The Tragedy of the Euro

Have we already reached the point of no return? Can the sovereign debt crisis be contained and the financial system stabilized? Can the Euro be saved? In order to answer these questions we must take a look at the sovereign debt crisis, whose advent was largely the result of government interventions in response to the financial crisis.

As Austrian business cycle theory explains, the credit expansion of the fractional-reserve banking system caused an unsustainable boom. At artificially low interest rates, additional investment projects were undertaken even though there was no corresponding increase in real savings. The investments were simply paid by new paper credit. Many of these investments projects constituted malinvestments that had to be liquidated sooner or later. In the present cycle, these malinvestments occurred mainly in the overextended automotive, housing, and financial sectors.

The liquidation of malinvestments is beneficial in the sense that it purges inefficient projects and realigns the structure of production according to consumer preferences. Factors of production that are misused in malinvestments are liberated and transferred to projects that consumers want realized more urgently.

Along with the unsustainable credit-induced boom, indebtedness in society increases. Credit expansion and its artificially low interest rates allow for a debt level that would not be possible in a one hundred percent commodity standard. Debts increase beyond the level real resources warrant because interest rates on the debts are low, and because new debts may be created out of thin air to substitute for old ones. The fractional reserve banking system causes an over-indebtedness of both private citizens and governments.

While the boom and over-indebtedness occurred on a world-wide scale, the European boom had its own signature ingredients. Because of the introduction of the Euro, interest rates fell in the high inflationary countries even though savings did not increase. The result was a boom for Southern countries and Ireland.

Implicit support on the part of the German government toward members of the monetary union reduced interest rates (their risk component) for both private and public debtors artificially. The traditionally high inflation countries saw their debt burden reduced and, in turn, a spur in private and public consumption spending. The relatively high exchange rates fixed forever in the Euro benefitted high inflation countries as well. Durable consumer goods such as cars or houses were bought, leading to housing booms, the most spectacular of which was in Spain. Southern countries lost competitiveness as wage rates kept increasing. Overconsumption and the loss in competitiveness were sustained for several years by ever higher private and public debts and the inflow of new money created by the banking system.

The European boom affected countries in unique ways. Malinvestments and over-consumption were higher in the high inflation countries and lower in Northern countries, such as Germany, where savings rates had remained higher.

The scheme fell apart when the worldwide boom came to its inevitable end. The liquidation of malinvestments—falling housing prices and bad loans—caused problems in the banking system. Defaults and investment losses threatened the solvency of banks, including European banks. Solvency problems triggered a liquidity crisis in which maturity-mismatched banks had difficulties rolling over their short-term debt.

At the time, alternatives were available that would have tackled the solvency problem and recapitalized the banking system.1 Private investors could have injected capital into the banks that they deemed viable in the long run. In addition, creditors could have been transformed into equity holders, thereby reducing the banks’ debt obligations and bolstering their equity. Unsustainable financial institutions—for which insufficient private capital or creditors-turned-equity-holders were found—would have been liquidated.

Yet the available free-market solutions to the banks’ solvency problems were set aside, and another option was chosen. Governments all over the world injected capital into banks while guaranteeing the liabilities of the banking system. Since taxes are unpopular, these government injections were financed by the less-unpopular increases in public debt. In other words, the malinvestments induced by the inflationary-banking system found an ultimate sponsor—the government—in the form of ballooning public debts.

There are other reasons why public debts increased dramatically. Governments undertook additional measures to fight against the healthy purging of the economy, thereby delaying the recovery. In addition to the financial sector, other overextended industries received direct capital injections or benefited from government subsidies and spending programmes.

Two prime examples of subsidy recipients are the automotive sector in many European countries and the construction sector in Spain. Factor mobility was hampered by public works absorbing the scarce factors needed in other industries. Greater subsidies for the unemployed increased the deficit while reducing incentives to find work outside of the overextended industries. Another factor that added to the deficits was the diminished tax revenue caused by reduced employment and profits.

Government interventions not only delayed the recovery, but they delayed it at the cost of ballooning public deficits—increases which themselves add to preexisting, high levels of public debt. And preexisting public debt is an artifact of unsustainable welfare states. As the unfunded liabilities of public-pension systems pose virtually insurmountable obstacles to modern states, in one sense the crisis—with its dramatic increase in government debts—is a leap forward toward the inevitable collapse of the welfare state.

As we have already seen, there is an additional wrinkle in the debt problem in Europe. When the Euro was created, it was implicitly assumed among member nations that no nation would leave the Euro after joining it. If things went from bad to worse, a nation could be rescued by the rest of the EMU. A severe sovereign debt problem was preprogrammed with this implicit bailout guarantee.

The assumed support of fiscally stronger nations reduced interest rates for fiscally irresponsible nations artificially. These interest rates allowed for levels of debt not justified by the actual situation of a given country. Access to cheap credit allowed countries like Greece to maintain a gigantic public sector and ignore the structural problem of uncompetitive wage rates. Any deficits could be financed by money creation on the part of the ECB, externalising the costs to fellow EMU members.

From a politician’s point of view, incentives in such a system are explosive: “If I, as a campaigning politician, promise gifts to my voters in order to win the election, I can externalize the cost of those promises to the rest of the EMU through inflation—and future taxpayers have to pay the debt. Even if the government needs a bailout (a worst-case scenario), it will happen only in the distant, post-election future.

Moreover, when the crisis occurs, I will be able to convince voters that I did not cause the crisis. It just fell upon the country in the form of a natural disaster. Or better still, it is the doing of evil speculators. While austerity measures, imposed by the EMU or IMF, loom in the future, the next election is just around the corner.”

It is easy to see how the typical shortsightedness of democratic politicians combines well with the possibility of externalizing deficit costs to other nations, resulting in explosive debt inflation.

Amid the circumstances such as these, European states were of course already well on their way to bankruptcy due to unsustainable welfare states when the financial crisis hit and deficits exploded. Markets became distrustful of government promises. The Greek episode is an obvious example of such distrust. Because politicians want to save the Euro experiment at all costs, the bailout guarantee has become explicit. Greece receives loans from the EMU and the IMF, totaling an estimated €110 billion from 2010 to 2012. In addition, even though Greek government bonds are rated as junk, the ECB continues to accept them and has even started to buy them outright.2

Contagions from Greece also threaten other countries that have extraordinarily high deficits or debts, such as Spain and Italy. Some of these suffer from high unemployment and inflexible labor markets. A spread to these countries could trigger their insolvency—and the end of the Euro. The EMU has reacted to possibility of danger and has gone “all out,” pledging, along with the IMF, an additional €750 billion support package for troubled member states. Ireland was already forced to tap the rescue fund in November 2010. Portugal in May 2011.

CAN GOVERNMENTS CONTAIN THE CRISIS?

The Greek government has tried several ways to end its debt problem. It has announced a freeze on public salaries, a reduction in the number of public servants, and an increase in taxes on gas, tobacco, alcohol, and big real-estate properties.

But are these measures sufficient? There are mainly six ways out of the debt problems for overly indebted countries in the EMU.

Overly indebted countries can reduce public spending. The Greek government has been reducing its spending but still runs deficits. The reduction in spending may simply not be enough. In fact, the Greek government failed to meet its goal to reduce its deficit to 8.1 percent in 2010. Despite the government’s promise to substantially reduce its deficit and to bring it below 3 percent in 2014, the Greek deficit in 2010 was 10.5 percent of GDP and is predicted to be 9.5 percent in 2011. Additional €60 billion loans to bring the Greek government through 2013 started to be discussed in May 2011. Moreover, it is not clear if the government can stick to these small spending cuts. Greece is famous for its riots in reaction to relatively minor political reforms. As the majority of the population seems to be against spending cuts, the government may not be able to reduce spending sufficiently and lastingly.

Countries can increase their competitiveness to boost tax income. The Greek government, however, has lacked the courage to pursue this course. Its huge public sector has not been substantially reduced, and wage rates remain uncompetitive as a result of strong and still privileged labor unions. This lack of competitiveness is a permanent drag on public finances. An artificially high standard of living is maintained via government deficits. Workers who are uncompetitive at high wage rates find employment in the public sector, drop out into earlier retirement, or receive unemployment benefits.

The alternative would be to stop subsidising unemployment, be it in the disguised form of early retirement, unproductive government jobs, or openly, with unemployment benefits. This would bring down wages in the private economy. The abolition of labor union privileges would further drag down prices. Competitiveness of Greek companies would thereby increase and government deficits would be reduced. Other Latin countries are faced with similar situations.

Governments can reduce debts by selling public property. Government may reduce debts by the one-time measure of privatising public property. Indeed, the Greek government was pressured to do so and even to sell public islands. The Greek government resisted to sell islands or monuments out of national pride. It resisted selling public companies because their new private owners would have drastically reduced the overblown workforce, leading to strong resistance on the streets. After complaints by the Commission and the IMF, in May 2011 the Greek government committed to privatizations of an unrealistic €50 billion.

Countries can try to increase their revenues by increasing taxes. Greece has done this. But the increase in taxes is causing new problems for Greeks. Wealth is being re-channelled from the productive private sector into the unproductive public sector. The incentives to be productive, to save and invest are further reduced. Growth is hampered.

Growth induced by deregulation. This way may be the easiest change to achieve politically, and the most promising. Its disadvantage is that it takes time that some countries may not have.

With sufficient growth, tax revenues increase and reduce deficits automatically. Growth and innovation is generated by an overall liberalization of the troubled economies. With regulations and privileges abolished, and public property and companies privatized, new areas are opened to competing entrepreneurs. The private sector has more room to breathe.

The packages enacted by the Greek government consist of this kind of deregulation. Greece has eliminated privileges—like mandatory licenses for truck drivers (who unsurprisingly went on strike and paralysed the country for some days). But Greece has, at the same time, taken measures making it more difficult for the private sector to breathe. Tax increases, and especially the increases of the sales tax, are good examples. The measures seem to be insufficient to produce the economic boom necessary to reduce public debts.

External help. But can an external bailout do what insufficient liberalization cannot? Can the €110 billion bailout of the Greek government, combined with the €750 billion of additional, promised support, stop the sovereign debt crisis, or have we come to the point of no return? There are several reasons why pouring good money after bad may be incapable of stopping the spread of the sovereign debt crisis.

1.The €110 billion granted to Greece may itself not be enough. What happens if Greece has not managed to reduce its deficits sufficiently at the end of their term? The Greek government does not seem to be on the path to becoming self-sufficient. A default of some kind seems to be inevitable. The Greek government is doing, paradoxically, both too little and too much to achieve this. It is doing too much insofar as it is raising taxes, thereby hurting the private sector. At the same time, Greece is doing too little insofar as it is not sufficiently reducing its expenditures and deregulating its economy. In addition, strikes are damaging the economy and riots endanger austerity measures. The situation in Ireland and Portugal is not much better. The €85 billion granted to Ireland and the €78 billion granted to Portugal may not be enough to solve their public debt problems.

2.By spending money on Greece, Ireland, and Portugal, fewer funds are available for bailing out other countries. There exists a risk for some countries (such as Spain) that not enough money will be available to bail them out if needed. As a result, interest rates charged on their now-riskier bonds were pushed up. Although the additional €750 billion support package was installed in response to this risk, the imminent threat of contagion was stopped at the cost of what will likely be higher debts for the stronger EMU members, ultimately aggravating the sovereign debt problem even further.

3.Someone will eventually have to pay for the EMU loans to the Greek government at four percent (formerly five). (In fact, the United States is paying for part of this sum indirectly through its participation in the IMF).3 As the debts of the rest of the EMU members increase, they will have to pay higher interest rates than they would otherwise. When the bailout was announced, Portugal was paying more for its debt already and would have lost outright by lending money at five percent interest to Greece.4 As both the total debt and interest rates for the Portuguese government increased, it reached the point where the government was not able to refinance itself anymore. The Portuguese government was then bailed out by the rest of the EMU, which pushed up debts and interest rates for other countries still further. This could knock out the next weakest state, which would then need a bailout, and so on, in a domino effect.

4.The bailout of Greece, Ireland, and Portugal (and the promise of support for other troubled member states) has reduced incentives to manage deficits. The rest of the EMU may well think that they, like Greece, have a right to the EMU’s support. For example, since interest rates may stabilize following the bailout, pressure is artificially removed from the Spanish government to reduce its deficit and make labor markets more flexible—measures that are needed but are unpopular with voters.

Spain is the next government in line after Portugal. Spain’s problems are many fold and contain characteristics of other peripheral countries. The main problem is Spain’s high public and private indebtedness. Artificially low interest rates caused by the ECB allowed for a housing boom. Housing prices soared, Spaniards indebted themselves and lived beyond their means. As housing prices fall and Spaniards lose their jobs many cannot pay their debts. Constructors and private households default posing problems to the banking system.

Public debts almost doubled from 36.1 percent in 2007 to an estimated 70.2 percent in 2011. Private debts are at over 200 percent of GDP. From a housing boom induced surplus of 1.7 percent in 2007 the public deficit exploded to 11.2 percent in 2009 and 9.3 percent in 2010. The unemployment rate hovers around 20 percent. At the same time politicians do not seem willing to engage in structural reforms.

Spanish banks may still have important bad loans and are exposed heavily to Portugal. Higher interest rates as announced by the ECB to curb inflation will pose problems to public finances and may trigger more private defaults and increase problems for the banking system.

The next countries in line are Italy and Belgium which are too big to be bailed out by the existing rescue fund. In 2010 Italy’s public debts rose to 119 percent of GDP with a deficit of 4.6 percent. Belgium, who does not have a functioning government, has public debt around 100 percent of GDP. The final nail in the coffin of the EMU, however, may be France. France debt to GDP ratio rose to 81.7 percent, with a deficit of 7 percent. Even small structural reforms such as an increase in retirement age from 60 to 62 years triggered massive protests and strikes in October 2010 which raises doubts on the political possibility to substantially reduce France’s deficit.

While deficits have been reduced somewhat, public debts are still rising all over Europe, in some countries fast and unsustainable. With every day that debts continue to rise and severe structural reforms are not undertaken, it is more likely that we have passed the point of no return.

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5 See Philipp Bagus, “The Fed’s Dilemma,” Mises.org daily (October 8, 2009), http://mises.org.

6 See Robert Lindsay, “ECB in U-turn on Junk Bonds to Save Greek Banking System,” Times Online (May 4, 2010), http://business.timesonline.co.uk. On January 14 2011 Fitch was the last of the three big rating agencies that downgraded Greek government debt to junk.

7 See Bob Davis, “Who’s on the Hook for the Greek Bailout?” The Wall Street Journal (May 5, 2010), http://online.wsj.com.

8 It is unclear whether countries that pay higher interest rates than five percent will participate. Tagesschau, “Müss Deutschland noch mehr zahlen?” Tagesschau (May 6, 2010), http://www.tagesschau.de.

• 1Roughly a year before starting to purchase government bonds, the ECB started to buy covered bonds issued by German banks. The purchases were progressive and reached €60 billion.
• 2Cash-online, “Forsa: Deutsche überwiegend gegen den Euro-Rettungsschirm.” News from June 7, 2010, http://www.cash-online.de.
• 3Shortnews.de, “Umfrage: Mehr als die Hälfte der Deutschen wollen die DM zurück haben.” News from June 29, 2010, http://shortnews.de.
• 4GRReporter, “The Social Tourism of Bankrupt Greece,” July 12, 2010, http://www.grreporter.info. In the summer of 2010, many Greek entrepreneurs did not want to serve clients participating in the state programme. The Greek government pays its bills six months late, if at all.
• 5In reaction to the crisis, the political class has tried desperately to save the socialist project of a common fiat currency for Europe. They have been successful—at least for the time being. After intense negotiations, an unprecedented €750 billion “rescue parachute” has been created to support European governments and banks. At the same time, however, the ECB has started what many had regarded as unthinkable before: the outright purchase of government bonds, an action which undermines its credibility and independence. The public and market perception of the monetary setup of the European Monetary Union (EMU) will never be the same.
• 6Resistance to these unprecedented measures is on the rise, especially in countries with traditionally conservative monetary and budget policies. A poll in Germany showed that fifty-six percent of Germans were against the bailout fund.
• 7It is not surprising that the majority of Germans want to return to the Deutschmark. They seem to understand intuitively that they are at the losing end of a complex system. They see that they are saving and tightening their belts on a regular basis while other countries’ governments embark on wild spending sprees. A prime illustration is the “Tourism for All” programme in Greece: the poor receive government funds toward vacations. Even amid the crisis, the Greek government continues the programme, albeit reducing the number of subsidized vacation nights to two. The Greek government also upholds a more generous public pension system than Germany does. Greek workers get a pension of up to eighty percent of their average wages. German workers get only forty-six percent, a number that will fall to forty-two percent in the future. While Greeks get fourteen pension payments per year, Germans receive twelve.
• 8It is not surprising that the majority of Germans want to return to the Deutschmark. They seem to understand intuitively that they are at the losing end of a complex system. They see that they are saving and tightening their belts on a regular basis while other countries’ governments embark on wild spending sprees. A prime illustration is the “Tourism for All” programme in Greece: the poor receive government funds toward vacations. Even amid the crisis, the Greek government continues the programme, albeit reducing the number of subsidized vacation nights to two. The Greek government also upholds a more generous public pension system than Germany does. Greek workers get a pension of up to eighty percent of their average wages. German workers get only forty-six percent, a number that will fall to forty-two percent in the future. While Greeks get fourteen pension payments per year, Germans receive twelve.