The mindset will not change; a depressionary relapse may be coming – European version

In March I wrote an American version of this post which pointed to the bailout culture in America as a major reason I fear a depressionary relapse. American policy makers have shifted private losses onto the government’s books while propping upf bankrupt companies in the private sector in order to forestall yet greater economic pain.

The mindset is fixed on re-engineering some semblance of past economic growth. The result has been a return in the US to the status quo ante of low savings, excess consumption, indebted households, and leveraged financial institutions, but with policy options significantly diminished and greater levels of government debt to boot. Clearly, when stimulus is withdrawn, policy makers should expect more severe economic bloodletting.

In Europe, the same bailout mentality is at work. However, the results are likely to be even more disastrous because of the fundamental misunderstanding of economics and financial sector balances amongst the policy elite in Euroland. The public and private sector cannot simultaneously net save unless the Europeans engineer a competitive currency devaluation. Therefore, the Europeans’ newfound fiscal austerity is at odds with the need of the private sector to reduce debt and will likely lead to a collapse in consumer demand and depression or a trade war. What Europe needs is to allow over-indebted nations to default, reducing the political and economic pressure of austerity.

Intra-Eurozone Trade wars

Let me review how I come to that conclusion. This is a trade issue, first and foremost. The reason the Eurozone exists from an economic standpoint has to do with European interdependence from business trade. The eurozone functions as an internal market much the way the United States does, with the majority of trade occurring inside the region as opposed to externally with non-Eurozone countries.

When the Euro was formed, exchange rates were fixed and a common monetary policy came into being – much as we see for states in the US or provinces in Canada. Of course, monetary policy is not run for specific regions within the zone, but for the zone overall. And this invariably means that the European Central Bank’s monetary policy is geared more to the slow-growth core of Europe than the periphery.

During any business cycle then, current account imbalances build up within any diverse economic group living under one monetary policy as some regions overheat and others languish. This is true in Canada, the UK, and the US as well as in Euroland.

For example, slow growth in Germany has led to an export model which not only makes Germany a huge exporter world-wide but also within the Eurozone (see The Soft Depression in Germany and the Rise of Euro Populism). Because there is no built-in adjustment mechanism to prevent large trade imbalances from building up in the Eurozone, the result has been extreme and unsustainable current account imbalances within the Eurozone.

When recession comes, the regions which overheated and suffered the largest capital inflows and largest current account deficits (like Florida in the US or Spain in the Eurozone) suffer the most. Unemployment skyrockets and budget gaps open up.

However, there is no devaluation escape hatch in a currency union. In the US, Canada or the UK, severe regional economic downturns are attenuated by levels of fiscal transfers, automatic stabilizers and labour mobility that are even greater than in the Eurozone. Moreover, recrimination across regions for huge trade imbalances are more muted in Canada, the US or the UK because of an integrated national identity. This is not true in Europe.

I certainly believe California is effectively bankrupt – and has been since 2008; an eventual  liquidity crisis will bring this issue to the fore. But, I do not anticipate Californians rioting in the streets because of the austerity imposed on them by Washington and budget zealots in Nebraska, Montana or South Dakota (see Chart of the Day: State Budget Gaps 2010). California is not going to secede from the United States and form its own currency even if does run out of money and defaults. However, this is what you hear people talking about in Europe. That’s the difference.

The sectoral financial balances identity

So, there is panic in Europe and a need for fiscal austerity, much as you see in American states. There is a problem though – the sectoral financial balances identity. Now, I have come at the credit crisis largely from an Austrian economics perspective. (see my early 2008 post The US Economy 2008 as an example). The flaw in this approach is the deflationary bias and  lack of realism Austrian school solutions have regarding the political economy in depression. So I have looked elsewhere for other frameworks. One important contribution the Chartalists (MMT’ers) have made to my framing of the economic landscape during this crisis is their emphasis on the sectoral financial balances identity. The great Wynne Godley, who recently passed away was a pioneer in this research, which I now often see in the FT’s Martin Wolf’s writings as he dissects what is going on in Europe.

I have written this approach up several times over the past few months. I did so most recently in my post MMT: Economics 101 on government budget deficits which gives one insight into the accounting identities between the private, trade and government sectors when the government runs budget deficits.  I suggest you read that post in its entirety. But, the long and short of it is that the sectors must balance. Government budget deficits, then, go hand in hand with a net surplus in the non-government sector. Therefore, the Eurozone must either open up a trade surplus or it must decrease private sector savings equal to the net downward shift in government deficits. Paul Kedrosky gives us a sense of the magnitude of fiscal adjustments coming in the Eurozone and elsewhere.

Scenario one: Competitive Currency Devaluation

I outlined my thinking here in an April post and this seems to be exactly the course the Europeans are taking as of last week:

The Euro is dropping as we speak.  But, I am talking about a more serious decline. As I recall, the Euro dipped to as low as 83 cents during Robert Rubin’s strong dollar policy days.  If the EU structures the bailout in the right way (fully backstops the period of increasing debt to to GDP) and floods each country with liquidity (aka prints money), you are sure to get this kind of outcome. Everyone gets a massive boost to competitiveness. Problem solved.

However, the Germans would never go along with this ‘weak currency’ strategy.  Moreover, the Americans would cry bloody murder because this is a competitive currency devaluation of the entire Eurozone.

To date, I have talked about the EU as a external-deficit neutral block.

you can’t have Germany and Spain both running current account surpluses, unless the EU as a whole runs a current account surplus. So, if Germany (or the Netherlands) wants to be the export juggernaut and run a massive current account surplus, this has intra-EU ramifications. The most important is that Germany’s (or the Netherlands’) current account surplus (capital account deficit) is matched by current account deficits (capital account surpluses) in Spain (Portugal, Greece, Ireland and Italy).

-Spain’s debt woes and Germany’s intransigence lead to double dip

But, if the Euro fell to parity with the US Dollar for example, the Eurozone would become a net exporter, pushing the US external balance even more into the red.

Twenty-first century competitive currency devaluations

The problems I saw with this scenario were German and foreign resistance to it.  In fact, the two German members of the ECB rejected the money printing aspect of this scenario (note the ECB says they are sterilizing sovereign bond purchases because of these kind of objections. But, I have my doubts). Nevertheless, this does seem to be the way forward in Euroland – and this has the Euro down near $1.23 as I write this.

So, the Euro is falling precipitously as I said it would if Euroland adopted this strategy. Will the Chinese and the Americans go along with this beggar thy neighbour strategy? I say no. But, let’s see. Clearly, this allows Europe to recover at the expense of everyone else. Already the Chinese are voicing their displeasure:

Pegged to a rising dollar, the yuan has appreciated against a trade-weighted basket of currencies in recent months, which many analysts believe could constrain the scope for a possible revaluation of the Chinese currency.

Commerce Ministry spokesman Yao Jian did not say how dollar strength might affect a long-awaited move to resume yuan appreciation, but he highlighted the impact of the weaker euro.

"The yuan has risen about 14.5 percent against the euro during the past four months, which will increase cost pressure for Chinese exporters and also have a negative impact on China’s exports to European countries," he told a news conference.

The yuan hit its strongest level against the euro since late 2002 on Monday as the euro tumbled against the dollar on global markets. The yuan was quoted at 8.3815 against the euro, versus Friday’s close of 8.5351.


Of course, what is good for the goose is good for the gander.  Let’s see what the Swiss or the British do next. This is not a depressionary scenario for Europe, but game theory suggests there will be a response from trading partners.

Scenario two: Private Sector Defaults

The only other way that the Eurozone can bring down the government’s fiscal deficits is through a reduction in savings across Euroland.

A friend Andrew sent a chart to a group of us which shows how indebted the household sectors are across the Eurozone – even in supposedly conservative Germany.


Austerity means lower aggregate personal income. So, reduced savings that emanate from budget cuts keep debt levels high and are driven by distress.  And that invariably means higher levels of defaults in the private sector.  This would be a particularly pernicious outcome in places like Spain and Ireland where the banking sector is carrying a lot of unrealized losses on its books.  Moreover, even the Germans and Dutch will feel this loss, particularly through reduced demand for exports. The result as I allude to in Spain’s debt woes and Germany’s intransigence lead to double dip is depression.

Bailouts all around make it worse

So, pain is coming to Europe, and, due to the Eurozone’s importance, to everyone else too. Policy makers in Europe are completely blind to the accounting identities of government deficits and non-government surpluses. So, instead of realizing that Greece cannot fulfil its debt obligations and undergo fiscal austerity at the same time, they are trying to prop up their banking sector with bailouts.

Apparently, Germany is now planning to make loans for Greece not just for 2010, but for 2011 and 2012 as well. This is a sea change in German thinking and is having a positive effect on all markets, with spreads on Greek debt and Greek sovereign CDS both coming in.  I believe this indicates Angela Merkel understands the gravity of the situation and the impact a Greek default would have on Germany.

Yesterday, I noted that the Germans are now talking publicly about German bank exposure to Greek sovereign debt. And earlier today Yves Q. Smith noted that a Greek default would be a catastrophic loss for the lenders. She quotes from the S&P’s press release on their downgrade of Greek debt to junk:

The outlook is negative. At the same time, we assigned a recovery rating of ‘4′ to Greece’s debt issues, indicating our expectation of “average” (30%-50%) recovery for debtholders in the event of a debt restructuring or payment default”

Now, we know that the German Landesbanks probably have a shed load of Greek debt on their books.  Moreover, the state of their capital base is very precarious indeed.  Think back to early last year when we were not discussing the potential impairment of Greek debt, but of losses related to US subprime and commercial real estate more generally. The Telegraph wrote a sensationalist story based on some leaked documents about the fragility of European banks. The details may be suspect but directionally, this is the real problem.

Germany may fund Greece for three years; the question is why

But, not only are the Europeans propping up these German and French banks, they are refusing to take a haircut. I agree with what Claus wrote last week:

[T]here are some things that still bug me.

Firstly, it should not escape us here that what our dear policy makers effectively are doing is fighting fire with fire. Debt will thus be substituted with even more debt and it is not clear just what the end game is supposed to be. However, one thing which is now crystal clear to me is that if there is any way that the EU and the Eurozone are to get out of this in one piece it will mean a much tighter coordination of fiscal policy. This will require a monumental rethink of the EU setup, and, while I believe that the joint effort of EU policy makers could indeed be pooled to make this happen, the chance of it actually materialising is slim. In this sense it will be interesting to see what exactly fiscal coordination (if any) will mean now that Eurozone economies are jointly asking the market for funds to pool in that loan guarantee entity.

Secondly, the introduction or implementation of all these so-called austerity measures are not linear and we can’t feed them into linear models and expect these models to come up with usable results. In this sense, and abstracting a minute from the general risk of doing too little too late, the road ahead is very difficult. On the good side it now appears that Spain and Portugal have awoken to the fact that they too need to turn the screw, and that what ultimately distinguishes them from Greece is merely market timing. This is universally good news, but it this is only the statement of intent. In fact, before we close the book on 2010 this is all we are going to see since the 2010 budgets (already passed) are thoroughly in the red. The biggest problem here is simply that, for all the good intentions in various EU commission and IMF proposals, the actual process of implementation on the ground may prove near impossible. And here I am not talking about some innate laziness or non-voluntarism on the part of the Greek, Portuguese and Spanish people; I am simply talking about the near impossibility of letting the entire burden fall on internal price and competitiveness adjustment from within a fixed currency union; but this, of course, has been the main issue all along. As I noted in another context, any state can only take so much of having to fight its own citizens with water and teargas week in and out even if they are trying to do good.

The considerations above have slowly, but surely convinced me that, while I support the efforts by EU policy makers (both in spirit and in terms of the technical measures), I have increasingly converged on the idea that some form of debt restructuring in Greece (and possibly elsewhere in EMU) has to be included in what we could call the main scenario going forward.

The Eurozone Bailout – Are We Still Standing?

Expect a sea change in government

Eventually, the Europeans will understand this. However, by then, things will have spun entirely out of control and the situation will be much worse. The likely outcome for Europe, therefore, is depression and the attendant social unrest that goes with it. In essence, the Europeans are imposing an Austrian school-style solution on Euroland.

We cannot sit by and watch this crisis liquidate assets, taking down good companies with bad, throwing people out of work, wreaking havoc on their lives, and leading to a brutal and painful downward spiral of asset and debt deflation and depression.  This is not a prescription for success, either economically or politically.  This is the prescription for chaos, turmoil, civil unrest and perhaps worse.

However, this is what the Austrians would have us do in the present downturn.  It is the same wrong-headed prescription given to the Asians in 1998 and to Argentina in 2001.  We squandered an opportunity for fiscal prudence when the economy was on more solid footing.  With depression on our doorstep, is now the right time to start cutting back?

This would mean liquidating General Motors, bankrupting Royal Bank of Scotland and Citigroup or allowing Iceland, Hungary and Pakistan to fend for themselves.  In theory, each of these measures seem prudent.  But, in practice, these measures would result in huge job loses, would induce further deleveraging and asset price declines, would deplete capital from an already fragile global banking system, and would lead to a probable depression of unimaginable severity.  It is in such a bleak environment that dangerous despots and dictators like Hitler and Mussolini rose to power, taking advantage of the natural human need for ’strong’ leader in a time of chaos and uncertainty.  Could we expect any different today?

Confessions of an Austrian economist

And my thesis about the connection between political extremism and depression has been confirmed by recent research. I will end this post with the conclusions from that research in The OECD’s growth prospects and political extremism.

Our main finding is that higher per capita GDP growth is significantly negatively linked to the support for extreme political positions. While estimates vary between specifications, we find that roughly a one percentage point decline in growth translates into a one percentage point higher vote share of right-wing or nationalist parties. Moreover, we find that the amount of income inequality in a country affects the role that growth plays. Highly unequal countries display a lower growth effect than more equal countries. For countries with a more equal distribution of income, a one percentage point drop in the growth rate may increase the vote share of far right parties by up to two percentage points.

Our results therefore make clear that countries should not expect right-wing parties to get majorities unless growth declines quite as much as in the 1920s. Nevertheless, even with a less significant fall in economic growth rates, a rise in support for extreme parties is likely to change political outcomes – for example through their impact on incumbent parties’ political platforms.

Our more recent research on the vote shares of other groups of political parties points out that smaller growth rates mostly benefit right wing and nationalist parties – and not so much the communist parties. One explanation for this asymmetry may be that voters perceive right wing parties as generating more individual income uncertainty.


Our results lend support to Benjamin Friedman’s view that economic growth determines the direction in which a democracy develops. This also implies that solving Europe’s growth problem may have important consequences that lie outside the purely economic sphere.

  1. Daniel says

    “Nevertheless, this does seem to be the way forward in Euroland – and this has the Euro down near $1.23 as I write this.

    So, the Euro is falling precipitously as I said it would if Euroland adopted this strategy. Will the Chinese and the Americans go along with this beggar thy neighbour strategy? I say no. But, let’s see.”

    Erm, at 1,23 the euro is still a bit overvalued. It reaches fair value at 1,15

    If the market decides that the euro should overshoot to the downside and become a cheaper currency, I can’t see how anyone has the right to intervene. Nobody intervened in 2008 when the euro became one of the most overvalued currencies on the planet and screwed european exporters (which made the spanish recession even worse from the beginning)

    1. Edward Harrison says

      Yes, the Euro is clearly overvalued on PPP on the Big Mac Index or whatever other measure you prefer. After all, it did come into being at 1.17. I agree that an overshoot is likely. The problem for the US of course is that the Obama Administration has said it wants to increase exports as a strategy to aid recovery and decrease deficit spending.

      Who are the Americans going to export to? To be continued…

      1. Olivier Travers says

        As I wrote in the previous thread, this is America’s problem, not Europe’s. The US had years with an extremely cheap currency yet kept digging its current account deficit. Let them eat brioche. All along the aberration was EUR at 1.5+ USD.

        1. Edward Harrison says

          By the way, we may be getting ahead of ourselves in any event because dollar-euro parity is not a fait accompli despite the Euro’s present over-valuation. Jim O’Neill has been saying that he thinks the parity talk is overblown. At a minimum, I would expect some serious counter-trend rallies before we got there.

      2. Daniel says

        “Who are the Americans going to export to?”

        Well, the USA aren’t the only ones who would like an export lead recovery. I just can’t accept that the export recovery is on the way because the dollar so undervalued in comparison to the euro. That’s simply a beggar thy neighbour strategy, nothing else.

        1. Edward Harrison says

          I may have to write something on the original Great Depression version of beggar thy neighbour competitive currency devaluations. But this is a natural outgrowth of a world in depression, with every nation looking for some way to gain a leg up.

          In a anti-growth economic environment – which fiscal austerity clearly is – everyone will look for alternative ways of boosting growth, even if it steals growth from someone else. I think that is a major lesson from the Great Depression.

          The pre-conditions are moot on some level. Yes, the Greeks had reckless fiscal management. Yes, the American household sector overspent. Yes, the Australians have had a property bubble. Yes, the German have been in no-growth mode for a decade. And Yes, the Chinese have huge amounts of malinvestment. All of that is irrelevant to a politician who is likely to be blamed for collapsing growth prospects. They will do anything to stop this. If we re-enter recession globally, it will be every nation for itself.

  2. Slayer says

    I don’t know why every non-EU member tells me that the EU is not a transfer union.IT IS!!!!The only reason why countries have been in it for so long was because of regular payments done to countries with a huge structural deficit. Ten years ago, these payments went to the now-crisis-countries (PIIGS). Since then, the payments are largely going to the eastern european block of countries. You see the correlation to the crisis intensity? To compensate for structural deficits, we instead ALLOWED these deficits and STILL ALLOW THEM to go on with these payments!And then there are all the European banks who made plenty of loans to Greece to get a good rate of return on their investments…. most importantly the french banks (now you know why Sarkozy threatened to leave the EU — because he has no bank regulation whatsoever (seemingly) and the Greece default would probably have made it as worse as if leaving the EU…). And some Italian. And then some German ones. And the kfw German bank to support development in the EU zone. Many of these banks were entangled with political interests (German Landesbanken, kfw etc.).You see what is going on? It is BECAUSE OF THESE POLITICALLY INSPIRED TRANSFERS why these states are now in such a mess.THIS IS NOTHING ELSE THAN BRIBERY ON AN INTER-COUNTRY-LEVEL, one thing the EU politicians are really known for among EU citizens….

  3. Blankfiend says

    Ed – great work! 10/10.

    IMO, France is the country to watch here. Their long-serving debt cloaking device seems to be losing efficacy, their market is crashing, and their 5 yr CDS went up 9% today.
    Meanwhile, Angela Merkel and Wolfgang Schaubel are talking about Schuldenbremse – a very austere minimal deficit proposition for the EU. The French, with their history of riots and strong civil employee unions, are very unlikely to submit quietly to budget austerity measures, much less those seen as being dictated from Berlin.

    1. Olivier Travers says

      Word (pun intended). “Rigueur” and “austérité” are taboo words in France (it’s been resurfacing in the semantic public debate lately). It reminds people who voted for Mitterrand in 1981 that his socialist program crashed hard and fast, which led to fiscal adjustments. People still want the free ponies they’ve been promised though. Chirac didn’t support Juppé in 1995 when push came to shove (a critical pivot in this 30-year cycle), and Sarko is Minichirac for most practical purposes.

      French public debt/gdp in 1981: just above 20%. In thirty years this has almost quintupled *before* most government-employed boomers even retired. I spent hours putting that data in a spreadsheet a decade ago and decided to leave the country – even then the trajectory was well established. As I’m writing this from my house in Chile with a view on the Pacific, I’m patting myself on the back.

      1. Blankfiend says

        C’est chanceux!

        Of note, the Markit CDS rate for France went up to 76 from 71 yesterday. As of this writing, it is back down to 72.

  4. Swedish Lex says

    Good post, unfortunately…………Thanks.

  5. David Merkel says

    When governments are indebted to the tune of 4x GDP or more, liquidation/default becomes a requirement, not an option, because the other options (borrowing more, taxing more, cutting spending) are infeasible.

    1. John Haskell says

      the highest debt/ gdp in the world is Japan at 200%. The UK got up to 300% in the aftermath of the Napoleonic Wars (and that debt was incurred and repaid in gold!) but I am not aware of any country, at least going back to the Cambrian period, that got up to 400% of GDP.

      1. David Merkel says

        You have to add in the unfunded promises:

        1. John Haskell says

          “Promises, promises, you knew you’d never keep.” -Naked Eyes

          Obligations are obligations (a government accepts your money in exchange for undertaking an obligation). Promises are just promises and do not have to be added. They just get adjusted away when they become too burdensome.

      2. mikekasky says

        You don’t have to go as far back as the Cambrian. Ireland, Switzerland (???) and the UK are indebted above 400% of their GDP.

        1. John Haskell says

          the article you link to proves absolutely nothing of the sort. So Irish entities have f/x obligations of 1200% of GDP. So what? Iacono carefully neglects to mention any f/x assets. If Iacono’s article were printed you could use it to wrap fish.

    2. mikekasky says

      What makes a whopping 400% external debt as percentage of GDP a bad thing? With interest rates near zero, why would you rise taxes (Switzerland has enough room to do so) and forgo growth? The biggest killer right now would be extreme austerity.

  6. mikekasky says

    Great post but a little bit too extremist. By that I mean that there will be no either or scenario (either scenario 1 or 2). It will be a little bit of everything, it will be patchwork and incremental moves, and it will look like nobody is really knowing what they are doing.It will be distinctively European. Despite the worst crisis since generations, everyone will keep on bargaining like they were on an oriental bazaar. In sum, it will be the right mix of spending to prop up output with stringent austerity measures elsewhere. This would be my scenario.Of course, the ECB could transfer money to every Euroland citizen with the obligation to spend it in the zone within 12 months. This would be the ultimate stimulus package. It will create jobs, more tax revenue and growth. But for some reasons, no one is buying into this. Why?

  7. merocaine says

    The public and private sector cannot simultaneously net save unless the Europeans engineer a competitive currency devaluation.

    Read more:

    What makes you think Europeans don’t understand this?
    A cheaper currency, internal devaluations, budget cuts, the ball is already rolling on this.
    If saving the Eurozone depends on a beggar thy neighbor policy I don’t think anyone over here will hesitate, why should they?

    1. Edward Harrison says

      Oh, the Europeans definitely understand the two scenarios I laid out and are moving on both fronts. As Mike Kasky says, it is a bit of both that they are attempting to pull off (without admitting for now that a default is inevitable for Greece at a minimum). You can see the depreciation side in my post from yesterday derived from a French-language article in Les Echos:

      And I should point out that the Europeans are following the model set by Japan, the UK and Switzerland who all have been printing money or intervening in currency markets to depreciate their own currencies. The Euro is STILL overvalued at 1.23.

  8. charlescecil says

    Two days ago I asked my colleague the following: What economic argument is there that the Euro should be valued more than the Dollar? Conversely, what economic argument is there that the Dollar should be valued more than the Euro? For my part, Ed H’s writings speak to the superior resiliancy of the U.S. economic (and political) structure when compared to the Euroland and so, in a time of economic imbalance-duress, I will expect the U.S. to perform better in righting its ship, and bet the Dollar higher over the Euro.

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