The Tragedy of the Euro by Philipp Bagus

Chapter Eleven

The Future of the Euro

Have we already reached the point of no return? Can the sovereign debt crisis be contained and the ﬁnancial system stabilized? Can the Euro be saved? In order to answer these questions we must take a look at the sovereign debt crisis, whose advent was largely the result of government interventions in response to the ﬁnancial crisis.

As Austrian business-cycle theory explains, the credit expansion of the fractional-reserve-banking system caused an unsustainable boom. At artiﬁcially low interest rates, additional investment projects were undertaken even though there was no corresponding increase in real savings. The investments were simply paid by new paper credit. Many of these investments projects constituted malinvestments that had to be liquidated sooner or later. In the present cycle, these malinvestments occurred mainly in the overextended automotive, housing, and ﬁnancial sectors.

The liquidation of malinvestments is beneﬁcial in the sense that it purges inefficient projects and realigns the structure of production according to consumer preferences. Factors of production that are misused in malinvestments are liberated and transferred to projects that consumers want more urgently.

Along with the unsustainable credit-induced boom, indebtedness in society increases. Credit expansion and its artiﬁcially low interest rates allow for a debt level that would not be possible in a one hundred percent commodity standard. Debts increase beyond the level real resources warrant because interest rates on the debts are low, and because new debts may be created out of thin air to substitute for old ones. The fractional reserve banking system causes an over-indebtedness of both private citizens and governments.

While the boom and over-indebtedness occurred on a worldwide scale, the European boom had its own signature ingredients. Because of the introduction of the Euro, interest rates fell in the high inﬂationary countries even though savings did not increase. The result was a boom for Southern countries and Ireland.

Implicit support on the part of the German government toward members of the monetary union reduced interest rates (their risk component) for both private and public debtors artiﬁcially. The traditionally high inﬂation countries saw their debt burden reduced and, in turn, a spur in private and public consumption spending. The relatively high exchange rates ﬁxed forever in the Euro benefitted high inﬂation countries as well. Durable consumer goods such as cars or houses were bought, leading to housing booms, the most spectacular of which was in Spain. Southern countries lost competitiveness as wage rates kept increasing. Overconsumption and the loss in competitiveness were sustained for several years by ever higher private and public debts and the inﬂow of new money created by the banking system.

The European boom affected countries in unique ways. Malinvestments and over-consumption were higher in the high inﬂation countries and lower in northern countries, such as Germany, where savings rates had remained higher.

The scheme fell apart when the worldwide boom came to its inevitable end. The liquidation of malinvestments—falling housing prices and bad loans—caused problems in the banking system. Defaults and investment losses threatened the solvency of banks, including European banks. Solvency problems triggered a liquidity crisis in which maturity-mismatched banks had difficulties rolling over their short-term debt.

At the time, alternatives were available that would tackle the solvency problem and recapitalize the banking system.¹ Private investors could have injected capital into the banks that they deemed viable in the long run. In addition, creditors could have been transformed into equity holders, thereby reducing the banks’ debt obligations and bolstering their equity. Unsustainable ﬁnancial institutions—for which insufficient private capital or creditors-turned-equity-holders were found—would have been liquidated.

Yet the available free-market solutions to the banks’ solvency problems were set aside, and another option was chosen. Governments all over the world injected capital into banks while guaranteeing the liabilities of the banking system. Since taxes are unpopular, these government injections were ﬁnanced by the less-unpopular increases in public debt. In other words, the malinvestments induced by the inﬂationary-banking system found an ultimate sponsor—the government—in the form of ballooning public debts.

There are other reasons why public debts increased dramatically. Governments undertook additional measures to ﬁght against the healthy purging of the economy, thereby delaying the recovery. In addition to the ﬁnancial sector, other overextended industries received direct capital injections or beneﬁted from government subsidies and spending programs.

Two prime examples of subsidy recipients are the automotive sector in many European countries and the construction sector in Spain. Factor mobility was hampered by public works absorbing the scarce factors needed in other industries. Greater subsidies for the unemployed increased the deﬁcit while reducing incentives to ﬁnd work outside of the overextended industries. Another factor that added to the deﬁcits was the diminished tax revenue caused byreduced employment and proﬁts.

Government interventions not only delayed the recovery, but they delayed it at the cost of ballooning public deﬁcits—increases which themselves add to preexisting, high levels of public debt. And preexisting public debt is an artifact of unsustainable welfare states. As the unfunded liabilities of public-pension systems pose virtually insurmountable obstacles to modern states, in one sense the crisis— with its dramatic increase in government debts—is a leap forward toward the inevitable collapse of the welfare state.

As we have already seen, there is an additional wrinkle in the debt problem in Europe. When the Euro was created, it was implicitly assumed among member nations that no nation would leave the Euro after joining it. If things went from bad to worse, a nation could be rescued by the rest of the EMU. A severe sovereign debt problem was preprogrammed with this implicit bailout guarantee.

The assumed support of ﬁscally stronger nations reduced interest rates for ﬁscally irresponsible nations artiﬁcially. These interest rates allowed for levels of debt not justiﬁed by the actual situation of a given country. Access to cheap credit allowed countries like Greece to maintain a gigantic public sector and ignore the structural problem of uncompetitive wage rates. Any deﬁcits could be ﬁnanced by money creation on the part of the ECB, externalizing the costs to fellow EMU members.

From a politician's point of view, incentives in such a system are explosive: “If I, as a campaigning politician, promise gifts to my voters in order to win the election, I can externalize the cost of those promises to the rest of the EMU through inﬂation—and future tax payers have to pay the debt. Even if the government needs a bailout (a worst-case scenario), it will happen only in the distant, post-election future.

Moreover, when the crisis occurs, I will be able to convince voters that I did not cause the crisis. It just fell upon the country in the form of a natural disaster. Or better still, it is the doing of evil speculators. While austere measures, imposed by the EMU or IMF, loom in the future, the next election is just around the corner.”

It is easy to see how the typical shortsightedness of democratic politicians combines well with the possibility of externalizing deﬁcit costs to other nations, resulting in explosive debt inﬂation.

Amid the circumstances such as these, European states were of course already well on their way to bankruptcy when the ﬁnancial crisis hit and deﬁcits exploded. Markets became distrustful of government promises. The recent Greek episode is an obvious example of such distrust. Because politicians want to save the Euro experiment at all costs, the bailout guarantee has become explicit. Greece will receive loans from the EMU and the IMF, totaling an estimated €110 billion from 2010 to 2012. In addition, even though Greek government bonds are rated as junk, the ECB continues to accept them and has even started to buy them outright.²

Contagions from Greece also threaten other countries that have extraordinarily high deﬁcits or debts, such as Portugal, Spain, Italy, and Ireland. Some of these suffer from high unemployment and inﬂexible labor markets. A spread to these countries could trigger their insolvency—and the end of the Euro. The EMU has reacted to the possibility of danger and has gone “all out,” pledging, along with the IMF, an additional €750 billion support package for troubled member states.

Can Governments Contain the Crisis?

The Greek government has tried several ways to end its debt problem. It has announced a freeze on public salaries, a reduction in the number of public servants, and an increase in taxes on gas, tobacco, alcohol, and big real-estate properties.

But are these measures sufficient? There are mainly ﬁve ways out of the debt problems for overly indebted countries in the EMU.

Overly indebted countries can reduce public spending. The Greek government has been reducing its spending but still runs deﬁcits. The reduction in spending may simply not be enough. Moreover, it is not clear if the government can stick to these small spending cuts. Greece is famous for its riots in reaction to relatively minor political reforms. As the majority of the population seems to be against spending cuts, the government may not be able to reduce spending sufficiently and lastingly.

Countries can increase their competitiveness to boost tax income. The Greek government, however, has lacked the courage to pursue this course. Its huge public sector has not been substantially reduced, and wage rates remain uncompetitive as a result of strong and still privileged labor unions. This lack of competitiveness is a permanent drag on public ﬁnances. An artiﬁcially high standard of living is maintained via government deﬁcits. Workers who are uncompetitive at high wage rates ﬁnd employment in the public sector, drop out into earlier retirement, or receive unemployment beneﬁts.

The alternative would be to stop subsidizing unemployment, be it in the disguised form of early retirement, unproductive government jobs, or openly, with unemployment beneﬁts. This would bring down wages in the private economy. The abolition of labor union privileges would further drag down prices. Competitiveness of Greek companies would thereby increase and government deﬁcits would be reduced. Other Latin countries are faced with similar situations.

Countries can try to increase their revenues by increasing taxes. Greece has done this. But the increase in taxes is causing new problems for Greeks. Wealth is being re-channeled from the productive private sector into the unproductive public sector. The incentives to be productive, to save and invest are further reduced. Growth is hampered.

Growth induced by deregulation. This way may be the easiest change to achieve politically, and the most promising. Its disadvantage is that it takes time that some countries may not have.

With sufficient growth, tax revenues increase and reduce deﬁcits automatically. Growth and innovation is generated by an overall liberalization of the troubled economies. With regulations and privileges abolished, and public property and companies privatized, new areas are opened to competing entrepreneurs. The private sector has more room to breathe.

The packages enacted by the Greek government consist of this kind of deregulation. Greece has privatized companies and eliminated privileges—like mandatory licenses for truck drivers (who unsurprisingly went on strike and paralyzed the country for some days). But Greece has, at the same time, taken measures making it more difficult for the private sector to breathe. Tax increases, and especially the increases of the sales tax, are good examples. The measures seem to be insuﬃcient to produce the economic boom necessary to reduce public debts.

External help. But can an external bailout do what insufficient liberalization cannot? Can the €110 billion bailout of the Greek government, combined with the €750 billion of additional, promised support, stop the sovereign debt crisis, or have we come to the point of no return? There are several reasons why pouring good money behind bad may be incapable of stopping the spread of the sovereign debt crisis.

The €110 billion granted to Greece may itself not be enough. What happens if in three years Greece has not managed to reduce its deﬁcits sufficiently? The Greek government does not seem to be on the path to becoming self-sufficient in just three years. It is doing, paradoxically, both too little and too much to achieve this. It is doing too much insofar as it is raising taxes, thereby hurting the private sector. At the same time, Greece is doing too little insofar as it is not sufficiently reducing its expenditures and deregulating its economy. In addition, strikes are damaging the economy and riots endanger austerity measures.

By spending money on Greece, fewer funds are available for bailing out other countries. There exists a risk for some countries (such as Portugal) that not enough money will be available to bail them out if needed. As a result, interest rates charged on their now-riskier bonds were pushed up. Although the additional €750 billion support package was installed in response to this risk, the imminent threat of contagion was stopped at the cost of what will likely be higher debts for the stronger EMU members, ultimately aggravating the sovereign debt problem even further.

Someone will eventually have to pay for the EMU loans to the Greek government at ﬁve percent. (In fact, the United States is paying for part of this sum indirectly through its participation in the IMF).³ As the debts of the rest of the EMU members increase, they will have to pay higher interest rates than they would otherwise. When the bailout was announced, Portugal was paying more for its debt already and would have lost outright by lending money at ﬁve percent interest to Greece.⁴ As both the total debt and interest rates for the Portuguese government increase, it may reach the point where the government will not be able to reﬁnance itself anymore. If the Portuguese government is then bailed out by the rest of the EMU, debts and interest rates will be pushed up for other countries still further. This may knock out the next weakest state, which would then need a bailout, and so on, in a domino effect.

The bailout of Greece (and the promise of support for other troubled member states) has reduced incentives to manage deﬁcits. The rest of the EMU may well think that they, like Greece, have a right to the EMU's support. For example, sinceinterest rates may stabilize following the bailout, pressure isartiﬁcially removed from the Spanish government to reduceits deﬁcit and make labor markets more ﬂexible—measuresthat are needed but are unpopular with voters.