The PIIGS Problem: Maginot Line Economics

maginot_line_150Marshall Auerback here with a post which I originally published at New Deal 2.0.

The Maginot Line, named after French Minister of Defense André Maginot, was a line of defenses which France constructed along its borders with Germany and Italy after suffering appalling damage and casualties during World War I. The French thought they were now protected from a repeat, and believed the defenses impenetrable.

Chatting to a number of German participants at last week’s Institute for New Economic Thinking (INET) conference, we couldn’t help getting a sense of the economic parallel in regard to Germany’s deep resistance to greater fiscal expansion as means of dealing with the problem of the “PIIGS“.

The Problem:

Germany’s fiscal deficit fetishism is largely a product of that country’s own hyperinflation experience during the Weimar Republic. As deeply ingrained as that trauma remains in the German psyche, it is now taking on an almost hysterically irrational quality as evidenced by the latest “rescue package” for Greece. Its EMU “partners”, led by Greece and soon to be followed by Portugal, Spain, Ireland and Italy, are increasingly being forced to embrace Germanic-style hair shirt economics, because the obvious fiscal response is constrained via self-imposed rules inherent in the rules governing the European Monetary Union. These rules are regarded, almost to a man, as “sound economics” by Germany’s policy makers and the vast majority of its citizens (if one is to measure this via the national polls, which continue to indicate visceral hostility to “bailouts” for “lazy Greek scroungers and tax dodgers”). We wonder if they’ll still be feeling that way if the contagion extends to Berlin and Paris.

Historians all know how effective the Maginot Line ultimately proved for the French in terms of defending a German occupation of their country during the Second World War: the Germans were able to avoid a direct assault on the Maginot Line by violating the neutrality of Belgium, Luxemburg and the Netherlands, whilst the Luftwaffe simply flew over it.

Likewise, we think Germany’s “Weimar 2.0″ phobia is based on similarly flawed “Maginot Line” thinking, thereby generating a correspondingly ineffectual response to the EMU crisis. It’s becoming a story of intellectual hubris, defending “good economics”, Germanic-style, over common sense.

Judging from the market’s reaction to the 45m euro rescue package of Greece, it appears that the EMU and, by extension, the euro, have dodged a bullet for now. But the PIIGS problems remain. The terms and conditions include IMF ‘austerity’ measures, which will act to slow the economy of Greece and the entire EU — which is already dangerously weak to the point of promoting higher budget deficits through low tax revenues and high transfer payments. All of which serves to further weaken the creditworthiness of all the member nations.

It also increases the euro debts of the other contributing nations because they are being forced to contribute to this funding package for Greece. The implication of the same type of ‘rescue’ for the larger euro nations is not pretty. Expect much higher levels of stress for the remaining euro member nations presumed to be ’strong’ as the same kind of forced austerity appears in store for other “violators” of the Maastricht Convergence Criteria. Think about Spain, which now has 20% unemployment, or Ireland, which has a classic Iceland problem, given that the liabilities of its banking system vastly exceed the country’s overall GDP.

The underlying assumption of the rescue package is not sound. The stronger nations still think by offering a big enough “guarantee” the markets will take up the slack and finance Greece for them. But the markets now want to see the cash and, more importantly, they want a firm demonstration that the funding guarantees provided will help to sustain the ability of nations like Greece to service its debt without turning the nation into an industrial wasteland. The markets no longer believe in a “contingent liability” model, which is something akin to indicating that you have a rich relative who can help you out if needed. The EMU’s “rich relative” has already indicated that this is verboten, but it has denied Greece and the other PIIGS nations the means to grow adequately to service debt going forward.

The Prognosis:

The euro should therefore fundamentally remain on the weak side after a temporary bout of short-covering, as the high levels of euro national government deficits are adding the non government sectors’ holding of euro denominated financial assets. And the austerity measures are likely to increase euro government deficits and thereby exacerbates potential national insolvency problems amongst the euro zone nations.

The common Germanic retort to this line of thinking is that a default in, say, California, would no more threaten the viability of the dollar than a Greek default would endanger the euro. Perhaps, although the Lehman experience should have taught us all that the negative externalities of such an event can seldom be determined in advance, given the opacity of today’s funding mechanisms. Additionally, the United States of America is an existing NATIONAL fiscal authority which can respond to the growing problem of state insolvency via dollar creation and corresponding revenue sharing with the states. No such comparable fiscal entity yet exists in the euro zone.

Although we have hitherto characterized Greece as the EMU’s “Lehman” problem, the rescue package announced on Monday makes us that think that the better parallel for Greece might well be Bear Stearns. Bear’s “rescue” in March 2008, initially looked like it enabled the global financial markets to avert a growing crisis in the asset backed securities markets. What it did in reality was kick the can down the road, as the underlying structural problems which created the crisis in the first place remained unresolved. The credit crisis that began in August 2007 involved failure of both the liquidity and the solvency risk systems. The consequent freeze-up arose because the subsequent bankruptcy of Lehman and collapse of AIG destroyed the markets’ expectations (built up by years of bailouts) of their being an ultimate market maker, which would always be able to deal in these securitized instruments.

By the same token, the creation of a common currency via monetary union has created market expectations that one country’s paper is as good as another, which explains why, for so many years, “fiscally profligate” nations such as Italy were able to borrow at Germanic level interest rates. But the decision a few months ago by the European Central Bank to block a basic “repo” function — namely, the purchases of a number of European commercial banks of Greek government debt and exchanging this debt via repos with the ECB for German and French government paper is what appears to have initially triggered the Greek crisis and raised issues of Athens’s potential insolvency.

From what we understand, the cessation of this repo function was largely done at the behest of the Germans, who saw this activity as a kind of “back door monetization” which would lead inevitably to inflation. This, despite the fact that the entire euro zone is characterized by huge unemployment , high output gaps, and collapsing domestic consumption. All of this at the core is being driven by Germany’s pathological fear of inflation which they see as the inevitable consequence of excessive government budget deficits.

But Germany’s irrational fears of inflation are storing up the conditions for a far greater crisis down the line. The euro contagion could now very well spread to Italy Portugal Spain and Ireland, all of which (under the terms of this package) have to lend to Greece, at around 5%. So what happens to their funding costs? They go north of 5% as a next step. In the US, when good banks took over bad banks, they became bad banks themselves (see Bank of America and Countrywide). And what about the seniority structure of these loans? Do they subordinate Greek Government Bond holders? One assumes yes, but this is not made clear by the rescue package. In short, this appears to be a cobbled together solution, and it won’t work for a Spain or an Italy. There’s no clarity even on how it gets ratified. The EU says it’s done, but Germany and Holland say they need Parliamentary approval (which can easily be delayed).

Let’s be clear: in the aftermath of World War I, German production capacity was either significantly damaged, or redirected toward output required by the military. The Allied blockade further restricted imports well into 1919, and in 1923, French and Belgian troops occupied the Ruhr valley which held a good deal of Germany’s manufacturing base. All of these measures significantly restricted Germany’s capacity to produce, fueling the distributional conflict that fed the hyperinflation.

There is nothing like that today in Germany, yet “Weimar 2.0″ thinking predominates in much the same way that “Maginot Line” thinking dominated French thinking in its defense establishment. The obsession with a”defense” against the “external” threat of inflation, is blinding Germany. It doesn’t see the risk that the collapse of aggregate demand within the European Monetary Union will ultimately lead to a collapse in Germany’s export sector (a large chunk of which is the product of intra-European trade), and the corresponding extension of the “PIIGS” disease of slow growth and high unemployment to the heartland of the euro zone. We know how it ended for France, once the Maginot Line proved to be a defense more apparent than real.

We hope that Germany’s similarly “successful” defense of inflation does not lead to a comparably disastrous result for Europe today.

  1. Matt Stiles says

    “But Germany’s irrational fears of inflation are storing up the conditions for a far greater crisis down the line.”

    I could say the same about the irrational fear of deflation prevalent in many.

    Without a little deflation here and there, malinvestments build up, holders of bad debts are unjustifiably rewarded, class mobility is stifled as are entrepreneurs who seek to improve on broken business models.

    But I suppose that is exactly what financial elitists want… “Losses must be socialized, or else.”

    1. Marshall Auerback says

      A little deflation or a little inflation are not bad outcomes. But clearly we’re dealing with something more profound than a little deflation, Stiles. 20% unemployment in Spain and a virtually insolvent Ireland strike me as being more than an “irrational concern” as you express it.

      1. Matt Stiles says

        If we had allowed a little deflation over the last 2 decades, perhaps we wouldn’t have to deal with a lot now.

        And if Ireland is “virtually insolvent” they should default on their debt.

        1. Marshall Auerback says

          I don’t dispute that the persistent resort to bailouts has created much bigger problems today. As I’ve said repeatedly, I want to see fiscal resources deployed to promote employment, not provide a safety net for banking millionaires. On your second point, if Ireland defaults on its debt and then what happens? Run the causality for me. They can’t devalue their currency unless they leave the euro zone and the banking liabilities vastly exceeds GDP. It’s an Iceland problem, but even worse, given the loss of fiscal sovereignty. So what do you do? Lay it out for me.

          1. Matt Stiles says

            You are correct, it is not just government debt that is the problem. It is financial debt, consumer debt and corporate debt as well. Each country has its own issues with regards to which is most prevalent.

            There is obviously no way out of this situation without financial stress being brought on multiple parties. Kicking the can down the road and hoping to grow our way out is not an option. With aging populations in the West and north Asia, we should likely experience below trend growth for a few decades.

            For me, the solution is determined by what is just for each party. I am a fan of Steve Keen’s “debt jubilee” idea, but with the caveat that the sanctity of contract be at least partially preserved (difficult, I know).

            Who deserves to take a haircut? In my opinion, anyone who has made speculations as to the solvency of institutions that are now insolvent and only believe they will be made whole by various interventions. The “they won’t let it happen” justification. This includes:

            – Financial institutions (most should be dissolved and new ones – perhaps with new business models – should take their places)
            – Hedge Funds, Mutual Funds, even some money market funds
            – Pensioners. They have promised themselves huge sums of money for their retirement while relying on ridiculous actuarial assumptions to make good on them.
            – Asset holders (eg. real estate moguls) who have accumulated assets based on the assumption that our monetary system is a one-way inflationary superhighway.
            – Foreign creditors

            Who does not deserve to take a haircut? Savers primarily. Those, like myself, who acknowledge that asset prices are influenced primarily by credit availability rather than traditional valuation metrics, and refuse to “join the party.” Those that have lent money to solvent borrowers in good faith. And, of course, our children.

            I don’t delude myself that this is politically possible, which is why I believe this should be a legal maneuver, not a political one undertaken in each nation.

            I’m fairly certain that once one country does this, the competitive advantage of lower debt servicing costs, lower asset prices, lower wages, and lower taxes will make it a no-brainer for nearly all to follow.

            The “wealth of nations” will not be affected. Our productive capacity and accumulated capital will remain. Only paper “wealth” will be lost. “Aggregate” demand and GDP will fall. That is a feature, not a bug. Demand in certain areas for things like real estate will fall tremendously, while the resources can be redirected to more productive applications (eg. manufacturing).

            This is getting long, so I’ll cut it off here. There are obviously more things to be done to restore our economies to rationality and reforming the financial system is high on that list. But I’m not convinced there are many prerequisites to the above other than juridical will and understanding.

        2. Edward Harrison says

          Of course they “should” default but the problem is that leads to an inevitable worst case scenario in the Eurozone. The Eurozone is a big problem, much more so than in the UK, the US or even Japan.

          Here you have a country that has a very low debt to GDP number but is still in jeopardy because of the Icelandic problem (small country, large and outsized banking system, socialization of losses). In some cases, it’s worse for Ireland than it was for Iceland because of the deflationary impact of the Euro and the mismatch between national debtor and monetary authority.

          So, if and when the banking crisis hits a critical state, you have game over for national solvency. This will definitely hit UK banks in a big way. The contagion will spread to Irish property prices. It will hit German banks and likely lead to contagion in Spain and Portugal and on.

          While I haven’t mentioned the US, you can be sure that a depression in Europe means a depression in the US and that means lower property prices, foreclosures, massive credit writedowns and bank insolvencies in the US.

          More than Greece perhaps, I see an Irish meltdown as a real Armageddon scenario. It would be even worse if we were talking about Spain. The question is: what do you do? Right now internal devaluation is all the Irish can do – and use this as a pretext for a bailout if worse comes to worst.

          Very ugly indeed.

          1. standingonmelaurels says

            Someone may have to explain the “reply” system, as I appear to have no option to respond directly to Matt Stiles, who said “Pensioners [deserve to take a haircut because] they have promised themselves huge sums of money for their retirement (while relying on ridiculous actuarial assumptions to make good on them)” and then went on to say savers don’t deserve to take a haircut!

            Matt – whilst I don’t understand the part of your quote I’ve put in (brackets), I assume you are not talking about State pensioners(UK)/basic social security US pensioners and huge sums of money in the same sentence, so you must be talking about private pensions, which are -guess what- savings! So on one hand you want to save savers but on the other hand screw pensioners who have done exactly the same thing as savers and saved!

          2. Edward Harrison says

            standingonmelaurels, there are only 3 or 4 levels of reply embedding possible. So, what probably happened is you reached the last level. This is because replies are indented and can only indent so far before they become unreadable.

  2. Matt Stiles says


    Pensioners and hedge funds, mutual funds, etc fall into the category of “asset holders.” Buying an asset is indeed a way of saving, but there is obviously no guarantee on all of the principal. Right now, it is assumed that pension assets are “money good” while at the same time they project their value to rise forever into the sunset until they are needed. That is not saving in the same sense as an individual who has $100k in a chequing account. Pensioners pay a certain amount during their working days into a pension fund, who then promises to pay many multiples of what was paid. There is no ability for these funds to make good on their promises and that needs to be recognized just like sovereigns need to recognize their inability to pay all their debts and like financial institutions need to recognize their current insolvency.

    In this case, pension funds need to be liquidated or restructured with achievable payout schedules.

    Haircut percentages should correlate with the riskiness of the investment. Savings accounts would not be 100% safe either, as they are also speculations on money market funds not “breaking the buck.”

    To put it another way, I do not believe it is moral for the holders of physical currency and demand deposits – who have never expected any yield on their savings – to be forced to pay for the speculative excess of others via inflation.

    Hope that clears it up.

    1. Marshall Auerback says

      I’d go further and ban the financialisation of commodities.

Comments are closed.

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