New York Review of Books, July 12, 2010
I believe that misconceptions play a large role in shaping history, and the euro crisis is a case in point.
Let me start my analysis with the previous crisis, the bankruptcy of Lehman Brothers. In the week following September 15, 2008, global financial markets actually broke down and by the end of the week they had to be put on artificial life support. The life support consisted of substituting sovereign credit—backed by the financial resources of the state—for the credit of financial institutions that had ceased to be acceptable to counterparties.
As Mervyn King of the Bank of England explained, the authorities had to do in the short term the exact opposite of what was needed in the long term: they had to pump in a lot of credit, to replace the credit that had disappeared, and thereby reinforce the excess credit and leverage that had caused the crisis in the first place. Only in the longer term, when the crisis had subsided, could they drain the credit and reestablish macroeconomic balance.
This required a delicate two-phase maneuver—just as when a car is skidding, first you have to turn it in the direction of the skid and only when you have regained control can you correct course. The first phase of the maneuver was successfully accomplished—a collapse has been averted. But the underlying causes have not been removed and they surfaced again when the financial markets started questioning the creditworthiness of sovereign debt. That is when the euro took center stage because of a structural weakness in its constitution. But we are dealing with a worldwide phenomenon, so the current situation is a direct consequence of the crash of 2008. The second phase of the maneuver—getting the economy on a new, better course—is running into difficulties.
The situation is eerily reminiscent of the 1930s. Doubts about sovereign credit are forcing reductions in budget deficits at a time when the banking system and the economy may not be strong enough to do without fiscal and monetary stimulus.
Keynes taught us that budget deficits are essential for countercyclical policies in times of deflation, yet governments everywhere feel compelled to reduce them under pressure from the financial markets. Coming at a time when the Chinese authorities have also put on the brakes, this is liable to push the global economy into a slowdown or possibly a double dip. Europe, which weathered the first phase of the financial crisis relatively well, is now in the forefront of causing the downward pressure because of the problems connected with the common currency.
The euro was an incomplete currency to start with. In 1992, the Maastricht Treaty established a monetary union without a political union. The euro boasts a common central bank but it lacks a common treasury. It is exactly that sovereign backing that financial markets are now questioning and that is missing from the design. That is why the euro has become the focal point of the current crisis.
Member countries share a common currency, but when it comes to sovereign credit they are on their own. This fact was obscured until recently by the willingness of the European Central Bank (ECB) to accept the sovereign debt of all member countries on equal terms at its discount window. This allowed the member countries to borrow at practically the same interest rate as Germany, and the banks were happy to earn a few extra pennies on supposedly riskfree assets by loading up their balance sheets with the government debt of the weaker countries. These positions now endanger the creditworthiness of the European banking system. For instance, European banks hold nearly a trillion euros of Spanish debt, of which half is held by German and French banks. It can be seen that the European sovereign debt crisis is intricately interconnected with a Europeanbankcrisis.
How did this connection arise?
The introduction of the euro in 1999 brought about a radical narrowing of interest rate differentials. This in turn generated real estate bubbles in countries like Spain, Greece, and Ireland. Instead of the convergence prescribed by the Maastricht Treaty, these countries grew faster and developed trade deficits within the eurozone, while Germany reined in its labor costs, became more competitive, and developed a chronic trade surplus. To make matters worse, some of these countries, most notably Greece, ran budget deficits that exceeded the limits set by the Maastricht Treaty. But the discount facility of the European Central Bank allowed them to continue borrowing at practically the same rates as Germany, relieving them of any pressure to correct theirexcesses.
The first clear reminder that the euro does not have a common treasury came after the bankruptcy of Lehman. The finance ministers of the European Union promised that no other financial institution of systemic importance would be allowed to default. But Germany opposed a joint Europe-wide guarantee; each country had to take care of its own banks.
At first, the financial markets were so impressed by the promise of the EU finance ministers that they hardly noticed the difference. Capital fled from the countries that were not in a position to offer similar guarantees, but the differences in interest rates on government debt within the eurozone remained minimal. That was when the countries of Eastern Europe, notably Hungary and the Baltic States, got into difficulties and had to berescued.
It is only this year that financial markets started to worry about the accumulation of sovereign debt within the eurozone. Greece became the center of attention when the newly elected government revealed that the previous government had lied and the deficit for 2009 was much larger than indicated.
Interest rate differentials started to widen but the European authorities were slow to react because the member countries held radically different views. Germany, which had been traumatized by two episodes of runaway inflation, was allergic to any buildup of inflationary pressures; France and other countries were more willing to show their solidarity. Since Germany was heading for elections, it was unwilling to act, but nothing could be done without Germany. So the Greek crisis festered and spread. When the authorities finally got their act together they had to offer a much larger rescue package than would have been necessary if they had actedearlier.
In the meantime, the crisis spread to the other deficit countries, and in order to reassure the markets the authorities felt obliged to put together a ?50 billion European Financial Stabilization Fund, with ?00 billion from the member states and ?50 billion from theIMF.
But the markets are not reassured because the term sheet of the Fund, i.e., the conditions under which it operates, was dictated by Germany. The Fund is guaranteed not jointly but only severally, so that the weaker countries will in fact be guaranteeing a portion of their own debt. The Fund will be raised by selling bonds to the market and charging a fee on top. It is difficult to see how these bonds will merit an AAA-rating.
Even more troubling is the fact that Germany is not only insisting on strict fiscal discipline for weaker countries but is also reducing its own fiscal deficit. When all countries are reducing deficits at a time of high unemployment they set in motion a downward deflationary spiral. Reductions in employment, tax receipts, and exports reinforce each other, ensuring that the targets will not be met and further reductions will be required. And even if budgetary targets were met, it is difficult to see how the weaker countries could regain their competitiveness and start growing again because, in the absence of exchange rate depreciation, the adjustment process would require reductions in wages and prices, producing deflation.