Keywords

Iceland; Latvia; Argentina; Ireland; Britain; Germany; fiscal discipline; fantasy economics

14.1 Iceland Comes Up from Under

Prior to its descend to the abyss in 2008 due to business expansion without limits and associated gambles by its three bigger banks, Kaupthing, Landsbanki, and Glitnir, Iceland was one of the richest nations in the world (in terms of income per head). The bankruptcy of these three mismanaged banks saw to it that this is now history, one of the calamitous results of financial deregulation.

The election which took place in Iceland right after the deep banking crisis had much to do with the punishment of the wrongdoers as well as with public acceptability of austerity needed to turn around the disaster left by the banking scam. But even if the measures which followed were largely about economic restructuring, fiscal consolidation, and debt reduction, the legal consequences should not be overlooked because they are a lesson for other, bigger countries.

Within 3 years after heaven broke loose, Iceland became the first country to put on trial for the crisis the political leader under whose watch the deep banking crisis took place. Bringing to justice is a solution highly recommended to all nations who have the misfortune to be led by politicians who accept (and often cover) acts which are corrupt and damaging to their nation’s fortunes.

The small northern Atlantic nation also offers live evidence of the advantages of an indebted country to simply let its banks collapse and default on their loans. The citizens who have been asked to underwrite against their will the banks’ huge losses would like to know through evidence presented to the court:

These queries reach deep into the soul of a nation and of its leadership. Unanswered questions still remain all the way from the 2007 subprimes scam in America—for which nobody was brought to justice—to the blow up of the Greek sovereign debt which reached for the stars in 2010, and so many other cases. Precisely because of this reason Iceland’s travails, as well as its recovery from the shock of the banking crisis, matters much more than might suggest the size of its small economy with a 320,000 population.

On trial went the man who ran the country from 2006 to 2009—the calamitous years of Icelandic banks running wild. “It is one of the big things that need to be dealt with … before the country can return to normal,” said Steingrimur Sigfusson, minister for economic affairs.¹ The former prime minister faced 2 years in jail if found guilty. Most significantly, however, this was the first of a series of legal procedures against people allegedly responsible for the crisis which led to a 700 percent increase in unemployment.

For its part, the trial of the Icelandic bankers began in early 2012, in sequel to a wide-ranging criminal investigation conducted against reckless financiers responsible for the country’s economic collapse. In February 2012, Iceland’s special prosecutor’s office charged Hreidar Mar Sigurdsson, Kaupthing’s former chief executive, and Sigurdur Einarsson, the bank’s former chairman, with fraud and market manipulation.²

“This is an important step for the country,” said Olafur Hauksson, the special prosecutor. “The public has been calling for justice to be done, and I think it will be a relief to see the courts dealing with these cases.”³ The Icelandic public seemed convinced that criminal charges against politicians and the banks’ alleged looters and mismanagers will matter little if the economy does not continue to improve. Hence, in parallel to disciplinary action, it did its utmost to:

Ethical standards require that wrongdoers, including politicians and bankers, are always brought to justice and from there, it found guilty, to prison. But nowadays in the West (though not in Iceland), the State Supermarket issues indulgencies. Nobody who has the inside track to the system’s benevolence is being punished. To this benevolence, Iceland is an exception.

It used to be quite different when ethics had a place in the western world. In their book Free to Choose, Milton and Rose Friedman make reference to the Bank of the United States which on December 11, 1930, at the time of the twentieth century’s Great Depression, folded up. The Friedmans say that this was a tragic event to the bank’s depositors, but justice was on the heels of wrong doers.

Two of the owners were tried, convicted, and served prison sentences for acts which were technical infractions of the law.”⁴ Technical infractions are a lighter case of malfeasance. Today, even very serious infractions go unpunished because in a society of widespread entitlements people came to admit the “right of looting” as God-given. All but forgotten is the old wisdom that:

The Icelanders acted the right way, on both bullets and they did not throw Molotov cocktails when the government said that everyone has to pay the cost of the damage. Since the collapse of the Icelandic economy in 2008, the average household has suffered a 30 percent fall in purchasing power. It became difficult to make ends meet as household debt exceeded previous percentages of disposable income, and corporate debt previous percentages of GDP. All parties, however, worked hard and eventually they were able to restructure their balance sheet.

Unlike the citizen of Club Med countries, the Icelanders did not descend to noisy (and useless) protests down the streets. Wisely, they decided to rebuild their economy rather than wait for somebody else to come to the rescue. Even the loans offered by IMF and Scandinavian countries were small, and therefore they could be easily repaid. The Icelandic economy shrank by 7 percent in 2009 and by nearly 4 percent in 2010, but by 2011 it turned the corner.

The island nation’s recovery has been led by fishing and tourism, helped by the boost to competitiveness from the 50 percent devaluation of the krona against the euro in 2008. Icelanders did their best to attract tourists. They did not go on strike to screw the tourists—like Greeks did from taxis to ferries—and the fact that inland prices remained fairly stable, in spite of the devaluation, did help as tourist numbers reached record levels.

The lesson learned from this experience is that the more sure way to recovery is working harder. As for the country’s new government, it abided by the IMF’s guidelines providing a model of crisis management. The GDP expanded by a respectable 2.5 percent in 2012. This contrasts starkly to the contraction in Euroland’s Club Med wounded economies.

The Icelanders are right in believing that a nation cannot borrow their way out of trouble. While it is true that growth is essential to restore fiscal sustainability and prune the sovereign balance sheet, growth can never be created by handouts. Handouts end in pockets. Growth requires both public and business confidence, investments stimulating the economy and structural reforms.

14.2 Contrarian Opinions on Iceland’s Escape from the Abyss

Iceland’s example of coming up from under in four short years is a lesson for all of Europe, and most particularly for Greece, Portugal, Spain, and Italy. Politicians have to face up to simple truth: past is past, but its legacy has to be confronted. In doing just that, governments find out that nearly every method has advantages and downsides.

European countries were accustomed to set the terms of engagement with most of the rest of the world; therefore, economic and social structures were framed accordingly to that principle. Today, however, it has become hopelessly outdated. The rise of developing countries turned the old rules and assumptions on their head; many of them were scraped, others are still around. Until mid-2012 Iceland’s, Latvia’s, and Ireland’s examples could be looked at as the new paradigm of coming up from under in a severe economic and financial crisis; also as a reminder that half-way measures don’t work.

Not everybody is in accord with the thesis I have presented. “Is there an Icelandic model for dealing with failing banks? My conclusion is mostly no,” says Már Gudmondsson, governor of Sedlabanki, Iceland’s central bank. “There is lot of misunderstanding about Iceland.”⁵ As Section 14.1 brought to the reader’s attention, in 2008 Iceland’s three largest banks whose total assets are 10 times the size of the Icelandic economy were permitted to fail. Here we have two models, in one go:

Revealed postmortem, a downside of Ireland’s method is that, according to the OECD, Iceland spent more as a percentage of GDP than any other country (apart from Ireland) in rescuing its banks. Allegedly, the banking crisis cost Icelandic taxpayers 20–25 percent of GDP, largely because of the loss in value of collateral that the three collapsed banks had pledged to the central bank when the latter was trying to save them. There have as well been other consequences.

Critics for instance say that trade improvements from the falling Icelandic currency have not been as important as many predicted. To the opinion of the central bank’s governor: “The level [of the currency’s exchange rate] does give stimulus to exports, that is absolutely true. But export growth has been lower than you would expect given the depreciation. Even if you depreciate the exchange rate you can’t create more fish.”⁶

Gudmondsson has put his figure on a crucial issue associated to the result expected from a major devaluation, which economists tend to forget. If Greece, Italy, Spain, and France were having their own currencies and they devalued—rather than being constrained by the euro—would they have solved their problems? For instance:

Following the 9 percent devaluation of the pound in recent past, in Britain the discussion has been that if there are limits to what can be achieved through genuine QE, there are also limits to benefit from weakening the pound. Three cheers for a sinking pound, suggested Martin Wolf, the economist, in a Financial Times article. Really? Answered other economists, who contested Wolf’s thesis.

The question several economists posed to themselves has been: How would the British economy react to further weakness of its currency in a globalized world? We are not in the late 1920s and early 1930s of competitive devaluations among western nations. For those who look at a cheaper currency as a salvation, the input from Iceland is not positive, let alone data from the pound’s 25 percent devaluation in 2007–2008.

In terms of the real traded goods balance, in the course f the 2007–2008 event, the capital and intermediate goods balances have proven to be insensitive to the currency move. More precisely, the real trade balance in cars improved while that for consumer goods declined. Neither had a 25 percent devaluation an impact on British appetite for Chinese consumer goods.⁷

If 25 percent devaluation sounds “small,” let’s return to that of the Icelandic krona. Right after the crisis, it fell by more than 50 percent against the euro. This evidently boosted the cost of imported goods, lifted consumer prices, reduced incomes, and (evidently) increased unemployment. Financially, the Icelanders say, the sinking krona has been a double-edged sword—as most Icelandic loans were linked to inflation.

Last but not least, when Iceland imposed capital controls after the property bubble burst, which was the alter ego of its three bigger banks collapsing, the prevailing political opinion was that the measures being taken will be only temporary. They were not. Moreover, the fact of splitting the Icelandic big financial institutions into “good” and “bad banks,” dented the confidence the common citizen had to the banking sector.

There have been as well collateral issues. The stabilization of the currency provided an important reason for control over the movement of capital out of the country, while the government also targeted legacy foreign investments in Icelandic securities. The next unexpected consequence was that capital controls had a negative impact on the economy:

In 2008, FDI collapsed and it remained about a quarter below the precrisis level. Summing up, the restrictions and controls imposed by the government to redress the country’s financials hit hard the common citizen. The fact that instead of being temporary controls became sort of permanent was one of the reasons which led to the debacle of the governing socialist party in the April 2013 election. Hence, yes, Iceland is still a good example but not as good as it seemed to be a couple of years ago.

14.3 Latvia Is Much Better-Off than Argentina

The case of Latvia proves what has been said in Section 14.1 about the “will and the way” the Icelanders found to bring their economy up from under. In 2008, the Latvian economy suffered from massive overheating, confronting the government with the option of devaluing the currency.⁸ The decision has been to hold the peg, and to do so without going hat in hand to richer nations for loans and handouts. The way has been:

Latvia has not been a member of Euroland to ask for handout from the ECB and from Brussels.⁹ Like Iceland, it has been able to withstand alone the shock of a massive bankruptcy of its big banks, and come back to a normal economy paying its debt to IMF and to Sweden ahead of time—indeed, almost 3 years earlier than the deadline.

In a nutshell, the Latvian recipe has been smaller income cuts for the poorer segment of the population and higher taxes for the more wealthy, accompanied by substantial structural reforms. The exchange rate of the currency was not changed, and no massive loans were contracted. The shakedown was not that long. In about 2 years, the economy started moving again.

According to the opinion of several economists, it was not austerity that caused the output fall in Latvia, but the liquidity freeze of September 2008. From 2000 until 2007, the country’s GDP had grown by an impressive 83 percent, which was unsustainable. This annual (nearly) 12 percent rise, however, provided a cushion for 2 years of output fall. In retrospect, the Latvian government was right to believe that a devaluation:

Indeed not only Latvia but as well Estonia and Lithuania, the other two Baltic countries, have successfully undergone internal devaluation. Wages and GDP per head shrunk by a quarter or more in order to regain lost competitiveness. The successful result sharply contrasts to the Argentinean experience (more on this later) as well as to what has followed the euro crisis.

Greece, Ireland, and Portugal have imposed swinging budget and wage cuts and other unpopular reforms on their voters. To come up from under, Spain and Italy now have to do the same. None of them learned anything from the Baltic and Icelandic experiences. Instead, they thought that they have a rich aunt in Berlin who should pay for all their profligacy and misconduct.

The failure to study all of the options, their costs and aftermaths is a serious mistake. Used properly, lessons from a past experience worth a great deal. While one should never uncritically cut and paste bygone circumstances to apply them to the new realities, plenty can be learned from what was done and not done, provided there is no:

All four events have happened in Argentina from 2001 to 2012 which is a paradigm to avoid. Successive governments did almost everything wrong. They defaulted, turned their back on alternative solutions at an early stage, adopted an aggressive position with their creditors, spent many years defending extensive litigation, and ended by being excluded from the international markets.¹⁰

They also made a joke of currency stability, even if a template which adorned the lobby of Argentina’s Central Bank, proclaimed that its “primary and fundamental mission is to preserve the value of the currency.” At the end of March 2012, this template was removed after the Argentinean Congress approved a government bill that gives the bank a new, wordier mandate:

To promote, to the extent of its ability and in the framework of policies established by the national government, monetary stability, financial stability, jobs and economic growth with social fairness.

Sounds familiar? Here we are with another central bank turned into employment Santa Klaus. Ben Bernanke finds imitators. Like the Fed, the monetary institution of Argentina lost its legal independence and became the piggy bank of the government. Conflicting goals given by parliaments and governments to central banks are a dime a dozen these days.

As for the Argentinean people they are de facto condemned to deal with this drama and uncertainty. So are the citizens of Greece, Portugal, Spain, and Italy whose governments asked Euroland for help rather than choosing the much safer self-help like Iceland and Latvia did.

Since the 2001 default of the South American country arranged nothing for long-suffering holders of devalued and restructured government bonds, analysts advise setting very low expectations regarding Argentina, assuming:

There has been no economic rebirth as in Latvia and Iceland whose choice was to take their fortune and their future in their own hands. By contrast, Argentina’s default sparked social unrest and runs on banks. It dirtied the country’s name and that of western banks that pushed its bonds down the throat of their clients. (A case in point is 60,000 middle class individuals in Italy, advised by their banks to buy Argentine bonds as the best retail investment.)

Club Med countries, but not the Baltics or Iceland, have confronted a similar problem to that of Argentina, with overcoming entrenched opposition to structural changes, supported by corrupt politicians. The other disturbing similarity between Club Med countries and Argentina is the resort to short-term liquidity fixes for long-term solvency problems. This means that the moment troubles brew up, investors rush out of the same door and the countries depending on short-term financing are cut off the capital market.

Long-term financing for longer term commitment is the way to successfully recover one’s freedom of action. This must be translated into the common economic language, to be learned and used by all its member states. There exists always a unifying power of a common language. As Latvia and Iceland demonstrated, an important element of a common economic language is how to suffer and recover all alone.¹¹

Working along these principles, the people of Latvia labored to recover their wealth. The economy resumed growth, expanding about 5 percent in 2012, the EU’s best figure. With a 2012 budget deficit of only 1.5 percent and public debt at 42 percent of GDP, Latvia’s finances are the envy of many countries. But there is also a puzzle.

On January 31, 2013 Latvian lawmakers flew in the face of public opinion by declaring a path for the Baltic nation to apply for Euroland membership starting January 1, 2014. According to a December 2012 poll, two-thirds of the country’s citizens oppose this move, and some parties wanted to sink the plan with a referendum. There was a protest rally in Riga. “Latvia should not provide aid for ailing euro-area nations” was one of the panel’s slogan. “If the EU collapses, it will be easier to recover without the euro,” stated another.

But there exist as well embedded interests, while Estonia provides a precedence. The Latvian government’s bet is that adoption of the euro will boost private direct investments in a country where more than 80 percent of loans and more than 40 percent of deposits are denominated in lats, and where labor costs have been brought down to competitive levels.

This does not change the fact that if Latvia now joins the euro, this will be at the worst possible time—at a time the common currency has a clear reputation problem in most European countries. Among the profligates, people associate the euro with austerity and forced structural reforms. In Northern Europe, the “transfer union” and bailout fatigue see to it that people no longer look at it as gateway to increased prosperity, trade, absence of exchange risks, and the common market.

14.4 Ireland Is in its Way to Win the Battle of Austerity

Ireland is the only member state of Euroland which, at least so far, provides a positive answer to the question creeping up on everybody’s mind: whether austerity and structural reforms are really working. Contrary to the case of Iceland and Latvia which took all alone the tough road and reached their goals, the Irish response talks of the ability of countries that have received bailouts to return to a healthy economy.

Economists who looked into this question started by defining the meaning of a country’s ability to come up from under and set as criterion its return to capital markets. Is it able to convince lenders that it is again trustworthy? Can it borrow longer term from banks and other private investors, at reasonable interest rate roughly resembling what it paid historically?

In 2005, prior to the economic and financial crisis, Ireland was able to borrow for 10 years at 3 percent, or a little less. Then, its ratio of debt to GDP zoomed, as it assumed euro 64 billion ($85 billion) of bank debt and it went through the EU/ECB/IMF bailout. The crucial question is: As of 2013 where does the notional 10-year borrowing cost stand? As of January 2013, it has been 4.3 percent—about 150 percent of what it were prior to the crisis.¹²

There are no miracles. Only hard work provides deliverables. For 2013, the Irish government established its sixth consecutive austerity budget. In the 5 years since 2008, nearly euro 29 billion ($38.5 billion) worth of spending cuts and tax rises have been implemented. Critics say that by strong-arming Dublin into a deal, Euroland safeguarded the interests of its banks¹³ via the Irish public purse. That may be true, but it is no less real life that—unlike southern Europeans—the Irish are in their way out of the public debt pit.

By mid-2013, the news from Ireland are relatively good. Instead of getting into political bickering and destabilizing public opinion—as it has happened in Italy, Spain, and Greece—Irish politicians got to work in order to rebuild the economy, and so did the common citizens. As a result, Ireland has a good claim to being a model of adjustment through structural reform and austerity.

In the aftermath, Ireland regained market confidence. This in no way means that risk has miraculously disappeared. As a major exporter, Ireland is exposed both to recession in the rest of Europe and to a slowdown of the global economy. It also faces the burden of its collapsed banking industry which is a drag on its economy.

Like the American and Spanish real estate market, the Irish helplessly watched the rapid fall of house and other real estate prices. Indeed, prices tanked more than in the other two countries. Experts say that the housing market has not yet bottomed out, though the restart of the American housing market tends to suggest that an inflection point may not be far away.¹⁴

Some economists say that Ireland’s problem is totally different than that confronting the Club Med countries. This opinion is only half-right. It is right as far as the origin of the troubles is concerned. It was the Irish banks and not the entitlements that brought the economy down. But it is wrong in terms of the real estate market which was overleveraged.

The British government’s willingness to offer support for Ireland suggested worries about possible fallouts on British banks. The Bank for International Settlements estimated that British financial institutions accounted for almost 30 percent of European banks’ total exposure to Ireland (estimated at euro 309 billion ($412 billion)).

The Royal Bank of Scotland and Lloyds Bank were at top of the list of British banks at the cliff of falling Irish real estate prices. More than 40 percent of Lloyds’ £27 billion ($43 billion) exposure was through commercial property, with impaired loans accounting for over two-fifths of that amount. Both British lenders expected impairments to remain high, and so did other European and American credit institutions with direct or indirect exposure to Ireland.

The argument that without support by the EU, ECB, and IMF, the measures would have been even more severe is not quite true. The Irish government and the people were determined to confront their challenge. The 4-year plan for recovery included:

With the exception of smaller parties, like Sin Fein, which engaged in fantasy economics to increase their followership, particularly among the young, the country’s political leadership understood the challenge. Both major Irish parties appreciated that unless politicians are prepared to dig into the pockets of middle- and upper-income families, government finances will not get under control; neither can recovery have a chance without cutting back all sorts of entitlements.

There was, of course, the risk that any serious effort to curb long-established middle-class benefits sets off a public backlash, but this did not deter Irish politicians from doing their duty. Compare this with the risk of full fallback to dolce vita that threatened Italy after the fall of the Monti government at end of 2012; also remember that Italy is a country both too big to rescue and too big for the euro to survive its possible departure.

The demanding task associated to the Irish austerity decision was particularly stark, since many families depended on the social safety net as an essential feature of western society since World War II. But, by all evidence, the Irish public understood that this has been largely built on providing unsustainable benefits—from health care to relatively comfortable pensions, augmented by:

As the Irish found out through their experience, the right level of austerity is a balancing act. Too little fiscal consolidation could roil financial markets, but too many risks further undermining the recovery and, in this way, could also raise market concerns, said the IMF in its Fiscal Outlook, in April 2012. Economists added that the debt dynamics of wounded countries are not helped by the global slowdown. When growth is a scarce commodity, only those who take very seriously the need to get out of the hole stand a chance.

Like the Icelanders and Latvians, the Irish appreciated that they had to cut state expenditures. To the contrary, the Spanish do not. The way Marco Annunziata, chief economist at General Electric, looks at this issue is, Spain is simply doing what it needs to justify the euro 100 billion ($130 billion) promised from the EU to shore up its teetering banks. “Madrid’s austerity measured send a very important signal that, just as Spain is receiving additional support from the Eurozone, it is in turn making an additional effort to keep its fiscal policy on track,” says Annunziata.¹⁶

The excuse that conditions in Spain are tougher than in other countries does not wash, because all wounded Euroland member states confront an unholy combination of challenges. Their banking industry suffers because of its past lending mistakes, as well as the fact that it massively bought government bonds without due care about credit risk exposure—and sovereigns are co-responsible for this aberration.

This difference between Ireland and Spain in righting the balances is very interesting because the countries share among themselves some of the underlying problems. In both, the real estate industry has collapsed, and they are both confronted by a bloated, mismanaged, and wounded banking industry. The difference lies in human capital.

Ireland has shown that austerity and structural reforms imposed as the price of bailouts can work. A sustained return to the bond markets (discussed in the opening paragraphs of this section) would boost confidence. This has also happened with unit labor costs which came down sharply, making the economy more competitive. In turn, competitiveness enhanced Ireland’s allure for foreign companies, which continue to favor the country for manufacturing and services. (A role is also played by its low corporate tax rate.) Hence the forecast is that in 2014, Ireland might be able to leave Euroland’s bailout program.

14.5 Britain Tries to Put its House in Order

In a statement made on March 27, 2012 Citigroup said the Netherlands is no more a “core” country of Euroland.¹⁷ With the exception of Germany, no European Union member is anymore a “core” country of the EU—surely not France which lost its AAA credit rating and, by all evidence, not Britain which also lost an A in rating, is not part of Euroland and still faces large budget deficits in spite of its government’s effort to bring them under control.

Theoretically, the principal cause for this persistent deficit is the collapse in sovereign revenues. This cannot be explained entirely through the loss of tax income because of banking woes, property-sector collapse, and the forfeit of taxes due to increased unemployment. These are contributing factors but not the whole story. Neither has the persistent budget deficit been caused single-handed by the need to bail out the banks in 2008 and 2009—which was a one-off increase in expenditure.¹⁸

Practically, the shrinking of sovereign revenues has been matched (even exceeded) by an increase in expenditures, in spite of the British government’s effort to reign over them. One of the more serious and persistent reasons is that 60 percent of government expenditures is exempt from the cuts made by the Conservative–Liberal coalition. The sacred cows include military spending and the wasteful National Health Service (NHS). Since it saw the light right after World War II, NHS exhibited a voracious appetite for “more money,” which can turn an austerity budget on its head.

All British political parties share the blame for this state of affairs, which in the post-WWII western countries “is a norm,” but lacks any good sense. The government’s original figures on “savings” were published not by George Osborne but by Alistair Darling when his March 2010 pre-election budget became public. The Labor’s “solution” was to assume that departmental expenditure and gross income would grow in line with the general inflation level of the whole economy, while deficits would hide behind inflationary figures. These became known as Darling estimates.

Labor’s 2010 light budget raised fears about Britain’s economic health which David Cameron exploited by reminding his audience about Britain’s humiliating 1976 bailout, under another Labor government, by the IMF. To Cameron’s words: If we continue on Labor’s path of fiscal irresponsibility, at some point, and it could be very soon, the money will simply run out. The thinly veiled implication was that Britain and its government will go bust.

Gordon Brown could, of course, have answered that a default under his watch would not have been a “first” for England. Edward III defaulted on debt to Florentine lenders in 1340. To save his reign from default, Henry VIII seized the Catholic church’s lands and was also debited with reneging on financial obligations. In more recent times, Britain in effect defaulted in 1932 in a “voluntary” reduction on the interest it paid on war loans.¹⁹

The core of the matter is that the former dynamics of western economy have run out of steam (and out of cash). All of the EU as well as the United States find themselves in a deteriorating economic climate. As if this was not enough, practically every western government, including Germany’s, has been obliged to engineer banking support packages which focused attention on:

Britain is neither the “good” nor the “bad” exception among western sovereigns. Many other governments are in a more unfavorable situation than they hoped for. Year-after-year entitlements become more expensive, while with growth weaker than projected future revenues are lower pointing to either:

How much “more” is the theme of a wide-ranging debate, because the frame of reference on which rests the debt weighting on the government’s shoulders continues to change. The concept underpinning the public sector is slowly but surely enlarged to include not only unaffordable new entitlements but also avoiding bankruptcies of highly leveraged credit institutions (which is a false target), as well as other newly found obligations.

It used to be that public sector debt was restricted to sovereign gearing. On such a premise, the government’s ability to finance itself without wealth confiscation or bankruptcy was measured in terms of creditworthiness. Because of the aforementioned reasons, however, this is no more an adequate definition. Governments are searching for a better one to define a believable strategy for growth.

Credibility is the name of the game and central to it is the recognition that because sovereign expenses are so far ahead of income much of what may be painstakingly gained in one year’s “austerity” might be lost next year. Therefore, there is need for persistent discipline in managing public finances. With:

Whether in Britain, America, France, or other western countries, the challenge is more profound than merely announcing budgetary cuts then getting back to business as usual. The worst of all solutions is entrusting the state with “new powers” and “more responsibilities.”

Pruning the bloated sovereign balance sheet and restoring the economy to sustainable growth is what the Cameron government had tried to do by means of growth-enhancing structural reforms and cost cuts, while sticking to fiscal consolidation plans. The bad news is that health care and other entitlements continued to increase upsetting government plans and suppressing the green shoots of recovery.

Osborne, the chancellor of the Exchequer, admitted that the country has deep-rooted economic problems but maintained that the government was “dealing with our debts at home and the debt crisis abroad.” Britain’s credit rating may not mean much to the majority of the population but investors grew increasingly wary even of the threat that the triple-A rating may be cut. Moody’s and Standard & Poor’s have both rated Britain AAA since 1978 but that materially weaker economic growth led to a rate cut.

Evidently, not everything is negative. Back in 2007 the trade surplus of London’s City stood at nearly 3 percent of Britain’s GDP (more than that with insurance). Even after the descend to the abyss of 2008/2009, the City’s trade surplus in 2011 was nearly 2.5 percent of British GDP. Critics, however, do not fail to remind that who says “financial industry” says leveraging.

The 2012 British downturn is incorrectly labeled “double dip” because it was milder than that suffered by the other European nations. The contraction hinged on construction activity is notoriously volatile. Still Britain ended below its cyclical peak in 2008. There is no guarantee that under a more expansionary fiscal policy the economy would have done significantly better.

Seen with hindsight, the effort of the coalition government to put Britain’s public house in order has hit against the hard rock of undiminishable public expenditures. To this are added headwinds from Euroland as well as from the United States, and households deleveraging which continues to damp demand and (by all probability) will be doing so for some time to come.

Not all sectors of the economy are equally affected. A mid-2012 £38-billion ($61 billion) development boom in London’s most expensive neighborhoods has been spurred by rampant demand from European and Asian buyers; some of the former moving away from turbulent Euroland economies. (François Hollande, the French president, added to it by his announcement to tax incomes of euro 1 million, or more, per year at 75 percent.)²⁰

Upmarket real estate investments are, in their way, a sign of growth. The pipeline of expensive housing projects in planning or under construction in Britain’s capital has increased by more than 66 percent during 2011, flourished in 2012, and continues as long as there is political and financial stability, but may fade with a radical change in government. Investors from overseas seek stable investments, away from economic and political turmoil.

Compared to other safe currency havens, like the Swiss franc, Norwegian and Swedish krone, Japanese yen, and US dollar, the pound has been rather cheaply valued leaving upside potential. The dark cloud is the return of business confidence which is not growing in the European Union. It has become volatile and bends with every new bout in the debt crisis.

In conclusion, there are good reasons to support the thesis advanced by some economists that (everything counted) Britain provides one of the relatively safer harbors in the West’s debt storm. As the European sovereign debt crisis deteriorated, Britain pulled out of the crowd. There exist, however, reasons for caution given the gap between market optimism and economic reality in the West. The negative effect of the printing presses (at Bank of England) working overtime is illustrated by the fall in 10-year yields on government debt to below 2 percent, the lowest levels since the 1890s.

14.6 Germany and the Policy of Fiscal Discipline

A short time prior to the outbreak of World War I, the total face value of paper reichsmark in circulation was 2.7 billion. This was less than half the coinage German citizens were encouraged to trade-in in exchange for paper money. In November 1918, after the WWI armistice, the amount of paper marks stood at 27 billion, an order of magnitude higher.²¹

Two years later, in November 1920, the mass of paper marks reached 77 billion and from there on its growth accelerated—most evidently with no real assets to back it up. The sovereign who might have guaranteed its paper money was in a coma, but the German central bank marched in. As prices zoomed, even strikes for higher wages made not much sense. The workers discovered that the misery resulting from the strikes fell largely upon themselves.

Let’s leap forward by nine decades. To make ends meet, the United States, Britain and Euroland’s sovereigns, and central banks chose the soft option: the printing presses. As with the German hyperinflation of 2003, deficit financing acquired its own momentum and became unstoppable. In November 1920 when Berlin’s hydra of inflation established its kingdom, the exchange rate of the British pound was 240 marks. Three years later, in October 1923, the number of marks to the pound was equal to the number of yards to the sun. As Daniel Lloyd George, the WWI British prime minister, noted words like disaster, ruin, and catastrophe had ceased to rouse any sense of genuine apprehension any more.²²

Not unexpectedly, the trauma can last for centuries like that of the Fourth Crusade which looted Constantinople and destroyed the last vestiges of the Byzantine empire. Who can blame the Germans for being unwilling to see the results of their labor and their wealth being utterly ruined and their economy devastated for a second time within 100 years?

By 2013, while the American public debt crisis continues unabated (Chapters 10 and 11), in Europe the Club Med sovereign debt crisis (Chapters 4 through 9) remains the greatest threat to financial stability in the old continent. Matters are made worse by the multiple transmission and contagion channels that are inherent within a closely integrated economic and monetary union.

Since its onset in 2007–2008 Euroland’s crisis has largely dictated the risk situation. The German financial system has undergone significant changes because of the crisis, but it lacks the breadth and resources to carry nearly the rest of Euroland on its shoulders all alone.

The German government is fully justified to maintain fiscal discipline and walks carefully on Euroland’s financially and economically mined terrain. The large majority of the citizens want it to be that way. Business is divided. Big firms tend to favor further support for indebted Eurozone members, since for them these are “markets.” Mittelstand firms²³ oppose it.

A short time prior to German’s vote empowering the EFSF lobbyists for the country’s biggest companies wrote urging parliamentarians to vote “yes.” By contrast, family firms said Germany must refuse, the reason being that small and medium company owners are personally liable for debts and other liabilities.

If there was a political union of Euroland member states, the situation would have been more transparent and, may be, better managed. With 17 jurisdictions each looking to protect its own interests, the risks not only to Euroland but also to the German financial system are high. The European sovereign debt crisis is still in full swing, dictating the level of exposure.

Economic exposure has broadened in the course of 2012 and came to a head at various times in the year, with doubts cast over longer term survival of the monetary union. To be effective, crisis management measures require plenty of funds, and as the EFSF funds did not suffice, Euroland instituted as well the ESM. Germany contributes:

If two other European support mechanisms are added to this lot: EIB and European Financial Stabilization Mechanism (EFSM), then altogether:

What is Germany getting in return? The answer most often one hears is a large market for its exports. Yes, but Germany exports to the EU roughly are 40 percent of its produce, much less than other EU countries’ statistics:

On a percent-of-exports basis Spain, Italy, and France (in that order) benefit more than Germany from the common market. But Germany pays more. Some economists say “that’s all right” because Germany has long been the economic powerhouse of Europe. This is a sort of twisted logic which also forgets that Germany is not immune from the global financial crisis.

Much of Germany’s industrial might comes from its strong manufacturing sector, which has meant that unlike many of its neighbors, the country did not have to inorderly rely on the financial services industry or the property market. Experts however warn that the German economy, which heavily depends on trade with China, may be highly exposed to any future trouble in the Asian markets.

Neither can Berlin do as it pleases without taking account of its citizens’ opinion. Most German citizens are unhappy with having to bail out the southern European countries. They are far from being convinced of having to give them their money. The majority have found it difficult to give up the Deutschmark. It was a symbol of the country’s recovery, and joining the euro was for them a sacrifice.

In exchange for this they wanted a financial and currency stability pact. They got it on paper, but not in reality. The ink on the Stability and Growth Pact was not yet dry when every member state started gaming it—particularly France but as well Germany’s socialist government. Then came out a new version whose rules were so diluted that it was worse than nothing. Euroland’s debt crisis followed on the heels of “Euroland without financial stability” rules.

Angela Merkel wanted a new pact: the Fiscal Compact, with reformed budgetary rules and emphasis on balanced budgets. Seen from the perspective of Stability and Growth Pact experience, however, there is a risk that the Fiscal Compact may fall short of the mark by a margin:

It makes plenty of sense for the Fiscal Compact to call for all of Euroland’s 17 members to insert a binding clause into their constitutions to set a ceiling on public borrowing, intended to make balanced budgets the norm. To be binding (at least theoretically) such a commitment has been put into national legislation, but it is highly doubtful that this will have any effect.

These are as well loopholes, like the absence of a rule to systematically include off-budget funds. (This was envisaged, but it is not implemented.) Another loophole is lack of rules not just to list the values for the agreed key figures in stability reports but also to show detailed (but standardized) calculations enabling to produce cross-member state comparisons extending beyond agreed ratios. Therefore, even with the Fiscal Compact:

Personally, I see it unlikely that independent member states will coordinate their budget plans and seek to negotiate a common corporate tax base. To do either and both feats, Euroland’s governments have to at least trust one another and reconcile differing priorities—which they are not ready to do. Instead, they choose the easy way out:

For evident reasons, Germany is strongly opposed to the idea of guaranteeing borrowing for profligate Euroland states. Even with much closer economic and fiscal harmonization, this will be highly risky for its economy and a very poor initiative indeed, as it will discourage Club Med countries to do whatever is needed to rid themselves of heavy public debt.

In addition, Germany is no longer the country with low public debt-to-GDP ratio that used to be, and it simply cannot afford to increase its national debt just to pay for other states. In the mid-1970s German debt-to-GDP ratio stood at about 18 percent; it rose to 40 percent in early 1990s with unification and reached 60 percent by 2000. In 2013, it has been about 83 percent (still a tentative figure). That’s better than over 110 percent (and fast growing) for the United States, but it is way beyond the 60 percent implied for membership to the euro.²⁴

The federal government has also to look after its own citizens’ needs, not only those of foreigners. Pensions is a case in point, and even more so health insurance. Beyond that is local government finances and the gapping holes opened by the derivatives gambles of German banks. Deutsche Bank’s assets, for example, are greater than 100 percent of Germany’s GDP, and early August 2012 saw a sharp deterioration in Deutsche Bank CDSs. Should Deutsche’s CDS widen, it would signal significant financial stress within Germany.²⁵

With its own problems to look after, Germany does not want to hear about a “transfer union” pooling national debts. Neither it wants, at least for now, a breakup of the single currency. These are two positions very difficult to reconcile even if one starts redesigning European institutions (which will be a hopeless task). Just new ways to enforce budget rules will not resolve the crisis nor ensure it does not recur. Euroland’s problems have been caused by the laxness of countries that piled up debt and lost competitiveness.

14.7 Mervyn Le King, Mark De Carney, and Fantasy Economics

Since the great banking crisis of 2008, the priority at Federal Reserve and Bank of England has been to demonstrate how dependent are the western countries’ financial, social, and political structures on money printing. This has created the illusion that fast running printing presses at central banks make sovereigns more solvent than they really are, and that budget constraints are really elastic with their breakup point a safe distance away.

This is nothing else than fantasy economics and coexists in competition with another fallacy: Many people still think that money is backed by real assets which guarantee its value. Right? Wrong. The value of money lays in the trust its users place in central bankers and sovereigns to keep it up and protect it as a store of wealth and means of exchange.

As Karl Brunner, my professor of economics at UCLA taught his students: The value of the money derives from the fact that it is limited in supply. This is not what two of the major western central banks believe in these days: Federal Reserve and Bank of England. With its LTRO and OMT, the ECB has joined them in their policies against monetary stability. With Abenomics the Bank of Japan has done the same.

Over the last 6 years, the Fed and Bank of England have printed enough money to buy over 60 percent of the issuance of their respective government securities. Contrarians are asking: What would bond yields in America and Britain look like without such wild purchases of sovereign debt? And the answer is: Probably similar to those of Club Med.

Rather than “masterfully navigating” the financial crisis and avoiding another depression, the unimaginative and easy solution of fast running printing presses has been the one already invented by successive French governments. In the 1980s, when he was president of the Fifth Republic, François Mitterrand used it, and thereafter he had to devalue the franc three times in a matter of a few years.

Anecdotal evidence suggests that Mervyn King might have been a French central banker where he got his experience with QE, rather than having learned it from Bernanke (who allegedly found it in books about the Great Depression). Collateral damage is widespread. The British pensions industry claims that it has been badly hurt by the Bank of England’s:

The National Association of Pension Funds (NAPF) has been one of the most prominent critics of the Bank of England’s £375 billion ($600 billion) of gilts purchases since 2009. By driving down long-term interest rates, QE has caused pension liabilities to rise.

To NAPF’s opinion, QE forces businesses to divert money away from jobs and investment and into filling pension fund deficits.²⁶ (The Bank of England’s response has been that QE’s impact was neutral on fully-funded defined benefit schemes though retirement plans that already had problems prior to the financial crisis were likely to have seen negative deficits increased.)

Another reason for caution, if not for outright worry, is that the effects of QE on the real economy appear to be far more limited in what is considered to be their “positive side,” while laying down the preconditions for a zoom in inflation. To some opinions, the 5 percent inflation recently experienced in Britain is just the hors d’oeuvre. And with the Bank already owning more than 40 percent of the British government bond market, there is clearly a limit to how often the trick can be repeated.

Mervyn King has been sensitive to this argument. The central bank admits that its policy has costs as well as benefits, and not all of them are easy to track. There is subtle recognition of the fact that whatever the Bank of England may be doing happens in an environment of disorderly high leverage among credit institutions and of a great deal of uncertainties about the sovereigns purse.

With oversized balance sheets stuffed with dubious assets but real liabilities, there is a potential for enormous losses. Something new is definitely needed, and it has been invented. Here comes Mark Carney, another hypothetical French Republic central banker who made his schooling as investment banker at Goldman Sachs (as well as formerly governor of Canada’s central bank and newly appointed governor of the Bank of England).

Carney is the inventor of a new economic theory on how to flood the market with newly printed paper money. Forgetting that the first and foremost duty of central banks is monetary policy and along with it currency stability, Carney announced his version of money of the mind: nominal gross domestic product spending (NGDPS).²⁷

Theoretically, NGDPS was intended to deliver financial stability in spite of its many enemies: populist politicians, the Berlusconi species, nineteenth century socialists of all colors and hues, and so on and so forth. That’s the folk to whom currency stability is anathema. To the contrary, inflation is their credo as well as that of the State Supermarket’s.

Worryingly, all of a sudden the Bank of England will be sounding much more hawkish, because with NGDPS the printing presses will be turning at so much higher speed than with QE. This will turn monetary policy on its head. It might, just might, also lead to a monetary policy crash that is appalling and unprecedented. To appreciate why the NGDPS affair should be looked at with mistrust, we should take a look on its pillars:

Men, financial institution, and whole nations are no more satisfied with the sure but slow way of earnings coming from cautious industry. Wild risk-taking, subprimes-type, is the name of the game. Society is falsely informed by the printing presses and their political bosses that such games with currency stability can only bring profits since all hazards will be guaranteed by the central banks’ QE, NGDPS, LTRO, OMT,²⁹ or whatever other anagram comes along.

Another popular delusion espoused by a horde of politicians, particularly populist and socialist, is that with paper money presses running full time, the voting public’s optimism will rise and all by magic everyone will become rich. The great central bank lottery will finance from now on the State Supermarket, and common citizen can make a fortune under the NGDPS regime, without ever searching for work.

As one piece of crazy ideas hides another, the NGDPS apostles are even able to provide assurances about the sunny future: thanks to NGDPS, countries will be able to address the public debt problem, as they should, without fear that austerity will cost jobs. That’s one of the miracles one of NGDPS’ apostles wrote in an article.³⁰

Who believes in that crap will believe anything. Aside the fact that NGDPS will produce inflation, there exist technical flaws in using GDP as basic monetary policy instrument. Unlike the consumer price index (CPI)³¹ which is rarely revised, GDP is not only actively restructured but also takes years till its revisions are implemented by the different countries—which means that, in the global economic landscape, it is a heterogeneous metric.

It also happens that after the “final” GDP version has been published at the end of a revision cycle,³² the index can be further manipulated if a new methodology or standard is introduced. This is true of both nominal GDP and volume measures, making NGDPS a moving target which is a negative for a policy instrument, particularly at a time of crisis.

Over time, however, Mark Carney’s views have become much more realistic. In his first big speech as the new governor of the Bank of England he explained that he leaves all policy options open, and plans no actions in the current environment. If the situation requires, Britain’s central bank might enter another round of QE or use other simulative measures; but he would also not hesitate to tighten standards by implementing macro prudential measures to stop a bubble. Carney as well calmed down worries that the Bank of England will revise the inflation target somewhat haphazardly in the future.

Cicero, the great Roman senator, author and orator, used to ask: “To whom it profits?” All this commotion is happening at a time when central bank balance sheets are set to increase further, most particularly those of the Federal Reserve and of the ECB. The Fed plays the leading role in global quantitative easing. The ECB may well be out of lack with its OMT operation if Spain and Italy ask it to massively purchase their (untrustworthy) sovereign bonds. The combined requirements stand between euro 2 trillion and 3 trillion, the money Mario Draghi does not have even in his wildest dreams. There are two options:

Most likely, the Germans will refuse to pay other people’s bills, as they recently did with Cyprus, and opt out of Euroland. This is still an event waiting to happen. When the time comes, we shall see what takes place. Another adventure, however, has already occurred, and it is far from being to the credit of politicians, central bankers, and regulators.

Under pressure by governments, on January 8, 2013 the Basel Committee on Banking Supervision announced that the implementation of Basel III³⁴ will be delayed for another 4 years. Not only the target date changed from 2015 to 2019 but also the liquidity conditions have been softened. Sovereigns and the banking industry teamed up to get the extra delay, as self-wounded credit institutions are not in a position to meet the core capital requirement and liquidity rules.

Worse yet, the original prudential rules of Basel III have been eased reducing by so much the effectiveness of bank supervision. With central bankers and regulators abandoning their caution, pressing ahead for tearing down the walls of the city, the way is open for another repetition of the 2008 severe banking crisis. Delays beset governments and big banks whose time is up. There are obstacles and potholes on the road. Fasten your seat belts.

* * *

Deleveraging with discipline is what Iceland, Latvia, and Ireland did with fair amount of success. The task is doable. Britain, too, has tried to rid itself off the Labor government’s high indebtedness but the coalition faces internal difficulties (such as redimensioning the NHS) as well as external constraints from the EU—a reason why Cameron seeks to repatriate powers.

Plato’s Republic has an allegory of people described as prisoners in a cave. Since childhood they live in half darkness and can only see shadows of two-dimensional objects projected on the cave’s walls. From this experience, they conclude that the shadow theater is indeed the real world. Rare is a person who can free himself from such a widespread make-believe environment, but when he explains to the others their mistake they are not able to understand.

The two-dimensional vision dominates and, joined by central bankers, politicians face an electorate forcing them to head down two tracks at the same time. The one is paved with debt and entitlements; the other with remnants of past glory mixed with hope for better tomorrow. But as with the people in the cave, hopes and illusions are not reality. And the drama continues, because resurgence does not come out of leftovers.

End Notes