Why Is There a Euro Crisis?
On Thursday, October 28, 2011, prices of European stocks soared. Big banks like Société Générale (+22.54%), BNP Paribas (+19.92%), Commerzbank (+16.49%) or Deutsche Bank (+15.35%) experienced fantastic one-day gains. What happened?
Today's banks are not free-market institutions. They live in a symbiosis with governments that they are financing. The banks' survival depends on privileges and government interventions. Such an intervention explains the unusual stock gains. On Wednesday night, an EU summit had limited the losses that European banks will take for financing the irresponsible Greek government to 50 percent. Moreover, the summit showed that the European political elite is willing to keep the game going and continue to bail out the government of Greece and other peripheral countries. Everyone who receives money from the Greek government benefits from the bailout: Greek public employees, pensioners, unemployed, subsidized sectors, Greek banks — but also French and German banks.
Europeans politicians want the euro to survive. For it to do so, they think that they have to rescue irresponsible governments with public money. Banks are the main creditors of such governments. Thus, bank stocks soared.
The spending mess goes in a circle. Banks have financed irresponsible governments such as that of Greece. Now the Greek government partially defaults. As a consequence, European governments rescue banks by bailing them out directly or by giving loans to the Greek government. Banks can then continue to finance governments (the loans to the Greek government and others). But who, in the end, is really paying for this whole mess? That is the end of our story. Let us begin with the origin that coincides with beneficiaries of the last EU summit: the banking system.
The Origin of the Calamity: Credit Expansion
When fractional-reserve banks expand credit, malinvestments result. Entrepreneurs induced by artificially low interest rates engage in new investment projects that the lower interest rates suddenly make look profitable. Many of these investments are not financed by real savings but just by money created out of thin air by the banking system. The new investments absorb important resources from other sectors that are not affected so much by the inflow of the new money. There results a real distortion in the productive structure of the economy. In the last cycle, malinvestments in the booming housing markets contrasted with important bottlenecks such as in the commodity sector.
The Real Distortions Trigger a Financial Crisis
In 2008, the crisis of the real economy triggered a banking or financial crisis. Artificially low interest rates had facilitated excessive debt accumulation to finance bubble activities. When the malinvestments became apparent, the market value of these investments dropped sharply. Part of these assets (malinvestments) was property of the banking system or financed by it.
As malinvestments got liquidated, companies went bust and people lost their bubble jobs. Individuals started to default on their mortgage and other credit payments. Bankrupt companies stopped paying their loans to banks. Asset prices such as stock prices collapsed. As a consequence, the value of bank assets evaporated, reducing their equity. Bank liquidity was affected negatively too as borrowers defaulted on their bank loans.
As a consequence of the reduced bank solvency, a problem originating from the distortions in the real economy, financial institutions almost stopped lending to each other in the autumn of 2008. Interbank liquidity dried up. Add to this the fact that fractional-reserve banks are inherently illiquid, and it is not surprising that a financial meltdown was only stopped by massive interventions by central banks and governments worldwide. The real crisis had caused a financial crisis.
Conditions for Economic Recovery
Economic recovery requires that the structure of production adapt to consumer wishes. Malinvestments must be liquidated to free up resources for new, more urgently demanded projects. This process requires several adjustments.
First, relative prices must adjust. For instances, housing prices had to fall, which made other projects look relatively more profitable. If relative housing prices do not fall, ever more houses will be built, adding to existing distortions.
Second, savings must be available to finance investments in the hitherto neglected sectors, such as the commodity sector. Additional savings hasten the process as the new processes need savings.
Lastly, factor markets must be flexible to allow the factors of production to shift from the bubble sectors to the more urgently demanded projects. Workers must stop building additional houses and instead engage in more-urgent projects, such as the production of oil.
Bankruptcies are an institution that can speed up the process of relative price adjustments, transferring savings and factors of production. They favor a rapid sale of malinvestments, setting free savings and factors of production. Bankruptcies are thus essential for a fast recovery.
A Fast Liquidation Is Inhibited at High Costs
All three aforementioned adjustments (relative prices changes, increase in private savings, and factor-market flexibility) were inhibited. Many bankruptcies that should have happened were not allowed to occur. Both in the real economy and the financial sector, governments intervened. They support struggling companies via subsidized loans, programs such as cash for clunkers, or via public works.
Governments also supported and rescued banks by buying problematic assets or injecting capital into them. As bankruptcies are not allowed to happen, the liquidation of malinvestments was slowed down.
Governments also inhibited factor markets from being flexible and subsidized unemployment by paying unemployment benefits. Bubble prices were not allowed to adjust quickly but were to some extent propped up by government interventions. Government sucked up private savings by taxes and squandered them maintaining an obsolete structure of production. Banks financed the government spending by buying government bonds. By putting money into the public sector, banks had fewer funds available to lend to the private sector.
Factors of production were not shifted quickly into new projects because the old ones were not liquidated. They remained stuck in what essentially were malinvestments, especially in an overblown financial sector. Factor mobility was slowed down by unemployment benefits, union privileges, and other labor market regulations.
Real and Financial Crisis Trigger a Sovereign-Debt Crisis
All these efforts to prevent a fast restructuring implied an enormous increase in public spending. Government spending had already increased in the years previous to the crisis thanks to the artificial boom. The credit-induced boom had caused bubble profits in several sectors, such as housing or the stock market. Tax revenues had soared and had been readily spent by governments' introducing new spending programs. These revenues now just disappeared. Government revenue from income taxes and social security also dropped.
With government expenditures that prolong the crisis soaring and revenues plummeting, public debts and deficits skyrocketed.1 The crisis of the real and financial economy led to a sovereign-debt crisis. Malinvestment had not been restructured, and losses had not disappeared, because government intervention inhibited their liquidation. The ownership of malinvestments and the losses resulting from them were to a great part socialized.
Sovereign-Debt Crisis Triggers Currency Crisis
The next step in the logic of monetary interventionism is a currency crisis. The value of fiat currencies is ultimately supported by their governments and central banks. The balance sheets of central banks deteriorated considerably during the crisis and with them the banks' capacity to defend the value of the currencies they issue. During the crisis, central banks accumulated bad assets: loans to zombie banks, overvalued asset-backed securities, bonds of troubled governments, etc.
In order to support the banking system during the crisis and to limit the number of bankruptcies, central banks had to keep interest rates at historically low levels. They thereby facilitated the accumulation of government debts. Consequently, the pressure on central banks to print the governments' way out of their debt crisis is building up. Indeed, we have already seen quantitative easing I and quantitative easing II enacted by the Fed. The European Central Bank also started buying government bonds and accepting collateral of low quality (such as Greek government bonds) as did the Bank of England.
Central banks are producing more base money and reducing the quality of their assets.
Governments, in turn, are in bad shape to recapitalize them. They need further money production to stay afloat. Due to their overindebtedness, there are several ways out for governments negatively affecting the value of the currencies they issue.
Governments may default on debts directly by ceasing to pay their bonds. Alternatively, they can do so indirectly through high inflation (another form of default). Here we face a possible feedback loop to the banking crisis. If governments default on their debts, banks holding these debts are affected negatively. Then another government's bailout may be necessary to save the banks. This rescue would likely be financed by even more debts calling for more money production and dilution. All this reduces the confidence in fiat currencies.
After crises of the real economy, the financial sector and government debts, the logic of interventionism leads us to a currency crisis. The currency crisis is just unfolding before our eyes. The crisis has been partially concealed as the euro and the dollar are depreciating almost at the same pace. The currency crisis manifests itself, however, in the exchange rate to the Swiss franc or the price of gold.
When currencies collapse, price inflation usually picks up. More units of the currency must be offered to acquire goods and services. What had started with credit expansion and distortions in the real economy, then, may well end up with high price inflation rates and currency reform.
It is now easy to answer our initial question: Who is paying for the mutual bailouts of governments and banks in the eurozone? All holders of euros, via a loss of purchasing power.
Instead of allowing the market to react to credit expansion, governments increased their debts and sacrificed the value of the currencies we are using. The remedy to the distortions caused by credit expansion would have been the fast liquidation of malinvestments, banks, and governments. As the innocent users of the currencies are paying for the bailouts, it is difficult not to be a liquidationist.
- 1. The tremendous increase in public debts after a banking crisis is typical. Carmen Reinhardt and Kenneth Rogoff write in This Time Is Different (2009), p. xxxi: "On average government debt rises by 86 percent during the three years following a banking crisis."