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The Euro Debt Crisis and Economic Theory

Mises Daily: Friday, February 04, 2011 by

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Throughout the last year, European debt problems have been cited as a threat to both the euro and to the American economy, among other entities. While many correct assertions have been made concerning the potential impact of a European debt implosion, there have also been many ill-conceived ones. It is often faulty economic theory that leads to faulty conclusions. This article revisits economic theory — from a free-market perspective — as it relates to the current European monetary challenges.

Decline of the Euro?

The cause of the European debt crisis, in its simplest form, was overspending by (mainly southern) European governments during the last decade, and especially after the 2008 financial crisis. The ECB (European Central Bank) enabled artificially low risk premiums on interest rates of government debt belonging to the so-called PIIGS countries (Portugal, Ireland, Italy, Greece and Spain). And these artificially low rates facilitated and encouraged the overspending.

The recognition that overspending had occurred was brought about by reduced economic growth and the subsequent reduced tax revenues, which were less than the amount needed for both expenditures and dept payments. For more insights into the development of the crisis, see Philipp Bagus's articles, "The Bailout of Greece and the End of the Euro," and "The Irish Subjugation."

One of the first concerns voiced at the start of the debt crisis — a concern that was acted upon by foreign-exchange traders — was that if PIIGS governments defaulted on their debts, the euro would decline in value. But this is an illogical assumption: in and of itself, the euro would rise, not fall, in the face of government default.

First, it must be understood that, in the case of default, there are two possible monetary scenarios: (1) monetary deflation due to a decrease in the money supply, in the case that no government intervention takes place; and (2) monetary inflation of the money supply in the case that it does. Each will be explained in turn below.

Monetary Deflation

If one or more governments defaulted, northern European banks, which were large-scale investors in government debt, would have massive loan and capital losses. The result of these losses would be banks going out of business, calling in outstanding loans, or both, thereby reversing the money multiplier process and causing a decline in the money supply. The falling money supply — deflation — would make the euro more, not less, valuable.

However, a more realistic threat to the euro is that some governments might shed it and return to their own domestic currency. Fed up with the (prudent) restraint of money creation imposed upon them by the ECB, indebted governments might want to be able to print their way out of their trouble. But even if one or more countries walked away from the euro in favor of their own currencies, the euro could still be protected by the ECB.

This is because the ECB could exchange a particular country's old, previous currency for the euro, thereby adjusting the euro money supply so that the volume of euros in the remaining countries remained the same. This operation would not alter the quantity of money in the economy; it would simply swap one type of money for another, keeping the overall purchasing power constant. (I don't know the exact process by which this would be done, but a switch from the original currency to the euro took place in 2002, so a switch away from the euro back to the original currency could certainly take place again.)

Even if the money supply was affected, the central bank could engage in various "sterilization" measures to control the excess supply of money, including tightening the access of banks at the discount window, adjusting reserve requirements or the placement of government deposits, engaging in open-market operations, and using a foreign-exchange swap facility. Each of these tools, however, can have undesired consequences.

Monetary Inflation

But, in lieu of individual governments opting to return to printing their way out of trouble, the ECB itself has decided to take on the job, and it will continue to do so (this is the second case from above). Why? Because European governments will not allow themselves to face the political consequences of a banking collapse and the subsequent economic problems that a debt deflation would bring about. Instead, they will, as all politicians do, delay the day of reckoning and let future politicians deal with the much larger economic crisis that will face them as a result of merely putting a band-aid on the current problems. Politicians save their current seats by letting taxpayers and future politicians suffer larger problems down the road.

Perhaps it was in fact the vision of future inflation and declining currency that foreign-exchange traders had in mind as they knocked down the value of the euro last spring.

Mises Academy: Robert Murphy teaches Principles of Economics

Apologists for printing money and increasing taxes and debt — to the tune of more than a trillion dollars — on the (northern) European taxpayer in order to prevent bank losses call these moves "saving the euro." But few people ask, Why is the euro worth paying such a price?

With the higher prices and lower standards of living that "saving the euro" entails, all Europeans — except bankers and politicians — would be better off shedding the euro and returning to a "less expensive" currency. At the least, individual countries should decide if they want to force their own citizens to suffer the consequences of printing money and overborrowing. Under the current scenario, German and French citizens (mostly) have to pay on behalf of the profligate Portuguese, Irish, Italians, Greeks, and Spanish.

The usual hope of government officials, if they can manage to sidestep default, is to grow their way out of their national debt. But this notion, too, is misconceived. The talk of growing out of debt is based on the facts that (1) national debt is usually looked at as a percentage of GDP; and (2) the lower the debt-to-GDP ratio (and GDP's corresponding level of tax revenues), the easier it will be for the government to finance the debt. Based on these facts, governments know that if GDP rises while debt remains the same or grows more slowly, the lower the debt-to-GDP ratio will be and the better shape the government will be in.

But how can it can it be that a growing economy — defined as the production of more goods and services — helps reduce government debt? How does the existence of more physical goods help the government pay back those who lent to it? Basically, it doesn't.

An increase in (even "real") GDP does not represent the amount by which physical goods are increased: GDP is primarily a function of inflation and rises only with monetary expansion. Physical production cannot be measured in terms of money, because money's value is not static, even after adjusting for CPI increases.

Therefore, what's really happening when the government has an economy "grow its way out of debt" is that the government is printing more money and pushing up final-goods prices (i.e., GDP) by having the central bank purchase government debt and expand bank credit — and in turn permitting the money supply to rise and the currency to fall. GDP rises; debt as a percentage of GDP falls.

This printing of money allows the government to (1) have the central bank monetize its debt; (2) redistribute purchasing power to the government from savers; and (3) reduce the value of the debt, which is largely in fixed dollar amounts. In other words, it reduces its debt burden by having the citizens pay it instead.

The Effect on the United States

The Europeans are not the only ones worried about how the debt crisis will affect their economies; so too are Americans. Some arguments for how Europe's problems will affect the United States are correct, while others are not. This section will assess some of the more common expectations of economic cause and effect related to this matter.

Dennis P. Lockhart, president and chief executive officer of the Federal Reserve Bank of Atlanta, in a speech last year espoused much of the consensus view on how the euro crisis could affect America's growth. He cited three primary factors.

The first is that, due to weak growth, European demand for American exports could fall. This is a true statement, but the overall effect of a "trade shock" would be minimal, if not altogether positive. This is because if Americans will ship fewer goods to Europe, they will have more goods at home, making domestic prices lower. Plus, if demand weakens in Europe, and especially if it is diminished by way of a falling money supply and falling prices, all else being equal, things will cost less in Europe. This would allow Americans to buy more lower-priced goods, thus helping their economic state.[1]

The second euro-crisis transmission effect cited by Lockhart is related to the first: that safe haven currency flows from the euro to the dollar could raise the value of the dollar and hurt export competitiveness. Here again, exporters might be harmed, but importers, including all consumers, would gain. Besides, economic growth does not come from shipping more goods out of the country; it comes from having more goods inside the country. A growing amount of physical goods, not a rising GDP number, is the essence of economic growth.

Additionally, capital flows to the United States stemming from risk aversion in Europe would be temporary. And the currency-induced changes in goods prices between countries resulting from the capital flows would likely set in motion a self-correcting mechanism whereby those engaged in international trade would readjust currency values so that they were in line with relative purchasing-power parity between the two regions.

Lockhart's third explanation of how Europe's debt woes could affect the US economy is that of a financial-system shock transmitted through the banking system or through retreat from sovereign debt. This is a possibility only under certain scenarios.

As far as banking issues are concerned, because Europe's banking system and money supply is separate from our own, financial problems in the EU would mostly be self-contained. The possible risks, however, depend on the extent to which American financial firms hold European sovereign debt or shares in European banks that might go bust. Large losses on these investments could indeed conceivably cause capital losses and bankruptcies in the United States, thus weakening the financial system.

Fortunately for us, US banks have little exposure. For example, last spring, at the start of the crisis, Bank of America had $1.3 billion of investments in Greece, and $731 million in Portugal. JPMorgan Chase had under $2.1 billion in the two countries. These are small amounts relative to their total investment portfolios. Small and medium-sized banks likely have no exposure at all.

There is also concern about American financial companies — in the case of European government defaults — being on the hook to pay out more in credit-default-swap insurance claims than they can afford. This too, in fact, depending on the scale, could be a significant threat to the financial system and money supply in the United States.

As far as a possible retreat by investors from American sovereign debt, the effects would likely be beneficial. With less capital going into government coffers and more into private-sector investments, the economy would only benefit. However, with a decrease in funding, the government would have to quickly implement austerity measures.

True, with waning demand for government bonds, US interest rates would rise. But a move back toward the "natural rate" — as opposed to an artificially low rate — is probably needed to (1) restore balance in the loan markets (i.e., balance between investments in capital goods versus consumer goods industries); and (2) slow the pace of money creation. Such an interest rate rise might lower stock prices, but stock prices are not related to the real economy.

Representing another view of how the US economy could suffer under European debt problems, economist Ed Yardeni points out that a stronger dollar would harm corporate profits.[2] He states that "with European products cheaper than US products, consumers in the US and other parts of the world might buy from Europe rather than the United States. And Americans will be more eager to buy less-expensive imports."

This would of course be true if the dollar exchange rate rose and stayed at an elevated level while relative consumer prices between the two countries stayed the same. But any sustained rise in the dollar would be based upon the euro falling. And the euro would fall, not as a result of debt default and monetary deflation (the first of the two monetary cases mentioned at the start of the article), as people seem to believe, but as a result of monetary expansion and inflation brought about by the ECB's quest to save the banks (the second monetary case).

In this scenario, a rising dollar would mostly be reflecting the change in expected purchasing power between the two regions based on changes in expected inflation rates. Therefore, in real terms, relative consumer prices — and thus trade flows and profits — would remain the same.

By contrast, as mentioned previously, a European debt default that resulted in bank losses, monetary contraction, and subsequent falling prices — as opposed to monetary expansion and rising prices — would cause the euro to rise, not to fall.

Conclusion

Though there are indeed some possible threats to the US economy resulting from a European debt crisis, the odds are small that harmful transmission effects would result. If such adverse effects did take place, the odds are even smaller that the damage would be great. But these possible future events can be seen clearly only through the lens of solid, free-market economic theory.

Notes

[1] Here I am merely presenting the other side of the same coin. The fact is that trying to forecast what changes in trade and incomes from trade would take place can be a messy undertaking, because there are many possible specific conditions under which exchange rates and goods prices could change between countries, and therefore many possible reactions, and therefore effects, that could take place as a result. To be precise, we would have to know exactly what the economic factors were that would take place (i.e., inflation vs. deflation; relative-price-induced changes in exchange rates or temporary-capital-flow-induced changes; specific policies governments instituted as a result of changing economic conditions, etc.).

[2] Even considering that many companies doing business in Europe hedge their currency exposure.