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.

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  1. Great article John. I’m aware each person from each of the PIIGS countries will have a reason why they’re different and “not as bad”, but is it not fair to say that the Irish state was perfectly solvent untill it started absorbing private debt, encouraged by the very same countries (France and Germany) who did not want to risk their own banks losing the investments they had made in Irish banks. Whereas the problem with Greece was that they lied for years about their situation, misspent EU structural funds, retired earlier than anyone else and gave their public sector workers the holidays normally only afforded to teachers, their debt was a public issue. Same with Italy, heading into this crisis, Ireland had the second lowest debt/GDP ratio in the EU of 62% I think, whereas Italy was already approaching 130% of GDP and it wasnt even suppose to be in crisis! It is also not fair to say the Irish public sector are still the best paid in Europe, gross pay yes but they have been taxed so hard it is meaningless. For example my friend who is a social worker earns €43,000 a year, not bad right, over €800 a week to play around with. She takes home €480 a week now, she used to work as a waitress in the golf club earning €10/hour and she worked 45-50 hours a week and took home €400-€450 a week, so we now have a situation in Ireland where people who apparently have well paid jobs are only earning just above minimum wage!!! Also the ECB has praised Ireland on the measures it has taken and has asked Portugal and Greece to follow our lead, that -in short- is why I think this article was a bit harsh on Ireland while I still agree with your logic for being tough on bail-out countries. Did Sweden offer bi-lateral loans to Greece and Portugal as it did to Ireland?

  2. Stephen, first I want to thank you for stopping by and reading my unintentionally long post. I never intended it to be more than 2000 words, that’s just how it became. I’ll be writing more about this subject in the future so please feel free to come back whenever you feel for it.

    First of all, whatever you say, Ireland has extremely low taxes compared to nearly all European countries. Taxes always feel like a robbery, they’re never fun to pay. But you are paying much much less than us Swedes do (we have the second highest marginal tax rates in the world), and for about a decade, you enjoyed lower and lower taxes every year as your entitlement programs grew larger. You can’t really say you don’t deserve it.

    If you think I’m a bit harsch on Ireland, consider that I’m living in Ireland for most of the year and so I know much more about Ireland than I do about Greece. So I tend to use Ireland as an example when I talk about the PIIGS countries. It’s nothing personal, I really do like you guys and I’m looking forward to coming back to your country.

    We need to remember that the ECB has to try and control expectations. If they bash you for not taking harsch enough measures, then what investors will take away is that Ireland and the Eurozone are going to collapse, and then they’ll pull their money out of it. So the ECB has a great incentive to pretend Ireland is doing just fine; if they criticize you too much, it will come back and bite them. I’m not saying that the ECB isn’t telling the truth, just that we can’t trust them blindly. Lately, you have done some necessary cutbacks, and I suppose it’s better late than never. However, you still haven’t dealt with the structural problems in your government (like the fact that the civil war 90 years ago still divides your parties) and you still – and this is based on what I’ve read in letters to the editor in various papers, as well as on online board – seem to think that the EU was the cause behind this crisis. You’re victimising yourselves instead of cleaning up your act. No, it wasn’t nice to pressure you into taking over all that bank debt. No, it wasn’t nice to contribute to overheating your economy by setting interest rates too low. Still, too few Irish consumers dare look themselves in the mirror and say “I contributed to creating this mess”. And yet they did. The thing about capitalism is that it gives people what they want. It has no values, unless we as consumers enforce them. It’s just supply and demand. We demanded a short, energetic boom during which we’d get to buy everything we wanted and feel rich, and we as consumers told companies that we didn’t care what happened tomorrow. So that’s exactly the kind of boom capitalism gave us. 

    And still, at least when I left at the end of may, the economy was not recovering. As a matter of fact, because of these cuts, you’ll probably experience a new recession as demand drops when unemployment goes up (which it does, when you fire public servants). They’re still necessary though or you’ll experience an even nastier recession down the road, and I want you to know I’m truly sorry to tell you that as I got many close friends in Ireland who will be hurt. This also means that you’ll have to cut even more than projected; in recessions, tax revenue falls and your budget deficit will then increase automatically. So in order to cut 2 billion, you may end up having to cut 3 billion, the last billion just to make up for the revenue loss caused by cutting the first 2 (cutting two billions causes unemployment, revenues fall by a billion as a result, so need to cut 3 billion). It’s just a scenario, but I think it’s increasingly likely. 

    I never heard of Sweden offering loans to Greece or Portugal, but it’s possible.

    Well, this was a long response. I hope you understand what I’m trying to say. If you have any more questions or feedback, just send another comment.

  3. Thanks for your prompt response John! Very true that the ECB has an interest in praising Ireland, but my point was not really that they were simply praising us, it was that they were praising us *relative* to greece and portugal. Though now I see why you mention ireland more because you do study there!

    Yes we have low taxes but again it is relative, Sweden has far higher taxes but I do not see social workers earning barely more than minimum wage! You Swedes are clearly earning far more gross. We certainly need an entitlement “adjustment”, eg half it! We give crazy unemployment benefits from Fianna Fail buying elections. How can we legislate for political parties being drawn on civil war politics, its just the way it is, its not a neccesary structural reform!

    I have a completely different feeling about who is to blame, i think people are blaming the governments they elected, yes they are angry at the ECB etc but with regards the source of the blame i think we are taking it within ourselves altho a lot of people do say “well i never partied during the boom!” which is rubbish 😀

    yes this budget will be another tough one but there is so much waste in the public service that they could achieve all of their cuts without ever affecting the public if they truly wanted! for example we are still hiring teachers on 9 month contracts and then paying for their entire summers holidays! and we still pay substitute teachers who have no quailifications €45/hour! so there are defo instances where we are not cleaning up our act!

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