I was supposed to write about this a couple of weeks ago, but a terrorist and a downgrading came in the way and I’ve been focusing my writings on those subjects.
Now, however, at least for tonight I’m going to return to what is probably my favourite subject: The Eurozone crisis.
This subject may feel distant to a lot of americans, who wonder why you should care. Here’s why: The financial institutions of America and Europe are so linked that if the Eurozone falls, America falls too. Several large American investment banks like Goldman Sachs have offices in many european capitals, and have large investments in the Eurozone. If a Eurozone country does default, you can count on the panic to spread to the United States as well. You may actually end up in a position where you will have to choose between letting your financial system collapse, or bailing it out for the second time in three years.
For those unfamiliar with the crisis, here’s a synopsis: The Eurozone consists of 17 European countries who all have the same currency, the euro, and the same central bank, the ECB. This system has a lot of benefits, mainly in the form of lower transaction costs and no currency risk when you buy and sell to other countries within the zone. If you’re from Germany and you want to vacation in Greece, you can use the same currency there that you have at home.
Of course, there is a serious drawback we recently discovered: When you have the same currency and the same central bank, that means you have only one central bank interest rate. That means you need to find an interest rate that fits everyone. And, as it turns out, that’s impossible. Imagine one country is in a recession. They will want the central bank interest rate to be low, as that will ease the recession by printing more money (it does help in the short run) and increasing lending. On the other hand, another country in the zone may be booming and may want the central bank to raise interest rates so that their economy isn’t overheated.
Other than monetary policy, a country can use fiscal policy to try and steer its economy. And when a country cannot use monetary policy (because its monetary policy is controlled by the ECB), it has to use fiscal policy. That means, if the economy is growing too fast or if there is a bubble going on, the country in question can only raise taxes to try and prevent the economy from becoming overheated.
In this case, what happened in the early 2000’s was that ECB was lowering interest rates, trying to accomodate the big countries whos economies were struggling at the time. You see, while in theory ECB, like school teachers, do not have any favourites, in practice, they do. In the case of school teachers, its that annoying girl sitting next to you who makes you look bad, and in the case of the ECB, it’s annoyingly big countries like France and Germany. So if France and Germany needs a low interest rate, then they’ll get it.
The problem was that some of the smaller countries, Ireland being the prime example, didn’t make the necessary adjustments. Instead of raising taxes to compensate for the low interest rates, they cut taxes. Their economy was on stereoids: The ECB provided easy, cheap credit and the state cut taxes and so increased consumption. The problem was, Ireland didn’t cut spending at the time because they didn’t need to. As long as the economy was booming, tax revenue kept going up even though tax rates kept falling.
When the growth stop, this whole bubble that Ireland and many other countries was living in popped. Suddenly, Ireland and the other countries who are now endangering the Eurozone had huge deficits. Cutting spending is painful politically, which is why they haven’t really began seriously with that until recently when they realized they were about to default (and still they’re not cutting enough).
Of course every country has their own “story” of how they got to where they are. But most of them are quite similar to Ireland’s.
Anyway, the EU, together with the IMF, has started to bail out crisis countries. First Greece, then Portugal and Ireland. Of course, the money was not a gift or anything. Ireland for instance was forced to accept an interest rate of 5.8 %. Way better than the rate they could get on the private market of course, but still a far cry from the rates countries like the US have to pay when they issue bonds.
I was living in Ireland at the time (and will move back there in a month) and I remember the public uproar over the interest rate. The general consensus was that this was only postponing the day of reckoning, or should we say the day of default. I know several people in Ireland who have been hurt in the recession and through the fiscal austerity measures that Ireland’s been forced to go through with. Naturally, I celebrated when, about three weeks ago, it was announced that Ireland and the other economic basketcases in the Eurozone would get an interest rate cut and more time to pay back the money, which for Ireland meant savings of 600 million euro (keep in mind, their total revenue/year is about 30 billion euro).
Actually I didn’t celebrate.
Why I didn’t celebrate
Do you remember Bear Stearns? That was the first investment bank to collapse in March 2008. They ended up being bought by JP Morgan, but only after the Federal reserve guaranteed 30 billion worth of subprime mortgages. The crisis was over for the time being, but about five months later, it was clear that Lehman brothers was only weeks away from collapse. Problem was, as Lehman was searching for prospective buyers, they found out all those buyers demanded to get the same guarantees JP Morgan had received from the Fed. Effectively, the Federal Reserve had shown that they were willing to provide guarantees to get banks sold, so what happened was a chicken race with the Treasury/Fed waiting for the banks to yield and buy Lehman without guarantees, and the banks waited for the Treasury/Fed to yield and provide them with said guarantees (granted, there were at some point a few private offers for Lehman, but they were rejected by the company). The Treasury was opposed to bailouts, because of political principles (remember when government had those?), and the banks were opposed to buying worthless assets without federal guarantees because of financial principles.
Well, we all know what happened after that, no need to go into greater detail. It’s interesting that everyone talks about the October 2008 bailout causing moral hazard, while seemingly forgetting that the whole crisis was caused by moral hazard. After Bear Stearns was essentially given a bailout, everyone else assumed they’d get them too. Bear Stearns didn’t have to go bankrupt, which is what should have happened, and that’s exactly what creates moral hazard: The government removing and covering for the consequences of someone’s actions.
Looking back, it would have been much better if the US government, or rather the Federal Reserve, hadn’t stepped in during the collapse of Bear Stearns. If they hadn’t, the financial crisis that happened in september 2008 would have started in March instead. And if you’re going to have a financial crisis, why not just have it as early as you can and get over with it? That financial crisis would also have been smaller, because if the banks had gone bust half a year earlier, that would have been half a year when they couldn’t have continued with their crazy lending standards, and so there would have been fewer toxic assets to deal with (although to be fair, by the time Bear Stearns collapsed, lending standards had tightened somewhat).
What does that have to do with anything?
Many of you reading this might be nodding your heads in agreement. Some of you may shake your heads in disagreement. But I imagine all of you are right now thinking, “What exactly does this have to do with those countries getting an interest rate cut?”.
Two words: Moral hazard.
At the same time as these countries (Portugal, Greece and Ireland) are getting lower interest rates, two other countries are quickly running out of money: Italy and Spain.
Imagine this scenario: Italy holds a bond auction in a couple of months which doesn’t go very well. They go to the EU (or the IMF) and tell them that they will default unless they’re bailed out. The EU agrees, but doesn’t have that much money. After saving three other countries, they as well as the IMF are running low on funds. On the other hand, they realize they have to save the euro or else the European Union in itself will be the next thing to implode. They manage to find 50 billion between the cushions, and offer Italy an interest rate of 6 % and demand fiscal tightening as part of the deal.
Italy rejects the deal, pointing out that Ireland is only paying 3.5-4.0 % on their debt (the exact rate has not been settled yet). Why should they pay more? And why should they agree to austerity measures? The Irish public sector is still the most well-paid in Europe, so why should the Italian public servants be forced to take a pay cut while their country gets a higher interest rate than they got?
Here comes the Italian chicken race. Silvio Berlusconi, Prime Minister of Italy (the worst PM they’ve had since Il Duce Benito Mussolini), is convinced that if they can only hold out long enough and not take the deal, they’ll be offered a better one. It’s not like the ECB can ever go bankrupt; like any central bank they can always print money. The EU has already shown that they are willing to provide interest rates below 4 %, so why not wait for them to yield? On the other side of the table, Angela Merkel and Nicolas Sarkozy (PM and President of Germany and France, respectively) have a harder and harder time trying to keep a straight face when telling voters about the importance of saving the Euro project at any cost. If they’re not tougher against reckless countries like Italy, they may lose re-election. And then, they may be replaced by people who don’t believe in the Euro in the first place. If they give in to Italy’s demands, they reason, that will be the end of the Eurozone because people in their own countries will vote for politicians who promise to end the handouts to countries like Italy and Greece and leave the Eurozone (and the Eurozone won’t survive without Germany and France, that’s for sure). On the other hand, if Italy defaults, that will mean the end of the Eurozone as well and a financial crisis will spread through Europe (and soon North America), potentially knocking out the world financial system and leading to even more defaults.
Here’s the thing: It’s rational for Italy to accept EU’s deal. It’s better to get a bailout with tough terms and austerity measures, than to default and risk an actual depression. Therefore, Germany and France will hold their line, expecting Italy to do the only rational thing and yield. But it’s also rational for Germany and France to accept Italy’s demands, because if Italy default, the Eurozone is definitely doomed and that risk isn’t worth taking.
So everyone is assuming the other part is rational, and is therefore doing what the other part assumes is irrational for them to do. That’s the definition of a chicken race. How it ends? It’s hard to tell. I’m personally bearish on the future of the Eurozone. The countries known collectively as PIIGS (Portugal, Ireland, Italy, Greece and Spain) are right now not being punished enough to scare them off from doing the same mistakes in the future. I realize I’m going to be lynched for writing that once I get back to Ireland, but an interest rate between 3.5 and 4 % is nothing. In general I get the feeling the people in the PIIGS countries blame everyone except themselves for the situation they are in. No-one forced Ireland to cut taxes while increasing spending, which ultimately is what overheated their economy. On the other hand, if Ireland had not received that cut, they would probably have defaulted and dragged everyone else down with them. If you don’t punish them, they’ll repeat it (and many more countries will follow them, thinking they too will be saved if they ever need to be). But if you do punish them, they will like I said most likely default. The massive debt burden will prevent their economies from growing, and the overhanging risk that they may default at any time will keep investors away from the entire Eurozone.
The saying “Damned if you do, damned if you don’t” has never been more fitting. This brings us to our conclusion:
The Eurozone must go
The Eurozone is unsustainable and should never have been created. The underlying problem behind this crisis is that the countries within the zone are all unique with unique needs when it comes to monetary policy. We should have known that. We should have seen it coming.
The interest rate cut is like the bailout of Bear Stearns. It works fine until everyone wants it. It buys time. It allows us to tell ourselves that we’ve solved the problem (like some “experts” in the eurozone did). But it doesn’t really solve anything, the underlying problem is still there. And like I said, if you’re going to have a financial crisis, let’s just have it now and get over with it. There are certain countries who are so indebted they will have to default. Isn’t it better for them to default now, before they rack up even more debt and the default becomes even more severe?
What we in Europe should aim for is a controlled demolition. Instead of fighting tooth and nail to preserve the Euro, we should recognize that it is indeed a dead man (coin?) walking. We should all go back to our national currencies in a way that is as stable as possible. Ireland and the other countries can then choose to either default or inflate away their debt; either way the effect won’t be as severe when they’re not linked to the other countries as much.
Is it possible to achieve a controlled demolition, or is it just as futile as trying to have a “soft landing” after a bubble? I don’t know, but anything is better than what we’re doing now.
It’s time to end the chicken race. Let’s call it a tie, even though in reality, it won’t be a tie.
In reality, we are all losers.
