As European Austerity Ends, So Could the Euro
The euro currency is a malady that condemns at least a generation of Greeks, Italians, Spaniards, Portuguese and Irish to the economic infirmary.
In these nations, unemployment rates are now at their highest levels in recent decades, and there are few prospects for recovery in sight. The economists and politicians who created the system still proclaim it can survive. Their time would be better spent recognizing they made a bad mistake and preparing for an orderly dismantling of the euro before the damage spreads and further undermines European unity.
The problem isn’t just the region’s lack of competitiveness or its budget deficits or the high stock of existing government debt, which the International Monetary Fund now puts at 90 percent of the euro area’s gross domestic product (see Table 5 in this report). It is all of the above, compounded by five years of complete political denial.
For three years, capital has been fleeing Europe’s periphery for Germany. That country’s liquid banks, competitive labor markets and sound fiscal policies have made it the ideal location in Europe for investment. The periphery’s illiquid banks are sharply contracting credit to the productive sector, even as their governments are cutting back and political protests are mounting. Wages are too slow to adjust to dent these powerful forces: Germany looks ever more attractive for investors, further exacerbating the imbalances that brought us to this point.
Is there any hope for the euro dream?
One potential way forward would be to create a European- level fiscal union that assumes all national debt, much like what Alexander Hamilton did as first U.S. secretary of the Treasury. That isn’t going to happen in modern Europe. Why would German taxpayers and savers agree to pay for the good times previously enjoyed in Greece, Italy or Spain? Who could even ask them to do so?
As a result, all eyes are turning to the European Central Bank, because some in the euro policy elite still hope loose monetary policy and higher inflation rates will provide an escape hatch. But addressing fiscal issues through monetary means generally doesn’t work, and it does nothing to improve the competitiveness of the struggling euro-area periphery.
It appears that the euro-area politicians and the ECB agreed to a pact last year whereby banks bought government debt, and the central bank provided the financing. In return, the ECB got national governments to sign on to fiscal austerity. So far, the results are disturbing.
Employment levels and leading indicators in Spain and Italy imply the economic decline has accelerated. Greece continues to fall. Ireland is held up as a success story, but its debt levels are enormous, a great deal of fiscal adjustment remains to be done, and the domestic economy declined over the past six months.
Voters are already tired of what they perceive as austerity -- see Greece, Spain and now France -- and the policy debate has begun to shift. The changed tone of the discussion is gradual but it would be a mistake to overlook this development: Austerity programs have been huge social and political failures, removing one more hope for saving the euro area.
The ECB surely has more “firepower” to deploy. And it probably will, not least because the institution itself could disappear if the euro area fails. Its natural reaction will be to double or quadruple its bets, issuing potentially limitless credits to banks to keep sovereign-debt markets afloat (and bond yields down).
The ECB will also lobby for austerity, which would reduce the amount of credit it needs to create. But democratically chosen governments will simply refuse to comply. The central bank will jettison its inflation-fighting credentials, and instead pray that the monetary issuance needed to keep troubled nations afloat isn’t too large and that inflation expectations don’t start to increase.
But here’s the problem: Pursuing such a monetary policy is a recipe for a dangerous loss of confidence in the euro system.
So far, this confidence has survived. A 10-year German bund, priced in euros, yields only 1.5 percent, showing that investors believe that credit risk, rather than inflation risk, is all that matters.
Bund investors should beware. At the moment, most attention is focused on Greece as the trigger for a euro-area collapse. There are good reasons to believe Greece would be better off leaving the euro area (although the exit could well be traumatic initially), but the same logic also applies to many more nations. And there are other triggers: Germany might become fed up, Italy will eventually turn against Prime Minister Mario Monti, and Spain’s woes are escalating.
Europe’s highly leveraged financial system may prove too fragile to suffer even modest increases in the perceived risk of a euro collapse. For example, what interest rate would you want on a euro-denominated 10-year bond if you believed the euro could turn into a basket of currencies, some of which would be high-inflation -- the Greek drachma or Italian lira, at, say, 15 percent inflation per year -- and others, such as a new deutsche mark, would be low-inflation, with perhaps 2 percent inflation? Perhaps that bond would need to yield 8 percent. That is far higher than current pricing.
Today, there are about 8.5 trillion euros ($11 trillion) of sovereign bonds outstanding in the euro area, and more than $180 trillion in derivatives linked to interest rates (looking at the notional value of those contracts and keeping in mind that “net” derivative positions tend to understate true losses in a full- blown crisis). These interest-rate derivatives -- known as swaps -- are held by large leveraged financial institutions (banks, hedge funds), or by pension and insurance companies with large, long-term liabilities. If interest rates rise, bond prices fall, and derivative contracts change in value (good news for people who have hedged into fixed interest rates and a potential disaster for those exposed to rising interest rates).
Anyone who has bet heavily on interest rates staying low -- for example, an investor with a great deal of leverage -- would be at risk of failure.
This type of shock could produce instability at least as extensive as the aftermath of the collapse of Lehman Brothers Holdings Inc. in September 2008. It would lead to massive redistribution of capital and wealth, forcing some leveraged institutions into instant insolvency. Investors would flee first and check the details later.
Until recently, whenever troubles worsened in the euro area, investors ran to German, Dutch and French bonds. Since capital flight stayed within the currency area, the value of the euro didn’t fall. During the last week, however, the number of troubled nations increased. French bonds weakened alongside those of Italy and Spain as concerns over Greece intensified.
External investors are also showing signs of impatience. The Norwegian sovereign-wealth fund recently declared that it would continue to reduce its holdings of euro-area assets due to the long-term uncertainty in the region. It also cited what it said was unfair treatment of national wealth funds, which were involuntarily forced to accept Greek write-downs, while the ECB and European Investment Bank made profits from their purchases of that debt.
Here’s what happens next: The euro becomes cheaper, prodded by the ECB taking extreme credit risk and the popular revolt against austerity.
A cheap currency won’t solve Europe’s deeper problems. Depreciation amounts to a nontransparent way for the Germans to bear more of the costs of the failed euro experiment as their purchasing power falls, but investors will still prefer Germany to Greece. It also increases the risk that European and international investors may simply lose confidence in the euro, leading to mayhem in the area’s leveraged financial markets.
For European politicians, the most important task now is to cover their tracks and blame others. Inflation is confusing. It also is an unfair tax on savers and a transfer of wealth to borrowers (assuming that interest rates can be held down or otherwise controlled, probably through nonmarket means). The ECB will now be under great pressure to take actions that create inflation. This may bring the end of the euro.
(Peter Boone is a non-resident senior fellow at the Peterson Institute for International Economics, a visiting senior fellow at the London School of Economics and an adviser at Salute Capital Management. Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co- author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.” The opinions expressed are their own.)
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