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The purpose of this two-part article is to give
readers the essential background to the economic problems in Europe and to
bring them up to date in what has become a fast-moving situation. At the time
of writing, there has been a lull in the news-flow, but that does not mean
the problems are under control: far from it.
When we talk about Europe today in an economic
context we really mean the Eurozone, whose seventeen members are the core of
Europe and share a common currency, the euro. The euro first came into
existence thirteen years ago on January 1st 1999, replacing national
currencies for eleven states (Greece joined two years later). In theory, the
idea of a common currency for European nations with common borders is
logical, and it was the work of the Canadian economist, Robert Mundell, on
optimum currency areas that provided much of the theoretical cover. However,
the concept was flawed from the start.
The euro would have made sense if the economies of
the member states had been allowed to converge, that is evolve so that they
had similar characteristics. While this was the intention from the outset,
the mistake was to put convergence in the hands of politicians and their
economic advisers, who if not representing socialist parties were and still
are all interventionists. This meant that they pursued their own national
agendas by intervening in their respective economies while paying lip-service
to the greater European ideal. Therefore, convergence was never going to
happen. The point everyone missed is that the only way convergence could
occur is if all member states relinquished government planning and control of
their individual economies, so that an undistorted free market across
national boundaries would have developed. Instead, central planning by
individual member states was the order of the day, and the control
mechanisms, limits on government borrowing as a proportion of GDP and
permitted budget deficits, were breached with impunity and the fines that
should have been imposed under the Stability and Growth Pact of 1997 were
never implemented. Today all Eurozone members are in breach, with the minor
exceptions of Finland, Estonia and Luxembourg.
The naïve ambitions behind the Maastricht Treaty
were only the start of the euro-fudge. The whole point of the euro, so far as
France and the Mediterranean countries were concerned, was to escape the
monetary straitjacket of the deutschemark, with which their individual
currencies were unfavourably compared in the
foreign exchange markets. The Bundesbank,
Germany’s central bank, was truly independent of government, and
operated with the single mandate of price stability, while the other national
central banks were extensions of high-spending governments. It was to de-politicise note issuance that the European Central Bank
(ECB) was created to be independent of all governments, based on the Bundesbank model.
However, while the Bundesbank
was focused only on price stability, the ECB relies on a wide range of
indicators to guide monetary policy. So where the Bundesbank
was single-mindedly objective in its approach, the ECB has become variously
subjective, being able to choose its statistical indicators at will. While
the ECB is regarded by most commentators as following restrictive monetary
policies, they are considerably more expansionary than the old Bundesbank. Anyway, the result was that borrowing costs
for France and the Mediterranean countries fell rapidly to a significantly
lower
margin over Germany’s,
which was taken as the "risk-free" rate. European banks geared up
their lending to benefit from the spread: locking in a one or two per cent
differential between German bond yields compared with, for example, Italian
government bonds. Gearing this differential ten or twenty times was a
no-brainer, particularly when it was backed by the implicit guarantee of the
whole system. This was party-time for banks, and was ready finance for
profligate governments, which was the underlying reason that Greece joined to
benefit two years after the start of the Eurozone.
In order to be eligible for monetary union in the
first place, the future Eurozone members had to put their houses in order to
meet the convergence criteria. For those with unacceptable debt-to-GDP
ratios, this meant shifting debt "off balance sheet", typically by
dropping nationalised industries from the national
accounts. Various other fudges were devised to make appearances acceptable
for the target year of proof of convergence, 1997. This means that even
today, declared government debt is only part of the whole government debt
story, with government guarantees, actual and implied, giving a far greater
potential problem than headline debt figures suggest.
Greece was a special case, joining the Eurozone two
years after the start. She had so mismanaged her affairs before entering the
euro that membership of the Eurozone amounted to a rescue of Greece’s
finances. Interest rates for government borrowing in drachmas had been over
20% for much of the 1990s. By 1999, when her plans to join the Eurozone began
to be discounted, short-term government debt yields had fallen to 7.25%. By
2005 they had fallen to only 2.5%, and even 10-year government bonds yielded
less than 3.5%. At the same time, Greece’s official central government
debt rose from €83.22bn in 1999 to €175bn in 2006, rising further
to €264bn by 2010. Bank lending was expanding rapidly in other
countries as well, particularly Ireland, Portugal and Spain. And it
wasn’t only government: the private sectors of these latter three
countries experienced property bubbles on the back of easy credit that sooner
or later were certain to burst.
When things are booming, politicians take the glory revelling in their supposed success. At the domestic level,
they loosen constraints on spending. They delude themselves that the boom is
the result of their economic policies, so they extend planning and controls
over the private sector at the behest of favoured
pressure groups. Most European parliaments are coalitions, whose cohesions
are bought through favours and money, corrupting
the whole political system. And at the pan-European level boom-times also
encouraged politicians to grab their share of glory on the bigger stage by
trying to outdo each other in their support of a common European ideal.
Theirs is still a world of imagined power and uncontrolled spending. The EU
budget, an expense on top of national accounts, is seen as a source of funds
for everyone to grab before the annual budget allocations are used up. The
result is that the EU budget has been unable to pass an audit by its own
auditors for the last seventeen years.
With this gravy-train in operation, it is hardly
surprising that the politicians and their favoured
appointees lost touch with economic reality. The extraordinary lack of
humility from European leaders is evidence of this, and entirely human.
Economic conditions have now changed, with fear of
deflation replacing easy money: that was before the credit-crunch and the
Lehman crisis. From then onwards, banking changed from a world of expansion,
of using all devices, including off-balance sheet vehicles and hypothecation
of collateral, to expand their lending. It was replaced with a sudden
awareness of risk, of falling
property prices and
over-extended construction businesses. This rude shock was a global
phenomenon, affecting the US and the UK as well as mainland Europe. To stop
the global banking system going into a systemic melt-down, Sovereign states
agreed to stand behind their commercial banks, guaranteeing all deposits. In
effect they were committed to underwriting balance sheets that totalled multiples of their own GDPs, turning a banking
crisis into a sovereign debt crisis.
This was bad enough for countries with their own currencies,
but Eurozone governments cannot support themselves with monetary printing,
control of this function having been passed to the ECB.1 So while the US and
UK were able to print dollars and sterling respectively by quantitative
easing, Eurozone governments were unable to do so.
1 The exception is the TARGET settlement facility,
which is described below.
2 See a research paper published by IFO at:
http://www.cesifo-group.de/portal/page/portal...Andere/...
The reason quantitative easing has been so useful to
governments elsewhere is that it allows government deficits to be funded
without paying interest rates demanded by bond markets. For that reason,
interest rates in US dollars, pounds sterling and Japanese yen can be held
artificially low despite government guarantees to underwrite their
banks’ liabilities. The further advantage of QE is that it provides
commercial banks themselves with liquidity to offset contracting balance
sheets. In the absence of QE, Eurozone governments cannot so easily address
their immediate financial and economic obligations and so they face the
scrutiny of risk-averse bond investors.
Of course, central banks are careful to de-emphasise the reasons for QE stated above. But the
publicly stated reason, which is to help kick-start an economy, is obviously
relevant where economic recovery is prevented by the actions of banks worried
about deposits walking out of the door. This problem and that of capital
flight generally is avoided in the EU periphery countries by the smoothing
operations of the national central banks, which control the cross-border
settlement system, known as TARGET (an acronym for the Trans-European
Automated Real-time Gross settlement Express Transfer System).
Money flowing, say, from Greece to Germany is
replaced by the Bank of Greece issuing euros to leave the quantity of money
in Greece unchanged, and the inflow into Germany is neutralised
by the Bundesbank withdrawing euros from
circulation for the same reason. Both trade imbalances and capital flight are
accommodated by these means, and there is therefore no net currency issuance
to accommodate them. By this mechanism local banks facing depositor
withdrawals in favour of stronger banks in other
jurisdictions are kept solvent without recourse to the ECB.2
If it wasn’t for TARGET, the ECB would have
had to step in to stop banks in the periphery countries from collapsing.
Instead, TARGET has bought time by smoothing capital imbalances, and can be
expected to continue to do so. The effect has been for national central banks
in the periphery nations to operate their own, hidden version of QE,
concealed from public scrutiny because it is offset by money being drained elsewhere
from the system, mostly by the Bundesbank in
Germany. In the accounts of the central banks, the withdrawal of money in
Germany by the Bundesbank is balanced in this
example by a loan to the Bank of Greece, and since the Bank of Greece is
guaranteed by the Greek Government, this is an extra, hidden government debt
of which bond markets are generally unaware. Loans under TARGET by the Bundesbank and other national central
banks to the Bank of Greece
at end-2011 stood at about €100bn, which is a combination of
Greece’s cumulative trade balance with Eurozone partners and capital
flight. To put this in context, Greece’s GDP is estimated to be about
€220bn, so the other national central banks are stuck with unsecured
loans on their books that amount to 45% of Greek GDP. And remember, this does
not include capital flight over the last three months, which in all
probability will have accelerated.
Other TARGET "assets" in the system at
year-end were €195bn owed by Bank of Italy (11.7% of GDP), €170bn
to Bank of Spain (12% of GDP), Bank of Ireland owes about €120bn (75%
of GDP) and €55bn owed by Bank of Portugal (30% of GDP). Exposures in
the form of loans are over €500bn to the Bundesbank,
and a further €370 to the Netherlands, Luxembourg, Finland and the ECB
itself.
These are serious imbalances, particularly for the
smaller countries, and without them not only would their commercial banks
have already folded, but asset prices would also be considerably lower. While
these outcomes have been avoided so far, growing imbalances if left unchecked
can only result in the eventual collapse of the TARGET system.
That is the essential background to the problems
faced by the Eurozone. In Part 2, I shall address how the tragedy will play
out from here.
Originally published at www target="_blank".Goldmoney.com
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