Keywords

Casino society; debt and growth; debt and decline; debt reduction; Outright Monetary Transactions (OMT); European Central Bank (ECB); the “big short”; debt sustainability

2.1 Debt and Growth

To assure their election or re-election, several EU chiefs of state have been repeatedly saying that (by using a magic wand) they will relaunch growth and wipe out public debt, all in one go. There exists an interesting precedent to those statements of “having your pie and eating it, too” dating back to François Mitterrand shortly after he was elected the President of the French Republic.

Jacques Delors, then minister of Finance, was sent by Mitterrand to Washington to measure how and how well the Reagan Administration was relaunching the US economy. Donald Regan, then Treasury secretary, told him that a great boom was lying ahead in America. But when Delors went to New York where he met Anthony Solomon, president of the New York Fed, and asked him what the outlook was for the American economy, Solomon told him precisely the opposite: The New York Fed was predicting a contraction.

Delors reported his findings to Mitterrand and the latter chose the optimistic version, announcing that his government would pursue an expansionist policy since the American economy would be booming. The US Treasury, to his opinion, had given irrevocable assurances. This was a gamble; the forecast of Solomon not of Regan proved to be the right one. The French government went ahead anyway and got clobbered. Thereafter, the franc was devalued 3 times.

“Growth” deprived of fundamentals, and being largely based on theories, does not deliver anything tangible. It does not lead to unambiguous and uncontroversial guidance or benchmarks. Trying to kill two birds with one well-placed stone may cost dearly to the economy. Solomon understood what really lays ahead, though the US Treasury secretary and the French president did not. Understanding is the name of the game, prior to:

Hopes that things will fall in line on their own accord because one has been selected as president are a harbinger to potentially disastrous developments. A recent example of inconsistent crisis management has been the often repeated call for joint liability on government debt by European Union member states through eurobonds, which is explicitly ruled out in the Lisbon Treaty. Article 125 forbids joint liability for public debt, and article 123 forbids the funding of such debt by the European Central Bank (ECB).

If unsound and undocumented “solutions” to the growth crisis are left aside—and the Mitterrand example talks volumes on why they should be discarded—then draconian measures for debt reduction will come as the only option for insolvent sovereign debtors. Debt keeps growth away, but all alone repayment will not restore trust on a longer term basis.

This effort to relaunch the economy should be properly planned from the start, and it is inseparable from the needed sharp reduction in public debt. A mid-2012 study by Bloomberg has shown the interesting relationship between public debt and the economic growth in a dozen countries, over the last couple of decades. A public debt below 40 percent of GDP is no problem and is normally accompanied by high growth rates of the economy. Notice that in many developing countries, public debt is below that rate.

By contrast, an increase of public debt from 40 to a maximum of 67 percent can temporarily boost economic expansion, but the effect is not lasting in all of the cases studied by Bloomberg. Its weight turns the economy into negative territory. Moreover, as the public debt grows beyond 67 percent, there is a clear negative correlation to growth: the higher the debt, the lower the real growth rate.

François Hollande should take note because the French economy has passed to 90 percent of GDP benchmark in public debt. Another very interesting Bloomberg finding is that in cases the debt exceeds 95 percent of GDP, there has never been a lasting growth rate of the economy. In those cases, all growth rates above 2 percent had their origin in excessive money printing or massive external help—and were followed by deep recessions.

A wise statesman, who wants to leave a name in history, would learn from his own travails, as well as those of others, to avoid repeating the same mistakes in relaunching the economy. The economy’s contraction and citizens suffering are an inevitable consequence of past excesses. The question is whether it is better to suffer it in the short term or continue living in a morose economic environment in the long run. Neither the central bank nor foreign governments can rescue a country’s economy without the latter’s:

Both are by more than 80 percent, political not technical decisions. The other 20 percent is cookbook economics, with academics divided between those who are believers in “this” or “that” past theory (Keynesian, monetarism, Austrian school) and those who have become doubters. The way an economist had it: “… the crisis has made the academic establishment fractious and vulnerable. Highly credentialed economists now publicly mock each other’s ignorance and foolishness.”¹

Past economic theories cannot provide guidance at a time when and with only a few exceptions,² in the stagnating economies of the West the total debt to GDP ratio keeps on increasing. It does not take a genius to understand that this is very bad for the future. Neither is the public debt to GDP ratio revealing the total depth of a nation’s debt. Summing up sovereign, corporate, and household debt,³ in order of magnitude in 2011, the 10 most indebted countries have been:

Though Germany has nearly half the total debt exposure to GDP when compared to Japan, the difference is a mere 12 percent when compared to total American and total Greek debt. There goes the myth that Germany can pull all the overleveraged countries of the EU out of the abyss into which they have fallen⁷ and, following that, lead them to a garden of roses.

An important criterion in evaluating the risks associated with the 10 most indebted countries in the world is their ability to refinance debt coming to maturity. For totally different reasons Germany, the United States, and Japan have (at least at the present time) no real problem with rollovers. To this small group might be added Britain and Canada—while the other five: Portugal, Spain, France, Italy, and Greece are at razor’s edge.⁸

It is improper to accuse only Greece for economic mismanagement when—in terms of total debt—the other four Mediterranean countries are worst off. Curiously enough, the amount of money that, in the first 4 months of 2012, the largest Euroland countries alone needed to refinance more than euro 370 billion ($500 billion) was mastered without a trauma in market psychology, in spite of the challenge which it has represented. Let’s wait and see what happens when to the end of 2014 Italy is confronted with bond redemptions of euro 426 billion ($564 billion), with Spain coming right behind.

A long list of factors tends to suggest that no matter what some chiefs of state may be saying in contemplating conditions favorable to growth, these will not show up till the economy can find a new base. In the mean time, increases in public and other debt contribute even more uncertainty in a word beset by doubt, while delays in deciding which way to go work to the detriment of western nations because:

Chinese economic growth may be slowing down somewhat, but it still leaves the American, European, and Japanese economies in the dust. In a lecture which he gave on January 18, 2013 to Assya, the asset manager, in Monte Carlo, Dominique Strauss-Kahn, the former president of IMF, expressed the opinion that the Chinese leadership is worried—and this for two main reasons:

Strauss-Kahn attributed this to American politics and a strategic plan targeting the country’s division into two weaker constituencies not necessarily friendly to one another. It needs no explaining that this will work to the detriment of the Chinese zone of influence, as well as of global growth. (It may as well correlate with the drain of capital from China, as sometimes investors have an extra sense politicians are lacking.)

What about debt and growth in the European continent? A study by UBS takes as proxy Swiss exports. In a year-on-year comparison, in 2011, Swiss exports to Europe stagnated. To the contrary, exports to many emerging markets have enjoyed double-digit growth rates.

Still, today, less than 20 percent of Swiss goods exports are targeted for Brazil, China, India, Russia, and other ex-China Asian emerging markets, but this share is increasing as these countries’ economic momentum is far from being saturated. Swiss export growth to developing economies has outstripped export growth to Europe.

But even Switzerland’s economy, which has a reputation of being very robust compared to those of other European countries, is not invulnerable because of steady rise in health care costs and in pensions. As far as entitlements are concerned, the same challenges practically confront every western nation, and therefore, failing to implement overdue reforms could have drastic effects on the economy (more on the disparity of health care costs are discussed in Chapter 10).⁹

2.2 Debt and Decline

According to several sociologists, nations decline because of the lobbying power of distributional coalitions, which represent special-interest groups. Their growing influence fosters economic inefficiency and inequality, suggests Mancur Olsen.¹⁰ Eventually, both inefficiency and rising inequality become powerful motors of public debt.

Like any other organization, nations decline because they are living beyond their means over long stretches of time. This is precisely what is happening nowadays in the western world—specifically in the European Union and the United States. Worst yet, there is no plan on how to come up from under and get out of the debt crisis.

The European people and their elected officials are wondering what would happen if, as the crisis intensifies, one or more countries leave the Euroland—or the currency union simply disintegrates. Even if Euroland’s structures do not collapse in the near future, the prevailing policy of muddling through (see Chapter 3) is more reactive than proactive. This makes the problem of finding a solution very complex. The same is true of establishing the basis for a new departure.

“… It will be harder to kick the can down the road,” wrote Nouriel Roubini, the economist, “A few eurozone members may need to coercively restructure their debts and even consider exiting the currency union… Markets in the US may become more concerned about the political gridlock that perpetuates unsustainable twin deficits.”¹¹ By 2013 at latest, we could face:

The slope of decline increases as debt, which feeds a mare’s nest of economic and financial problems, becomes second nature, and the eradication of bad spending habits is no more a strictly national or even regional project. Neither it is possible to reach valid solutions by accepting a priori that sacred cows will not be spared the clean-up effort; for instance, health care and pension costs paid fully from public money. Everything across the board should be on the table, subject to restructuring and to budget cuts.

Short of a holistic solution limiting expenses below the level of sovereign income, the economy first of Euroland and then of America and Britain will risk collapsing in whole or in part. At an interview, he gave to Bloomberg News on January 25, 2012 in Davos, Switzerland, during the World Economic Forum, Roubini said that Euroland’s debt problems are spreading to the core. That’s to Germany, because he would consider France a peripheral country.

According to this line of reasoning, to help the economy of the old continent recover, there should be euro/dollar parity. The downside is the risk of American-style leverage in Europe, trying to correct the ills of debt with more debt—which is evidently a very risky strategy with lots of unexpected consequences. One of them is that of revising downward economic forecast for economic growth.

The concept of euro/dollar parity is challenging, particularly so as it is a serious error to forget about the impact of exchange rates. One of the effects of globalization has been that, other things equal, a cheap currency imports inflation. As Chapter 1 brought to the reader’s attention, globalization has helped up to a point, but as (since the start) it has lacked guideposts and limits, it turned into a runaway train:

Don’t count on the G20 and its heralded aims of global coordination. To the opinion of Gideon Rachman, “…Efforts to rescue the world economy will be afflicted by a perilous political paradox. The more that international co-operation is needed, the harder it will be to achieve.”¹⁴ Despite G20, every country is looking inward; neither is there much purpose of searching around for global leadership. The world is divided into two groups:

The almost exponential rise in industrial output of emerging economies has been fed by the growing western economies indebtedness. According to Goldman Sachs, however, the decade of the BRIC may become history. While China might have a soft landing, India and Brazil (particularly the former) are facing major economic problems (Chapter 12)—while Russia looks like entering a time of political instability.

Several economists now suggest that another sort of déclinisme in the offing. The trend toward a multipolar world which manifested itself with the projection that emerging markets will be eventually contributing 75 percent of global output which, by now, looks like an overestimate. If historical precedence is of any value, there are fewer and fewer reasons for being so cheerful about developing economies.

At end of the nineteenth century, the world’s biggest manufacturer was Britain. Two world wars bent Britain’s economic, financial, and industrial might. A great deal of deindustrialization has happened in the Thatcher years (1980s). Britain lost its markets abroad. The British industry (like the French and other western industrial economies) also got penalized through an inordinate amount of social costs. This wrong-way policy is now infiltrating developing countries.

The changes referred to in the preceding paragraph are not going to happen overnight, but neither will they take several decades. Things move faster these days, thanks to global communications while, for their part, western labor unions do their best to export the western brand of entitlements to developing countries. By so doing, they are raising the social costs of companies in developing countries.

After the Iron Curtain fell, Renault, the French automobile manufacturer, bought control of Dacia, Romania’s automaker. This gave it access to low-cost labor which showed all the way to the car’s price tag. Renault profited handsomely by exporting low-cost Dacias in the different countries it operates till, prodded by their French colleagues, Romanian workers at Dacia went on strike:

Cross-border penalizing through a movement, which at the base raises labor costs in developing countries, has a chance of being more effective than betting on technology to revolutionize the production process and bring western manufacturing costs down. Theoretically, technology does not know frontiers. Practically, new ideas and discoveries, which have been a very important cause of sustained productivity (hence economic growth), originate from an intensive basic research effort which nowadays has declined. In the last couple of decades of the twentieth century and in the first one-and-a half decades of the twenty first:

In retrospect, the high point of new ideas and new inventions was the late nineteenth and first half of the twentieth. Among them, they produced electric light, the electric motor, the internal combustion engine, telephony, radio, phonograph, television, refrigerators, vacuum cleaner, man-made chemicals, artificial fertilizers, as well as the airplane, computers, telecommunications, new pharmaceuticals, (the basics of) space exploration and systems of mass production, mass distribution, and logistics.

Both individually and collectively, the practical applications of these inventions transformed lives. In the late twentieth and early twenty-first centuries, by contrast, apart from the seemingly “magical” services of Internet and the mobile phone, life in broad material terms is not so different from what it was in 1950. Biotechnology has made plenty of promises, but expectations are still below of what it was thought it could deliver. While there may always come a major breakthrough, this is still expected. We shall see.

2.3 The Debt Reduction Pact for Europe, Real or Fancy?

Debt’s ugly progeny is inequality, injustice, and poverty, yet these same issues are called upon to justify, even legitimize, acts of financial trickery by sovereigns who do not want to live according to their income. This is, of course, indefensible but it has curiously found a widening circle of adherents. Euroland’s Mediterranean countries, the so-called Club Med, and the United States are examples.

Countries featuring chronic budgetary deficits justify them by making reference to social pressures which are behind their inability to observe budgetary constraints. This is merely another manifestation of the more fundamental problem of irresponsibility in governance. Social demands are infinite, but since the resources we have at our disposal to satisfy them are finite, the responsibilities a government assumes should not exceed the resources to see them through—even if this means we have to do something “unpleasant” like:

Getting in debt to buy time in making tough and urgent decisions attests to a much greater pain: that of a head-on collision with reality. This spirit also underlines requests and propositions to pay other peoples’ debts to be a “nice chap.” Here is a real-life example on how this wrong-way strategy is used to sugar-coat poorly planned initiatives.

In 2011, the German Council of Economic Experts thought to be an opinion leader among German economists, presented its plan for a Debt Reduction Pact for Europe (DRPE). According to this plan, the debt of Euroland member states above 60 percent of a jurisdiction’s GDP would be financed by common bonds, under strict conditionality.

While so far DRPE has remained a theoretical paper, precisely because nearly everyone understands that a “strict conditionality” clause is not going to be fulfilled, it is quite instructive to dwell into its logic to learn from its fallacies. To start with, it does not make any sense to sign treaties, like the EU’s Lisbon Treaty, and then throw them to the waste basket for ill-conceived “rescue” purposes. Second, the rush to come up with money for Euroland’s profligate member states has significantly reduced the incentives to:

Third, the 60 percent of GDP criterion makes funny reading. The way this DRPE proposal wants it, the public debt of every Euroland country above 60 percent of GDP will be shared. If this becomes the rule, then for every country every year there will be a deficit of over 60 percent to be mutualized. This is like giving all governments carte blanche to go on “as usual.” Let’s recall that in the 1993–2003 time frame, when Euroland membership was decided, creative accounting¹⁶ had a field day.

Instead of upholding the important link between liability and risk control,¹⁸ the proposal by the German Council of Economic Experts is opening the valves of the former, while dropping the latter by the way side. This means eliminating altogether responsibility for fiscal discipline. Over and above that come different schemes for an extensive mutualization of liabilities resulting from sovereign debts, which are made by magic to disappear through the debt reduction fund and other gimmicks.

It is not only German taxpayers who revolt against such unwarranted plans to legalize a transfer union, with the result that money will freely run from those who work and produce to those who enjoy the sunshine and simply consume, smaller countries, too, are fed up. “Taxpayers here are extremely angry,” said Timo Soini, the leader of True Finn, whose party got 19 percent of the vote in the last election, “There are no rules on how to leave the euro but it is only a matter of time. Either the south or the north will break away because this currency straitjacket is causing misery for millions and destroying Europe’s future. It is a total catastrophe.”¹⁹

Warnings were also echoed by Miapetra Kumula-Natri, chairman of the Finnish parliament’s Grand Committee on Europe, who said bailout fatigue is nearing its limit. She added that Finland can be pushed only so far: “There is a feeling on the street that there has to be a limit. I can’t say whether it is 10 percent of GDP, or what. It’s not written. But it is obvious that a small country can’t help big countries eternally.”²⁰

What proposals and plans like DRPE aim to establish is an eternal nirvana for profligates—a permanent perpetual motion machine transferring money from Finland and other small Euroland member countries to much bigger ones like Italy and Spain. When Mario Monti went to Helsinki hat-in-hand to convince the Finns “to give,” the world saw a country of 55 million people (third economy in Euroland) begging support from a country of 5.4 million people—but well-managed. When it becomes permanent, eleemosynary help is no more welcome by the donors.

Avoiding to throw money to the four winds, which means protecting the savings and pensions of hard-working people in the better managed Euroland member countries, is also synonymous to taking care of moral risk which abounds in Euroland. It does not look like the German Council of Economic Experts includes among its members experts in moral risk management. If this were the case, it would not have proposed that:

The more curious part of this fancy proposal is that at the end of the day the higher is a member country’s debt ratio to its GDP, the larger the benefit it will derive through the jointly guaranteed debt. And the more economically sick a country is, the more it will featherbed in the covert bailout scheme. It did not occur to those who wrote the DRPE that money does not grow on trees. Where will the other Euroland countries find the money to feed the imaginary patient hand-to-mouth?

The pros say that this critique is not right because of DRPE’s conditionality clause. But as already stated, this argument forgets that, as past experience documents, conditionality clauses are for the birds. Sovereign countries are not prone to accept conditions unless these are hard-wired in the loan; there is steady supervision of their budgetary chores and penalties which cannot be negotiated or overrun.²¹ This is true whether we talk of bailout or mutualization of debt. The curious thing is that the authors of DRPE pride themselves that their proposed Pact:

The second bullet is another sugarcoating. Most states believe that supervisory control clauses infringe national sovereignty. Their negative reaction also includes the case imposing a premium on a national tax and using that revenue for direct debt redemption as well as of pledging national gold and foreign currency reserves. As for DRPE’s clause of ending mutualization should commitments not be met, with so much money already run under the bridge, this clause guarantees that DRPE never gets into action.

Other demands included in the same proposal are equally unrealistic. DRPE asks for collateral and that’s precisely what it cannot get from a country whose public debt to GDP ratio is 123, the case of Italy. Even if the conditionality outlined in the proposal by the German Council of Economic Experts were fulfilled, what remains has many characteristics of a free lunch, and not because the majority of Euroland’s member states have or are nearing a public debt above 60 percent of GDP.

Let me add this in conclusion: As annual deficits continue to weigh heavily on budgets of Eurolands’ members, this 60 percent-to-GDP rule would mean that big spender governments can keep adding to their 60 percent and in return for their profligacy are offered an interminable motion machine with collective liability taking care of their mounting debts—no questions asked. In addition, as no rights of sovereignty would or could be transferred to European level under the DRPE proposal, there is no way to intervene in trimming the excesses of national budgets. That’s not an economic pact. It’s a Disneyland.

2.4 Outright Monetary Transactions Mean Debt to Infinity

On September 16, 2012, the ticker on Bloomberg News read: “Financial industry warns of cliff effects²² in ECB’s bond pricing.” Ten days earlier, on September 6, when he announced the ECB’s Outright Monetary Transactions (OMT) Mario Draghi stated that he is right with “unlimited” purchasing of bonds by highly indebted Euroland countries because his mission is to support the currency. He probably forgot about the cliff effects. Lapsus?

These two statements, by Draghi and by the financial industry, contradict one another. In addition, with OMT, the ECB positioned itself as lender of last resort for governments. The positive side is that, at least temporarily, this announcement reduced Euroland’s tail risk and may be for some time it removed some of the contagion risk from the Greek bailout (but not from eventual Greek exit from the euro). There exist contradictory opinions on this “unlimited” bond intervention.

Spain and Italy have already been featherbedded by Euroland and the EU with the Troubled Countries Relief Program (TCRP) of June 28/29, 2012²³ as well as on-and-off buying of their bonds by the ECB. In one go, the ECB violated Articles 123 and 125 of the Treaty of the Functioning of the European Union (Lisbon Treaty) as well as its own.

Spain, whose banks are bleeding cash, has already benefited from a loan of up to euro 100 billion ($130 billion) authorized by Euroland’s ministers of finance after talking a couple of times on the phone. Nobody really knows the depth of the abyss of the Spanish banking industry. Some estimates talk of euro 300 billion ($390 billion).²⁴

All these disasters did not happen overnight. Chapter 7 will explain how the Spanish economy has been shaken by the bursting of the real-estate bubble, which pulled down the country’s banking industry. As for budgetary overruns at sovereign level, the Spanish budget deficit is still alive and kicking, even if its rate of growth has been somewhat reduced.

Italy’s economic situation is not much better than Spain’s. For both, the only bright star in the horizon is that they benefit from the ECB benevolence without limits. Hopes that the Santa Klaus will be visiting daily got a boost when just 10 weeks after TCRP Draghi announced the OMT program—an intervention ECB’s president considers as necessary because of “severe distortions” in the bond markets. Draghi added that:

Draghi’s action, which has not been based on a unanimous decision by the central bank’s governing council, underlines the opacity and lack of an institutionalized mechanism for dealing with member states’ debt crises. According to the ECB chief, troubled Euroland countries either could choose a full bailout or a precautionary program, adding that bond buying would include strict conditionality and would happen only in concert with the European Financial Stability Facility (EFSF) and the ESM—Euroland’s bailout funds.

Jean-Claude Juncker, then head of Eurogroup (Euroland’s council of finance ministers), commented that the meeting of the ECB’s Governing Council went well and there was “no trouble.” No reference was made to the fact that Jens Weidmann, president of Germany’s Bundesbank, strongly criticized the sovereign bond buying plans and the central bank funding of state budgets by the ECB.²⁶

This is not Draghi’s opinion, who says that (to his viewpoint) he is strictly within his mandate to maintain price stability over the medium term. No assurance was given that these short-to-medium term sovereign bonds will not be exchanged some time later with long-term sovereign bonds in an ECB version of the Fed’s “Twist.” To cover itself from unavoidable slippages, reportedly the ECB would seek IMF involvement for:

OMT may be a different ball game than TCRP and the suggested DRPE (Section 2.3), but all three share two facts: They definitely lack endgame characteristics, and they risk remaining “nothing but initials” if they don’t find the torrent of money to have any effect on Euroland’s economy. Pertinent has been the advice general George Marshall, the US Army’s Chief of State in WWII, gave to the nuclear scientists who, at president’s Roosevelt’s request, met him to ask his opinion about the atomic bomb project.

Marshall asked the visiting scientists, “That projected factory of yours, how many nuclear bombs will it produce: One per week, per month or per year?” The scientists had not thought of this subject and found it difficult to answer this general’s question. “Remember, gentlemen,” Marshall said, “the power of the military rests on its ability to deliver.” The same principle applies with the power of the central bank and with any other economic authority. There are six reasons why OMT may end up as a fiasco:

2.5 The End of ECB As We Knew It

“The Fed’s effects (with QE3) are fading,” read a financial news dispatch in late September 2012. “Fading” has anyway been the course many economists expected from the “new and improved” version of unlimited money printing by Ben Bernanke’s Federal Reserve. Three months after that dispatch, in December 2012, came QE3.5 as substitute to the Fed’s Twist.

Many economists suggested that by continuing the same medicine without practical results, Bernanke’s reputation for competence is badly strained. As for the effects of the ECB’s unlimited buying of (useless or devalued) sovereign issued by Euroland’s profligates, we are still waiting to see if and when it becomes popular. Yet, at the time of its announcement it was hailed by many analysts as an “ideal solution.”

The impact of “unlimited” profligate bond purchases by the ECB has been wearing out even before OMT handouts started, though the populist rhetoric (as well as the political and social risks) remain. So far politicians and central bankers have managed to avoid the storm of popular reaction which is, by all evidence, negative. Nobody wants to take the responsibilities for having the ball rolling. God, the father, is not the first in line, said an analyst. It’s his son who dies on the cross.

Contrary to the years which followed the devastation of World War II, there is no Italian or Japanese miracle to lift these economies. In a way quite different from the Bernanke strategies fixed on printing money and spending, Draghi of ECB is opening his eyes. On February 15, 2013, he was quoted by Bloomberg News as having said that: In the eurozone you cannot create growth simply by inflating the budget—even for social reasons.

Quite an important element in defining Draghi’s behavior as central banker is the position he is taking in regard to the ongoing currency wars. In a press conference on February 7, 2013, he issued a veiled rebuke to François Hollande, the French president, who a few days earlier had called for managed exchange rates.

“President Hollande. Well, we should always remember that the ECB is independent,” Draghi said. “We heard all over the world now talking up, talking down currencies. The ultimate judgment of the effectiveness of this strategy is to see what markets make of these statements.”³¹

Regarding euro’s rise against the US dollar, Draghi commented that the central bank’s mandate is to target inflation, or maintain price stability, not the exchange rate. It is no less true, however, that the strength of the euro has alarmed European politicians since a sustained rise could kill early signs that Euroland might return to growth in 2013. Not every Euroland chief of state, however, looks at the stronger euro with disdain. The Germans like it because:

while German competitiveness sees to it that a stronger euro’s impact on exports is limited. Despite the interminable EU summit tourism and proliferation of those “summits” labeled “last chance,” a common ground among the 17 on stronger or weaker euro has not yet been formal.³²

Those participating to the “summits” are typically defensive and deprived of out-of-the box ideas. This makes hard to learn from past mistakes. Recent political developments have shown that the process of Euroland’s integration has entered a phase of institutional stagnation, at least in the short to medium term. This:

Tiny Slovenia is the new basket case. At Iron Curtain times, as part of Yugoslavia, Slovenia used to be the envy of Eastern Europe. In 1991, it declared independence from a disintegrating Yugoslavia, joining the European Union in 2004 and Euroland in 2007. At independence time, Slovenia was the richest of the former Yugoslav republics.

Times have changed, and so did the will to be ahead of the curve. Like the Club Med countries, Slovenia has been slow to reform and now seems to need Euroland’s help to keep its banks afloat. Since 2007, and despite promises made, there has been remarkably little restructuring of Slovenia’s labor market and of the banking system (which is primarily in public ownership). The privatization process itself was sluggish, and most importantly, living standards in this country of 2 million grew faster than productivity, resulting in:

As bad loans proliferated in Slovenia’s banking system, the government came up with a bailout plan equal to 11 percent of GDP, increasing the public deficit by an equal amount. In addition, like Spain, Slovenia has one of the European Union’s most unsound pension systems. In 2011, a proposal to raise the retirement age to 65 was overwhelmingly defeated. Add to this excessive entitlements and what you get is a miniature version of Spain and Greece—as well as an expanded firefighter role for the ECB.

Since it is well-known that one misfortune never comes alone, Jens Weidmann has plenty of reasons in warning the ECB against buying “addictive” sovereign debt. When Draghi decided to massively buy “unlimited” amounts of worthless sovereign bonds (Section 2.4, OMT), he should have thought that Spain and Italy don’t stand alone in the queue for handouts which, in modern parlance, have been called monetary financing (a misleading term).

It is indeed quite curious that, with the exception of the Bundesbank, no other of Euroland’s central banks objected to this destabilization of the common currency through a policy which rather than “saving” the euro is killing the euro. Several analysts are now expressing the worry that by using blank checks the ECB may be limiting its own room for maneuver.

Blank checks by the ECB were the main reason why Jürgen Stark, known as a hawk in monetary policy, quit as the ECB’s chief economist.³³ Former Bundesbank president Axel Weber, who had been front runner to succeed Jean-Claude Trichet at the ECB’s pinnacle, also resigned in February 2012 in protest at the same policy.

Critics say that no matter how careful Draghi may be in building up his defenses, these defenses risk to crumble. For instance, he would not have taken the initiative to buy Italian and Spanish bonds if this was not a move Merkel had tacitly approved, allegedly giving her consent in exchange for having voted the fiscal compact by the parliament of Euroland’s member states. If so, this was a very bad deal, indeed.

Aside the fact that Euroland’s fiscal compact, Angela Merkel’s darling, is nothing more than a beefed-up version of the penalties foreseen by the Stability and Growth Pact—which have never been applied—“unlimited” buying of sovereign bonds and fiscal compact bite one another. This reflects a contradiction embedded in Euroland’s policies, many experts see as forerunner of huge problems to be confronted by the central bank.

Germans, Dutch, and Finns clearly face challenges with the direction the ECB has taken. Economists who care for financial stability and for the value of the currency warn that, as experience teaches, excessive hope that unlimited buying of sovereign bonds will solve Euroland’s debt problem is bound to end in disappointment. This is particularly true when the profligates “hope” is that someone, with supposedly very deep pockets, to come along and pay the bills.

As we will see in Chapter 13, small Latvia had the political courage to take a different road to economic recovery: Internal devaluation, and after 3 years of steady effort, it succeeded in getting out of the tunnel. In Euroland, too, references have been made to the need for internal devaluation, but that issue has been discussed in a half-baked and unconvincing way.

The expectation of a strong decline in wages in Greece and Portugal was deceived, and by all evidence the same will happen in the case of Italy and Spain. Greece and Spain also have the highest levels of youth unemployment in Euroland, with more than 55 percent of under-25-year-olds in the labor force out of work in Spain and 61 percent in Greece. Neither have the EU’s, ECB’s, and IMF’s calls to stimulate job creation by opening up some professional sectors been respected. The political backing is missing as if governments don’t understand that attacking unemployment requires:

Critics have also noted a sharp deterioration in markets’ assessments of businesses’ credit risk, particularly in Italy. Neither is there a pan-European agreement on which course to take. Italy and Spain don’t like the internal devaluation solution having found that with the ECB’s “unlimited” purchasing of sovereign bonds Germany will, at the end of the day, be paying their bills even if German taxpayers lose their money in this transaction.

In addition, as long as Spanish and Italian banks can remain solvent, thanks to massive financial help by Euroland, they can obtain liquidity from the ECB which will continue buying highly risky bonds issued by these countries. The funny thing which defies sound lending practices is that these bonds can then be used as collateral for other ECB funds. That’s the daisy wheel in ECB money.

Just as funny is the fact that financial markets have been cheered by the ECB’s buying of short-term government debt, albeit on the condition that ailing governments first ask for help from Euroland’s rescue funds. The euphoria of vulture funds, which make billions from this unprecedented mismanagement of European finances, is so great that some market players are pushing for LTRO III while others, the more sober, are unconvinced by the need for another LTRO, given that liquidity is no longer the main issue for banks.

Still another of the proposals made not long ago by commercial bankers is that the ECB can use more effectively its program to buy banks’ covered bonds (debt backed by a pool of collateral, usually mortgages). Many analysts, however, look at this option as unlikely given that some banks have been buying back debt and repackaging it to pledge as collateral with the ECB—which is another version of the perpetual motion machine.

2.6 Still, the Big Short Is Europe

Mid-April 2012, John Paulson, the only hedge fund manager who made it big by betting on the 2007 debacle of the subprimes,³⁴ said, “The new big short is Europe.”³⁵ In half a dozen words he described Europe’s plight and his strategy for the next couple of years. Paulson is not alone in following that line of thinking. Josef Stiglitz of Columbia University also says that Europe’s window of opportunity (to put its house right) is closing.

What Paulson and Stiglitz did not say is that their opinion about sovereigns in the sick bed applies hand-in-glove also to America, and for good reason. America has abandoned its strengths of hard work, flexibility, and persistence in reaching a goal. Instead, it adopted Europe’s weaknesses which add up to a moribund economy.

There exist good reasons why bankers, hedge fund managers, and bond investors are still betting on economic weakness in major western countries ranging from America’s stalling economy (Chapters 10 and 11) to Europe’s not so stable common currency as well as repeated demonstration that the old continent can pull defeat from the jaws of victory.

Euroland’s currency union, whose longer term survivability is being questioned in many quarters, has its roots in the agreement signed in 1992 known as the Maastricht Treaty. This set in motion the rules for creating the euro and for screening the countries wanting to join Euroland. Everything done in this connection is imperfect. Moreover, the Maastricht Treaty stopped short of telling chief of state how to handle:

The Lisbon Treaty, which followed Maastricht, did not close the many gaps which were left open, and in the few cases it did so the letter of the law is not being observed by Euroland’s chiefs of state and the ECB. An example is the Treaty articles which forbid joint liability for public debt. The same criticism is valid of the agreement establishing the ECB, with the responsibility for currency stability and for managing interest rates much like the original pact of the US Federal Reserve (early twentieth century). Unfortunately, the ECB also copied the Fed’s bad habits—downplaying its main mission: monetary policy, and:

It is nobody’s secret that the ECB takes inordinate risks (including reputational) by trying its hand at tasks to which, as The Economist put it: “…(are) ill-adapted and on which its 23-strong governing council, made up of the heads of the 17 national central banks and a six-member executive board finds it very hard to reach consensus.”³⁶

There are good reasons why the market is and will remain nervous about the perils of overindebtedness in government, which in other times might have raised no eyebrows, but this is no more the case today. For their part, banks are unsure about their huge loans to sovereigns after the haircut of 73.5 percent on Greek debt (PSI, Chapter 4), and are afraid that more haircuts will come in desperate effort to solve Euroland’s crisis.

With the absence of a global western leadership, power has been accruing to upcoming nations like China, each of which exerts its own gravitational pull. One of the reasons this is important is that nearly every issue the world presently faces requires negotiation, which on one hand spurs greater uncertainty and amplifies risks while on the other it diminishes most significantly western influence.

There is no great surprise regarding the disastrous effects of this drift because, as documented through the ages, no society can flourish in which the greater part of its members are uncertain about tomorrow, as is the case in the diminished and impoverished West, the United States included. Western countries have been hit by a double whammy which is undisputedly their own doing.

William White has been economic advisor to the CEO and head of the monetary and economic department at the Bank for International Settlements (BIS). Among his many contributions to economics and finance is his exploration of unintended consequences of a protracted super easy monetary policy. White outlines as follows the ways in which steady rapid increase in western nations’ monetary base:

Let’s face it. Economic, fiscal, and monetary policies in the West have got off the track, while populism has taken their place, and rational thinking, particularly about the consequences, is in permanent stagnation. Those responsible for fiscal policy and monetary policy are doing anything else but their job and even that “other job” they are doing it badly.

In a paper “Seeking Growth in a G-Zero World” published in mid-2012, Ian Bremmer and Lisa Shalett bring attention to the fact: “In the years since the financial crisis, the largest emerging economies, such as China and Brazil, have gone through two complete monetary cycles—easing in 2008 amid the global recession followed by tightening as growth heated up in 2011–2012, with easing resuming again in 2011–2012. During the same period, the developed world, led by the United States, largely remained stuck in the ultra-low-interest-rate doldrums.”³⁸

There exists an interesting parallel between monetary base overshooting and military adventures. McGeorge Bundy, national security advisor under presidents Kennedy and Johnson, observed in retrospect that “our effort” in Vietnam was “excessive” after 1965, when Indonesia was safely inoculated.³⁹ Precisely the same can be said about the monetary policies individually and collectively followed by Bernanke of the Fed, and his colleagues at Bank of England and ECB after the results of the first quantitative easing (QE1) waned, QE2 failed, QE3 has been a nonevent, and still in December 2012 Bernanke went ahead with QE3.5.

In Euroland, the basket case of economic malaise is Spain. Spanish banks repeated the same mistakes Japanese banks did in the 1980s applying low standards in granting loans while they themselves got overleveraged. By wide margin, the market thinks that the stress tests of Spanish banks have been manipulated. At the same time, the Spanish economy is unable to diversify and therefore remains in very bad shape.

The irony with the euro’s weak fundamentals and ECB’s spending habits is that in the first 40 days of 2013, the euro has been the strongest G10 currency, while the pound has declined more than 7 percent against the euro. Analysts and economists ask themselves whether this is a reversion of the “save haven” flows of 2012.

The answer is not at all clear. While diversification flows supported the pound in 2012 from both the private and central bank sides, there are reasons to believe that the current move of the euro against most of it crosses as overdone. Euroland’s economy is only slowly recovering and the ongoing political risks in Greece, Spain, and Italy are not supportive of a strong euro. As an article on global financial markets had it: “… While the OMT has reduced euro tail risks, at the same time it has increased the risk that the ECB may need to implement a sort of quantitative easing program…”⁴⁰

When Draghi was still a new face in the ECB, an old hand like Mervyn King, the governor of Bank of England, had cautioned that the ECB’s decision to buy Italian and Spanish debt had “gone to the outer limit” of what a central bank should do. The onus for handling the debt crisis should lie with the eurozone’s governments, King aptly said at that time, adding that:

You cannot expect a central bank to engage in credit allocation decisions and to be a substitute for the inability to deal with the fiscal problems facing the euro area. That is a problem for governments.⁴¹

Rightly so. At the World Economic Forum, Davos 2013, Ignazio Visco, governor of Bank of Italy, put his thoughts in a similar way: “The objective of monetary policy is to provide financial stability. You cannot rely only on monetary policy to fix the current economic situation and restart growth.”

That’s precisely what ill-advised central bankers and chiefs of state in the western democracies are trying to do. Not unexpectedly, they are unsuccessful. The following paragraph explains how Dominique Strauss-Kahn, the former head of IMF, looks at Euroland’s future.

Current European policies will not lead to resolution of the crisis whose roots can be found in the absence of economic growth. Tensions have temporarily subsided, and this masks the fact that the underlying problems are still unsolved. There are plenty of negatives due to absence of confidence by the public and the market—which persist. European growth, including growth in Germany, is too weak. In a few months, the hidden problem will resurface and reignite the crisis. In the end, Paulson’s dictum “The new big short is Europe” may prove right.

* * *

There is no international standard defining debt sustainability and its limits. To study this issue, economists are often using scenarios, hypotheses, and answers to some critical questions. The most important question is: Can the country afford the debt it has contracted? But the response is usually qualitative, which means subjective.

While it is indeed impossible to separate sharply what is sustainable and what is unsustainable, I have found in my studies a danger zone of sustainability which tends to fall in the band of 8 percent to 10 percent of interest cost to government revenues. Ratios beyond 10 percent are unsustainable. Ireland, Italy, and Greece are in that area above 10 percent. For Portugal and Spain the ratio of interest cost to government revenues falls between 8 percent and 10 percent. Both governments try to keep a tap on their ratio. If it falls below 8 percent, even better below 6 percent, then the chances are good that it will be sustainable.

End Notes