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