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Professor Roger Bowden

The Eurozone Meltdown: Part 1 – The Why and Where of the Euromess

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Economic life these days seems to shudder from one crisis to another. The US finally looks like clawing its way back from its own version of a financial nightmare, the subprime crisis. But Europe is another story. Amid the welter of media commentary, it’s harder than it should be to find a clear diagnosis and prognosis of the Eurozone convulsions. Doubly so for me, for my own views are slanted by my German hosts (for whom the rescues evoke exasperation and social guilt); and my favourite English tabloid the Daily Mail (with its English loathing for the Eurocrats and their dictatorial ways). But here goes.

The European crisis has double origins. Problem #1 stems from failure of many member nations to live up to the promises they made about good economic management. The Maastricht Treaty convergence criteria, as reinforced by the Stability and Growth Pact 1997, specified max 60% for the Debt to GDP ratio, together with a side constraint of 3% of GDP for the annual government deficit. Even France and Germany have been guilty of violations (now both at 90%), but the story really starts with Ireland, Greece, Portugal, and Spain. More recently Italy has taken up running backwards as well, a real worry as its economy is bigger than all the other four put together. A pity that, because unlike the others, Italy has quite a healthy government budget operating surplus. Their problem is a huge historical debt overhang, even now about 120% of GDP, which means that once investors start panicking, the burden of servicing the interest become crushing very quickly.

The second origin (Problem #2) is that, just to add to the woes they already had over the earlier subprime crisis and derivative exposures, European banks invested heavily in Eurozone sovereign debt and related derivatives. They did so because market yields had been dropping; and hey, this is our performance bonuses we’re protecting. As result, their balance sheets look like a disaster movie. In fact, some major players are only being kept alive by artificial suscitation (we haven’t got as far as resuscitation). For several major banks there are serious doubts about whether the life support machine will have to be turned off anyway; or perhaps just nationalised, which means more bad luck for the taxpayers.

So there we have it. The stronger nations, led by Germany and France, have to rescue their banking systems. To do that, they have to stop their southern bedfellows from falling out of the Euro. Or so they think, driven to distraction by the eurocrats who dominate both social opinion and economic decision making. Many sceptics think the Gordian knot might be cut by casting off Greece from the euro; after which the devalued drachma would solve things at a stroke. But that would write the value of Greek debt down to zero, so best to push on and hope the European banks manage to salvage a few cents in the euro (now down to just 25 cents!). Less chaotic, though I suspect it will cost just as much.

How did they all get in such a mess? That’s an essay in itself. One common theme is a massive real estate boom and the speculation that goes with it (just take a drive along any Spanish coastline, and there is the evidence, in all its ghastliness). In turn, the speculation was driven by the lower interest rates of the mid 2000’s and the imperative to generate better returns for investors. The same yield imperatives drove the European banks to pile into Greek sovereign bonds and the like.

A second theme is that governments forgot that good times can be followed by bad and failed to set aside reserves. Or became hostage to the unions; in the case of Greece driven by wage contagions like the newish Athens underground, where train drivers earn the equivalent of NZD100,000 a year or more.1

A third theme is the rise of China as a manufacturing exporter, together with an undervalued RMB. The competition was too much for the less sophisticated manufactures of Spain and Italy, hamstrung as they were with a strong Euro dominated by the more technocratic Germany economy. Together with the real estate collapse, that is why the unemployment rate in Spain is now 22%, with a whopping 48% for the youth rate.

So how to fix it? Three main institutional initiatives are now in play. The first is the European Financial Stability Fund. Its capital is subscribed by the EU nations (for which read Germany and France), and it can raise its own debt with those nations as guarantors. Last time I looked the funds available were euro500billion. This can be directly invested in wobbly sovereign debt; unlike our second source, the European Central Bank, which to date has (largely) resisted such pressures. What the ECB does instead is to provide a short term borrowing window for the European commercial banks. The banks pay 1% for the privilege and earn 3.5% on short term sovereigns, so that’s a nice little margin helping the banks under pressure to rebuild their depleted capital. The third initiative takes the form of bailouts from resurgent IMF, who would like to be even more helpful, but are currently constrained by a shortage of capital because the US and UK won’t come to the party.

The European Commission is trying to chip in on its own, by levying new taxes on the EU as a whole. In particular, they proposed a financial transaction tax, to extend to wholesale transactions as well as retail. The British saw this as a thinly disguised grab for the economic surplus generated by the City of London, a financial centre that generates about 10% of the GDP of the UK. A bit rough, as they weren’t Eurozone members in the first place. Correctly perceiving that this would decimate London as a global financial centre, Mr Cameron said no, and M. Sarkozy had a hissy fit. So the Eurozone and a few hangers on will go ahead with their own ‘fiscal compact’.

It’s all bit frightening; especially so when you try totting up all the guarantee commitments entered into by the major underpinners of the Euro, namely France and Germany, who will shortly face economic pressures of their own, probably leading to credit downgrades. Will it all work? The central problem is that to solve the budget deficits you have to restrain public spending and raise taxes, a recipe for recession that compounds the whole problem and creates social unrest.

The key is Italy. The new (unelected) Italian cabinet under Professor Mario Monti is shaping up well, though I remain a little sceptical about their policy leverage and budget saving claims. Likewise Mr Papademos, another installed2 Prime Minister, has been making good noises in Greece. My own guess is that the eurozone will not break up, though there are plenty who would disagree. But I wouldn’t bet against Greece having to leave it3.

For the thing about the jocks who sit behind screens in financial centres, and those who feed them the views on which they trade, is that they have only a limited attention span. What all the rescue packages will do is first and foremost to buy a little needed time. In the meantime, the regional governments can be persuasive enough, or simply cook the books, to show that their budget deficit looks to be on the mend. If it works, it will lessen the pressure to pay high interest rates. It may already be working for Italy.

But even if the euro does survive, European economic life as we knew it may not, for many of the problems canvassed above are not being addressed. It could theoretically work if workers in problem countries would be prepared to accept large falls in their wage and salary packets. But a more likely scenario is for a wholesale labour migration from the south into Germany and other northern EU nations. Grapes of wrath stuff, that. Expect trouble of the socio-political kind – some uncomfortable analogies with the ‘thirties and their outcome in Europe.

Well, there are plenty of lessons in all this for those of us who advocated common currencies (including the present writer). But what does it all mean for us Kiwis? On first glance, not too much. But in economics no man is an island, and that applies to nations as well. There are some gathering clouds for us that are indirectly blowing up from Europe. The second article in this series will look at the prospect of a Sino-mess, to follow the Euro-mess, and what it might mean for NZ.

  1. The new underground was built for the 2004 Athens Olympics. Someone should write a book about local authorities and economic disasters. Start with the Montreal Olympics, but don’t forget the Hamilton Super8’s. 
  2. Monti is a former economics professor while Papademos was a central banker with impeccable academic research credentials. I’m available, Jerry. 
  3. Greece has recently threatened to leave the euro if the EFSF and IMF don’t cough up the next big rescue tranche. The blackmail is directed at the Eurocrats, committed at all costs to preserving their creation. I suspect that some German and French government circles, including ECB, would just love to call the bluff. There’s a history there.