Wednesday, 13 June 2012

A Layman's Guide to the Euro Crisis.

There is a lot in the news about the crisis in Europe, and a lot of the coverage is filtered through political lenses as people project their beliefs onto what’s going on. Eurosceptics are enjoying saying “I told you so!”. Left-wing parties are blaming the banks and the political right is seizing an opportunity to ‘shrink the state’. It’s often difficult to separate fact from journalistic wishful-thinking. So what’s really going on?

The EuroZone is a ‘currency union’ without a ‘fiscal union’. ‘Currency union’ means sharing the same currency. The 50 States of the USA are in a currency union with each other, and so are the nations of the UK. The EuroZone is a currency union between some European Union nations.

A ‘fiscal union’ is where a central government makes spending decisions for a currency area. Despite devolution in the UK or the American states’ tax and spending powers, the USA and UK are ‘fiscal unions’. The American Federal government distributes funds from a central pot to the individual states to spend on things, such as roads or law enforcement. In most fiscal unions, richer areas pay more tax, but don’t get more state spending per head than poorer areas, resulting in a ‘fiscal transfer’. Some ‘entitlements’, what people in the UK would call ‘benefits’ for example are paid out of a federal pot. In the UK, the greater South East subsidises the poorer areas of the UK by this method.

In the EuroZone, many thought this union would cause problems, and indeed the designers of the currency knew this too, but considered the problems would act as a driver of ever closer union, their ultimate end aim. The Euro was a political, not an economic construct.

What precipitated the crisis around Europe was the inability or unwillingness of Northern Europe to subsidise the periphery in the way London and the South East subsidises the rest of the UK. As the periphery ran out of money, and succumbed to financial crises, one-by-one the markets lost faith in the ability of these governments to meet their debts.

Governments issue debt as bonds. If investors think the risk is low, they will be willing to pay a high price, resulting in a low yield to the investor and low costs to the borrower. If the risk goes up, the price falls, and the yields rise. Countries afflicted by the financial crisis saw bond yields rise as investors sold. The money investors raised by selling this debt flooded into the good risks at the core – especially Germany, which has seen yields fall sharply as a result. The UK and Switzerland have enjoyed a similar effect, being perceived as safer-havens. This rapidly became a self perpetuating downward spiral for the bonds of the afflicted governments.

The problem with the Euro is that small countries or those which had poor track records of paying back debt, suddenly saw their borrowing costs fall when they joined the Euro. This is because the markets initially thought all EuroZone bonds ranked equal, or nearly so, to those of Germany. Because the peripheral governments’ borrowing costs fell, so too did those for business and consumers. This resulted in banks lending and people borrowing much more than they would otherwise have done. Some governments, notably Greece, fell into the same trap too.

In Ireland and Spain in particular, this very low interest rate resulted in a huge speculative property bubble as a flood of new money inflated property prices. People got rich very quickly, and numerous new developments were built. However all bubbles must burst, and the oversupply of property meant there was insufficient demand for all the new flats and houses. The market crashed. The bad loans secured on overvalued property created losses which overwhelmed the banking sector. The Irish government, despite the fact it had been ‘fiscally prudent’, by running large budget surpluses during the boom was also overwhelmed. In 2007, Irish debt was just 25 per cent of gross domestic product (GDP) – a measure of the size of an economy. Despite this, the Irish state, unlike that of the UK, simply didn’t have the line of credit to finance the enormous banking losses, and needed help from the EU and UK. Because of the banks’ losses assumed by the Irish state, debt to GDP ratio has now risen to nearly 100 per cent.

Portugal, however did not suffer such a crisis, as it lacked a big banking sector of its own, so much of its property bubble was financed from across the border in Spain. However the Portuguese government didn’t run significant surpluses in the good times, and when the economic crisis came, tax receipts fell, and the market lost confidence in the government’s ability to pay its debts. As the country was running a large deficit, when interest rates hit 7 per cent, a burden totaling 80 per cent of GDP, the market considered this unsustainable. The EU & International Monetary Fund was forced to ride to the rescue.

Spain, being a larger economy than Ireland, took much longer for the bubble to deflate. Its banks were also sounder, carrying more capital than Ireland’s. Like the Irish, the Spanish government ran a prudent surplus during the boom, but it too may now struggle to raise sufficient money to bailout its banking sector, which has suffered the same fate as Ireland’s. As a result, Spain needs a bailout. And the EU has made €100bn available. Because it is not clear whether this is from the European Financial Stabiliity Fund (EFSF) or European Stability Mechanism (ESM), existing holders of Spanish debt are unsure whether the new creditors are ahead of them in the queue for repayment. Investors fear they have been ‘subordinated’ by the new line of credit. As a result, after brief euphoria on the markets, borrowing costs in Spain and Italy rose on the news.

Italy did not have a property bubble, nor did it have a banking crisis. Instead, it enjoyed a cheerfully chaotic political system which was incapable of balancing its books. Short-lived governments had little incentive to save money, finding it easier to buy off supporters without taking long-term decisions. Their problem as a result is simply an enormous debt burden of 130 per cent of GDP. Currently, Italy is running a ‘primary surplus’, that is, it is able to meet its costs – public sector wages and so on, and would be able to balance its books, were it not for debt interest. Italy’s budget deficit is therefore a direct function of the yield on its bonds. Perversely, this is the moment countries are most likely to default, as they will not need to tap the bond-market to meet existing expenditures. As a result, investors have fled Italian debt in a self perpetuating downward spiral in their bonds and increasing the likelihood of default.

Greece’s problems can be summed up as ’all of the above’, and then some.

As a result, everyone in the EuroZone is seeing their borrowing costs rise, except the dwindling core of Northern European AAA rated countries. Even France isn’t safe – they haven’t had a balanced budget since the early 1970’s, and borrow at nearly twice the price of Germany.

The UK’s debt burden is 80 per cent of GDP or so (worse than Ireland in 2010), a deficit in 2010 of 11 per cent (the worst in the developed world) and an enormous banking sector relative to GDP. So why doesn’t the UK have a massive economic crisis like Ireland, Italy and Spain? Why is UK 10-year debt yielding a paltry 1.8 per cent when equivalently indebted countries with far smaller deficits find their debt yielding over 7 per cent? Ultimately, it’s because for the time being, the debt markets have confidence the UK can meet its obligations, if necessary by printing money. This option is not open to the EuroZone, who have subcontracted this to the European Central Bank. Furthermore, the UK’s government debt has a much longer maturity than many equivalent countries, so does not need to access the bond market to ’roll over’ maturing issues, giving the UK’s government time to bring the finances under control. Finally, and this is almost certainly the least important effect, the UK’s government is committed to gradually cutting the deficit.

The EuroZone therefore is suffering from the logic of a ’currency union’ without ‘fiscal union’. As the breakup of the EuroZone looks increasingly possible, bank depositors in Greece (most urgently), Portugal, Spain, and Italy do not want to risk waking up one morning to find they’re holding Drachma, Escudos, Peseta or Lira instead of Euros. So they open bank accounts in London, Geneva or elsewhere in currencies – Euros, Dollars, Swiss Francs or Sterling which they trust to remain ‘hard’, and where their cash-strapped governments can’t get at it.

This causes a collapse in the money supply – often a cause of deep recession. Unlike in a ’fiscal union’, this money is not replaced by transfers such a grants paid out of EU pooled funds, which are simply not large enough to do this job. As the economies of the EuroZone periphery shrink, so do tax revenues. With no corresponding shrinkage in obligations, the deficit can only rise. Spending cuts cause further short-term pain as public-sector workers get laid off, and the economy risks spiraling down. Wages, for those who retain jobs get cut and living standards fall. This is the mechanism by which ’austerity’ is accused of driving economies down.

Unfortunately, for the citizens of the EU, from an economic point of view this fall in living standards and wages is exactly what is needed. The underlying problem is competitiveness. Italian workers are just more expensive than Germans per unit of output. Italians’ wages have to fall by around 20 per cent to regain competitiveness, Spaniards by 30 per cent and Greeks by 50 per cent.

The Italian economy was never really as large as the UK’s, nor were Italians as rich as Germans. They just got access to Germany’s credit card for a decade and so thought they were. Bringing the economy back to reality will be a painful process. This is called an ’internal devaluation’. It will be miserable, and scar the people forced to endure it for life, and result in a flight of talent and capital, from places suffering its effects. An internal devaluation on the scale needed may not be possible without violence.

Devaluation of the currency means most countries overcome these effects, and make their exports and workers competitive. It’s worked for the UK many times, but for the periphery, this means leaving the Euro. A new Drachma would probably fall by 50 per cent almost immediately, achieving competitiveness with the German worker in a matter of months rather than years. This is no easy option though, either from the point of view of the Greeks who will see imports, even of staples become prohibitively expensive; or the rest of the EU. Once the market has forced one country out, the next one (Portugal or Spain) looks more likely to go too, creating a cycle of instability. It is this EuroZone policymakers fear the most.

If Southern Europe is to remain in the Euro, and yet avoid grinding recession for a decade or more sudden economic catastrophe, it is going to need vast injections of cash to pay the bills. It also needs its productivity and wealth to catch up with that of Germany and Northern Europe. For an idea of the scale of cash transfer needed, look at fiscal transfers from the North to the ex-Confederate states after the US civil war, or from West to East Germany after unification. 10-20 per cent of GDP. It is unlikely the (West) Germans can be persuaded to pay on that scale again. Nor do Germans seem willing to underwrite the deposits in EuroZone banks (a so-called banking union) or underwrite the bonds of the struggling EuroZone states (the so-called Eurobond).

People describing themselves as ’Keynesians’ think the death-spiral of austerity and internal devaluation can be averted by governments injecting demand into the economy by borrowing huge sums in order to spend. Who is going to lend to these peripheral governments? The German government seems unwilling to let the European Central Bank print enough money and the open market has already said “no”.

It is not a binary choice between ’growth’ and ‘austerity’. Even if these governments could raise the money, they may not achieve the necessary growth. There is evidence that the negative effects of increased public spending can cancel out any stimulus to the economy. Public debt often ‘crowds out’ private investment. High debt burdens may also cause people to anticipate future tax rises and rein in spending and increase their savings which will hurt the economy. These negative effects seem to become greater than the positive when the debt burden reaches 80 per cent of GDP, though this is not a hard and fast rule. Furthermore, economies seem to find any growth at all very difficult to achieve if public debt reaches 120 per cent of GDP. Thus, attempting to spend your way out of recession, an indebted Government risks fruitlessly adding to the debt burden, to no effect on overall GDP growth.

It seems the money for stimulus has probably already run out.

In my opinion, the best thing to have done is to not join the currency union in the first place! The UK’s ejection from the European Exchange Rate Mechanism in 1992 and Iceland’s experience since 2008 seem to bear this out. ’Austerity’ and the devaluation in place is painful, so ’stimulus’ is superficially attractive, but it risks creating a bigger problem for the future for little gain now. The unfortunate conclusion is what is necessary is impossible, and what is possible is unappealing. There are simply no easy answers. The Euro crisis is likely to form the backdrop to investment decision for some time to come.


Luke said...

How about stimulus in Germany (it can afford it) leading to higher inflation in germany than the periphery? So peripheral wages decline relative to German wages, but not in nominal terms. I accept that this depends on germans relaxing and having fun (maybe even going on holiday in the Med) , but desperate times call for desparate measures.

Jackart said...

Germany doesn't need stimulus, it needs to start paying the bills of the periphery. And yes, Germans should party on the Med.

Luke said...

"Germany doesn't need stimulus." That's the point. If it has stimulus, it will have inflation. Then German wages go up, and sourhern Europe is competitive again.

Jan said...

Good post Jackart - a very handy summary of the crisis.

I suspect one way out of the crisis is fundamental structural reform in the Southern European economies (particularly to their labour markets) to increase productivity. This is no easy thing to achieve politically, I concede, given the leftist mindset in most of these societies and the strength of the labour unions in each of those countries.

Could the relative openness of the British labour market (and I stress "relative") be a fourth reason for the low yields on UK debt?

amit said...
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Anonymous said...

Another excellent article

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MarbellaBoy said...

Many thanks Jackart for this very clear and concise descrition of how we got into this mess. I'll be sure to pass it along.

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