one another to account, allowed the Greek situation to get out of hand. For months it seemed the most that European leaders could manage was a muddle of bluffs, half-measures, and mixed-messages. Upcoming regional elections had the Germans dithering at the rank unfairness of paying for the Greeks to retire at 55 when they retire at 67. And before long, what had begun as a bad debt problem in Greece had degenerated into a broad liquidity crisis for the Eurozone.

Then European leaders stunned everyone. They announced a massive, one-trillion dollar emergency stabilization package–a plan big enough to meet the funding needs for the next three years of every Eurozone state currently under a cloud. More significant, the plan corrects what has emerged as one of the common currency’s key institutional flaws in times of crisis: the lack of a European Treasury to back the euro. The European Central Bank has the power to set interest rates and manage monetary policy through traditional banking operations. But only a Treasury has the power of the printing press; it can issue debt. As George Soros himself (whose managers attended the doomsday townhouse lunch) pointed out in an editorial in the Financial Times in February: “A fully fledged currency requires both a central bank and a Treasury. The Treasury need not be used to tax citizens on an everyday basis but it needs to be available in times of crisis. When the financial system is in danger of collapsing, the central bank can provide liquidity, but only a Treasury can deal with problems of solvency.” With its power to issue bonds, the special purpose vehicle that the $1 trillion bailout package creates is, in effect, Europe’s new shadow treasury.

That’s where things stand today. Except, a perusal of the papers would suggest otherwise. Much coverage continues to ascribe the panic sell-off in the euro to “lingering worries” over the debt crisis, and “continuing nervousness over Europe’s finances.” Though it does seem a bit strange to judge the success of this plan by the market’s short-term reaction to it, since the whole idea is to build a bulwark against the market’s short-term vagaries. The fact that the EU has now effectively ring-fenced the PIGS (the financial community’s shorthand for Portugal, Ireland, Greece, Spain) seems not to matter. But the market is a myopic, panic-prone indicator; over the short run, it creates its own reality. What’s doubly odd is how many still haven’t shaken the habit of attributing wisdom to it.

But let’s put things in perspective. The sixteen countries that make up the Eurozone have a combined population just shy of 330 million, making it a tad larger than the US. In 2009, the Eurozone had a combined GDP just below $9 trillion euros (about $11¼ trillion). Greece, by contrast, is a country of 11 million people. In 2009, Greek GDP was about $234 billion Euros ($292 billion), according to Eurostat. That represents 1/40th of the total Eurozone output, putting it on a par with Michigan’s percentage of US GDP. We should keep this in mind as we watch the angry Greek protestors and imagine the conflagration spreading, leaving Europe a smoldering, post-apocalyptic setting for the “Left Behind” series. Without doubt, Greece will face daunting political choices as it struggles to pare back its unaffordable state sector. Yet the weight of her troubles, measured on the scale of Europe, is comparatively small.

On the whole, the fiscal predicament facing the Eurozone is no different from that facing every other major western country. According to the OECD, in 2010 Germany and France will have debt to GDP ratios of 82 percent and 92 percent, and budget deficits of 8.6 percent and 5.3 percent respectively. Italy has a larger debt (120 percent) but a low deficit (5.4 percent) and Spain has a high deficit (8.5 percent) and a lower debt (67 percent). None of this looks particularly bad when compared to the US, which according to the OECD will have a 2010 budget deficit of 10.7 percent and a debt ratio of 92 percent. And California, its wealthiest state, is not looking so fiscally sound either.

Still, let’s assume the worst case scenario. Say the Greeks ultimately reschedule their debts, as many feel they must. Now that the Eurozone has bought bailout protection from the market havoc wreaked by the “wolf pack” speculating on the likelihood of a sudden disorderly default by Greece, the EU should have enough time to analyze and implement the necessary fiscal restructuring in an orderly fashion. This, in turn, will allow the market time to discriminate, as markets do, among the Eurozone states, and to evaluate their progress in trimming their budgets–individually and relative to one another–which makes a catastrophic domino default by Greece and other southern European members a very unlikely scenario. Let’s say, then, the Greeks do in fact leave the euro, choosing the inflationary costs of currency devaluation over the onerous burdens of debt deflation. The notion that even this extreme scenario would somehow lead to the dissolution of the euro begs credulity, for it completely underestimates the level of commitment of Europe’s political class to monetary union.

More to the point, there are limits to how low the euro can go before Eurozone export growth scotches its fall. According to the OECD model, every ten percent drop in the value of the euro translates into a one and a half percent rise in the growth rate of the Eurozone. The massive export economies at the core of Europe, such as Italy and particularly Germany, heat up as the euro cheapens. And France, as the world’s number one vacation destination, hosts more tourists than there are Frenchmen. Such effects are likely to overwhelm the margins. Europe’s core economies—France, Germany, Italy and the Netherlands—combined produce 70 percent of the region’s GDP. The Greek situation, while dire, is more or less peripheral to the European economy.


None of these calculations, which can be made by anyone even a little familiar with the relative size of European economies, seem to daunt the euro-skeptics, who continue to soberly declare that the common currency is a utopian dream from which the Europeans must inevitably awake. What is perhaps not apparent from the sporadic American coverage, however, is that such critics are a fixture on the European scene. They have been grinding their organs for over a decade now, foretelling the imminent demise of the common currency. Every time there is disagreement among members or protest among voters they portray it as an existential crisis of the Eurozone. True, many of their arguments begin with reasonable critiques of the euro currency regime as it is currently configured. But more often than not, they are a mask for vested interest and ideology.

Certainly the first decade of the euro has made its shortcomings plain—we probably should have expected that an endeavor as ambitious and unprecedented as the common currency zone would never come off without a hitch. Fiscal coordination and regulatory oversight in the Eurozone have been deficient. Eurozone fiscal pacts over-emphasized balanced budgets. They were no stand-in for pan-European economic governance. Thus the overly optimistic Growth and Stability pact targeted fiscal deficits and debt levels, but didn’t ensure that members would manage their growth wisely or behave in good faith. As long as growth was robust, deficits and debt levels remained manageable. All the while, Spanish governments were enabling their frenzied property markets, and Greek governments were fudging the numbers.

But there are signs we’ve entered a new era of coordination. Last Thursday, Pierre Lellouche, France’s Europe minister, told the FT that the emergency stabilization package, “institutionalized solidarity between states.” The bailout mechanism, he argued, “is nothing less than the importation of Nato’s Article 5 mutual defense clause applied to the Eurozone. When one member is under attack the others are obliged to come to its defense.” It is, he said, a step toward Eurozone economic government. Of course, this is quite a controversial claim. But then again, the history of central banking is replete with ad-hoc solutions to unprecedented problems, which are institutionalized after the fact. Perhaps the speculators may have it backwards: the crisis may be helping cement, rather than undermine, Eurozone solidarity.

As we listen to the fund managers and pundits who benefited disproportionately from the boom and binge lecture Europeans about their debts, it is worth remembering who helped us get here in the first place. We have just come through a twenty-year boom in asset prices that fostered a complacent and short-term culture, and enabled the regulatory fecklessness that refused to acknowledge the US housing bubble, the Wall Street credit bubble, and the global debt bubble. And now the costs of all the bailouts are reflected in the yawning budget deficits and ominous debts of the developed world.

One thing should by now be clear: The seizures of the stock market and the short-term gyrations of currencies are not reliable indicators of the health of an economy; policies meant to assuage market fear should not take precedence over long-run economic and social goals. For the Euro-skeptics have got one thing very right about the European dream: it is utopian. It is a political, as much as it is an economic union, and its goals are pacifist and social democratic. “Structural reform” of the sort advocated by neoliberals has long been code for lower wages, fewer social protections, and the abolishment of the sort of programs that mitigate wage and wealth inequality–in other words, it’s wealth transfer from normal people to commanders of capital.

This is what lies behind the rhetoric (and practice) of euro-speculation. And its consequences are scrawled across societies everywhere. In the 2007 UNICEF report card, the US and UK underperformed every other economically advanced nation in measures of their children’s well-being. Any economic calculus that places the US ahead of the Eurozone, and overlooks such costs, is simply the wrong measuring stick.

Image: creative commons license

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