Archive for the ‘New Politics’ Category

Desincrustada da sociedade, a tal economia de mercado, que tende para o equilíbrio desde que o Estado não estorve, criou na América do Norte e na Europa esta interessante circunstância: “(…) excess debt has created a situation in which everyone is trying to spend less than their income. Since this is collectively impossible — my spending is your income, and your spending is my income — the result is a persistently depressed economy (…)”.

E agora?

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Ferguson illustration

The biggest question in any debt crisis is whether a credible path back to solvency can be found. For Greece, this now seems very unlikely. The same is true, to a lesser extent, for Ireland and Portugal. This raises three further questions. First, how big is any required restructuring? Second, who should bear the cost? Finally, is restructuring enough? If the answer to the last question is No, then one has to ask whether the currency union will last in its current form.

On the first of these questions, an analysis by Citigroup provides a negative answer. According to this analysis, by 2014 the ratio of gross debt to gross domestic product will have risen to 180 per cent in Greece, 145 per cent in Ireland and 135 per cent in Portugal. In none of these cases will the debt ratio start moving downwards over this horizon. Spain looks far better, with a debt ratio at about 90 per cent of GDP in 2014, though its path, too, will not have turned down. (See chart.)

The assumptions behind these forecasts are: a cumulative fiscal tightening between 2011 and 2014, inclusive, of 10.8 per cent of GDP in Greece, 8.3 per cent in Portugal, 7.3 per cent in Ireland and 5.7 per cent in Spain; interest cost of new funding rising from close to 5 per cent to 5.6 per cent in 2014 for Greece, Portugal and Ireland (determined by a weighted average of rates from the International Monetary Fund and the European Financial Stability Fund) and higher rates for Spain, since the latter will rely on the market; and, finally, privatisations and bail-outs. The analysis also assumes that a percentage point of fiscal tightening would lower growth by half as much.

Assume that these countries could borrow affordably in private markets at a gross debt ratio of 80 per cent of GDP. Assume, too, that European governments ensure that the IMF takes no losses. Then, the reduction in value of the rest of the debt would need to be as much as 65 per cent of GDP for Greece, 50 per cent for Ireland and 45 per cent for Portugal. The total “haircut” would be €423bn: €224bn for Greece, €107bn for Ireland and €92bn for Portugal.

One can quibble over the figures: these may be too pessimistic. But, without a big restructuring, these countries are now most unlikely to be able to finance themselves in the market on bearable terms. That is also what markets are saying: spreads on 10-year bonds over yields on German Bunds are 1,340 basis points, or 13.4 percentage points for Greece, 875 basis points for Ireland and 818 basis points for Portugal. This is why they are all now in official programmes. Worryingly, spreads for Spain are also now uncomfortably high, at 240 basis points, while those for Italy have reached 190 points. The eurozone, in short, is confronting a frightening sovereign debt challenge, aggravated by the dependence of its banks on support from its states and of its states on finance from its banks.

Now turn to the second question: who should bear the losses? If all the haircuts were to fall on private creditors, their losses in 2014 would be 97 per cent of their holdings of Greek debt, 63 per cent of their Irish debt and 60 per cent of their Portuguese debt. Official creditors would, by then, have to bear a substantial part of the total losses. Since governments would also need to bail out some of the holders of the restructured debt, particularly the banks, the eurozone would be revealed as a “transfer union”. Note, moreover, that this would occur despite a big fiscal effort in the affected countries. But even that would be insufficient to reverse the unfavourable debt dynamics in the medium term, partly because GDP growth is likely to remain so weak.

Against this background, proposals for rollovers by the banks, whether or not deemed technically a default, are neither here nor there. Much more to the point would be debt buy-backs at levels close to current market prices, as discussed in last week’s statement on Greece of the Institute for International Finance, which brings together the biggest international banks. That would crystallise losses. So be it. Let reality be recognised. As the Financial Times has also argued this week, the case for offering a menu of options with partial guarantees, similar to those under the 1989 Brady plan for Latin American debt, is powerful.

The question is whether such voluntary debt reductions would be enough, particularly for Greece. The answer is No. Governments would also have to play a part, by either accepting losses on the face value of their loans or ensuring lower interest rates, as proposed by Jeff Sachs of Columbia University. These are just two ways of achieving a lower net present value of debt service.

The dangers of debt relief are great. But the chances of success with denial are close to zero. True, it is possible for an ever greater share of the debt to be assumed by governments, so bailing out private creditors. Yet, ultimately, the cost of the debt owed to official sources will have to be cut by lowering interest rates or reducing sums outstanding.

It is not a question of whether such adjustments will have to be made, but of when. The history of such crises strongly suggests that it should be done sooner rather than later. Only after debt is on a sustainable path is confidence likely to return. Allowing foolish lenders, incompetent regulators and sloppy policymakers to hide past mistakes is a bad excuse for endless delays.

The doubt, in truth, is not over whether relief on the present value of the debt service is required. The real questions are elsewhere. One is over how to manage a co-operative debt restructuring. The other is over competitiveness and the return to growth. Some point to the success of Latvia in managing its so-called internal devaluation. But its GDP is 23 per cent below its pre-crisis peak. That is a depression. Moreover, the more successful a country turns out to be in cutting its costs, the worse the debt burden becomes. Thus, debt restructuring is merely a necessary condition for an exit. It is unlikely, in all cases, to be enough. Some economies may just wither away.

Alternatively, politicians may pull their countries out of the eurozone regardless of short-run costs. It is far too early to assume this will be the outcome, though some already do. But if there is to be any chance of avoiding this outcome, realism is required. At some point, the present value of the cost of debt must be drastically lowered. This does not have to happen today. But it has to happen soon enough to give people hope. In its absence, failure is not just likely. It is close to a certainty.

Moment of truth for the eurozone, Financial TimesBy Martin Wolf.

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Sofrimento sem sentido

J. Bradford DeLong*

Por três vezes na minha vida, concluí que o meu entendimento do mundo estava substancialmente errado.

A primeira vez foi em 1994, na sequência da assinatura do Acordo de Comércio Livre da América do Norte (NAFTA), quando os fluxos financeiros para o México com vista à construção de fábricas que exportassem para o maior mercado consumidor do mundo se revelaram claramente inferiores aos fluxos de capitais com destino aos Estados Unidos da América em busca de um clima de investimento mais favorável. O resultado foi a crise do peso mexicano (que eu, enquanto Secretário Adjunto do Tesouro norte-americano, tive que ajudar a conter).

A segunda epifania surgiu no Outono/Inverno de 2008, quando se tornou claro que os grandes bancos não tinham controlo nem sobre a sua alavancagem nem sobre as suas carteiras de derivados, e que os bancos centrais de todo o mundo não tinham nem capacidade nem vontade de sustentar a procura agregada em face de uma crise financeira de grandes proporções.

O terceiro momento é agora. Enfrentamos actualmente uma contracção nominal da procura de 8% relativamente à tendência pré-recessão, não existem quaisquer sinais de pressões inflacionárias e as taxas de desemprego na região do Atlântico Norte excedem em pelo menos três pontos percentuais todas as estimativas credíveis do que possa ser uma taxa de desemprego sustentável. Ainda assim, e apesar da falta de atenção ao crescimento económico e ao desemprego implicarem normalmente derrotas nas eleições seguintes, os líderes políticos da Europa e dos Estados Unidos clamam pela adopção de políticas que reduzem, no curto prazo, os níveis de actividade económica e de emprego.

Estará a escapar-me aqui alguma coisa?

Julgava eu que as questões fundamentais da macroeconomia se encontravam resolvidas por volta de 1829. Por essa altura, já nem o próprio Jean-Baptiste Say acreditava na Lei de Say dos Ciclos Económicos. Say sabia muito bem que as situações de pânico financeiro e de excesso de procura por activos financeiros poderiam dar origem, no sector real da economia, a uma procura insuficiente para manter os níveis de produção e de emprego; e que embora a não aplicabilidade da Lei de Say no curto prazo pudesse ser temporária, isso teria, ainda assim, consequências altamente destrutivas.

Fazendo uso deste conhecimento, as perturbações do ciclo económico deverão ser corrigidas através de uma, ou mais, das três formas seguintes:

1. Primeiro que tudo, não deixar acontecer. Evitar o que quer que seja que possa dar origem a uma situação de escassez de activos financeiros ou de excesso de procura por esses mesmos activos – quer se trate do esvair de fluxos financeiros para o exterior no contexto do padrão-ouro; de um colapso da riqueza de longo prazo, tal como sucedeu aquando do rebentamento da bolha das empresas tecnológicas; ou de uma movimentação em massa em direcção a activos financeiros mais seguros, como em 2007/2008.

2. Se não for possível evitar o problema, então o governo deverá intervir e aumentar os níveis de consumo público de bens e serviços, de modo a manter o emprego nos seus níveis normais e a compensar a contracção da despesa privada.

3. Se não for possível evitar o problema, então o governo deverá criar e disponibilizar os activos financeiros que o sector privado quer deter, por forma a relançar a procura privada pelos bens e serviços produzidos em consequência da capacidade instalada.

Há um sem-número de subtilezas relativamente à adopção de cada uma destas opções políticas por parte dos governos. A tentativa de implementação de uma delas pode comprometer, ou interferir, com as tentativas de prossecução das restantes. Para além disso, no caso dos agentes económicos incorporarem a expectativa de tendências inflaccionárias nos seus cálculos e acções, pode suceder que nenhuma destas três curas se mostre eficaz. Porém, não é essa a situação em que nos encontramos.

Da mesma forma, se o grau de confiança na capacidade de um governo fazer face aos seus compromissos financeiros sofrer um abalo, a intervenção de um financiador externo de último recurso pode ser essencial para assegurar a eficácia tanto da primeira quanto da segunda cura. No entanto, actualmente também não é esse o caso entre as principais economias do Atlântico Norte.

E no entanto, de alguma forma, todas estas três curas deixaram de estar em cima da mesa. Não se vislumbra como provável a implementação de reformas em Wall Street e Canary Wharf que visem reduzir a probabilidade e gravidade de um qualquer pânico financeiro futuro, tal como não são prováveis quaisquer intervenções governamentais com vista a regular os fluxos de activos financeiros de elevado risco no interior do sistema bancário. Também não existe qualquer pressão política no sentido de alargar, ou mesmo prolongar, as anémicas medidas de estímulo que foram adoptadas.

Entretanto, o Banco Central Europeu está activamente à procura de formas de reduzir a sua oferta de activos financeiros ao sector privado e a Reserva Federal dos Estados Unidos encontra-se sob pressão para fazer exactamente o mesmo. Em ambos os casos, o argumento é que a adopção de políticas expansionistas adicionais poderá despoletar processos inflaccionistas.

Contudo, quando observamos a evolução dos índices de preços ou a forma como os mercados financeiros têm estado a reagir às estimativas e previsões anunciadas, não é possível observar quaisquer sinais de inflação. Por outro lado, se atentarmos na evolução das taxas de juro praticadas nos mercados de dívida pública das principais economias desta região, também não encontramos quaisquer indícios de risco de emergência de uma crise da dívida soberana entre estas economias.

Ainda assim, quando escutamos os discursos dos decisores políticos de ambos os lados do Atlântico, aquilo que se ouve é Presidentes e Primeiros-Ministros a dizer coisas como: “Assim como as famílias e as empresas tiveram que ser cautelosas a gastar, também o Governo tem agora que apertar o cinto”.

E é aqui que atingimos o limite dos meus horizontes mentais enquanto neoliberal, tecnocrata e economista mainstream e neoclássico. Neste momento, a economia global encontra-se no meio de uma convulsão de grandes proporções caracterizada pela insuficiência da procura e pelo elevado desemprego. Nós conhecemos as curas – e, contudo, parecemos determinados a infligir mais sofrimento ao paciente.

*Artigo de J. Bradford DeLong, ex-Secretário Adjunto do Tesouro norte-americano, é Professor de Economia em Berkeley na Universidade da Califórnia e Investigador Associado no National Bureau for Economic Research (EUA), publicado por http://www.bepress.com/ev/ em Março de 2011. Original aqui.

**Tradução de Sandra Paiva, Paulo Coimbra e Alexandre Abreu.

***Também publicado em Portugal Uncut.

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It is time to stop pretending that we are about to see a “grand bargain” for the eurozone in March. Last week, the political developments in Germany shifted dramatically in the wrong direction. The Bundesbank, the parliament, the small business community and influential academics have all come out openly against an extension of the various support mechanisms. German society as a whole is in open revolt against the eurozone.

The single most important event was the decision by the three coalition parties in the Bundestag to reject, categorically, bond purchases by the European stability mechanism. The ESM will be the permanent anti-crisis institution from 2013. The Bundesbank came to a similar conclusion in its monthly report. On Thursday, 189 German economists wrote a letter to a newspaper denouncing the ESM, calling for immediate bankruptcy proceedings of insolvent eurozone states. It is no longer just the constitutional court that puts a break on the process.

In last week’s column, I tried to explain the origins of that sentiment. Today, I will focus on the consequences. The best outcome, in my view, would be a failure of the current crisis resolution strategy, followed by a complete rebooting. The worst would be a never-ending stand-off, followed by a financial cardiac arrest. The most likely outcome is a very small compromise of the kind that resolves nothing.

The current bargaining revolves around four pillars: current crisis management; the ESM; a new stability pact with budgetary surveillance; and co-ordination of social and economic policies. Negotiations on the ESM’s funding have been going well, as have discussions on the stability pact. But there is no agreement on bond purchases, and no progress at all on current crisis management.

The least sturdy of the four pillars is policy co-ordination. Chancellor Angela Merkel insists on a German-inspired competitiveness pact as a quid pro quo for Germany’s readiness to provide credit guarantees. But how should other countries respond?

My answer is: reject it. I would recommend eurozone member states to veto the competitiveness pact, even if that jeopardises the entire package. If Germany cannot deliver its side of this quid pro quo, it is not clear to me why anybody would accept a loss of sovereignty – which is effectively what policy co-ordination would imply. The only reason to accept such a loss of sovereignty would be the prize of an ever closer economic union. But that would have to include a common eurozone bond at one point. Through bond purchases the ESM would eventually mutate into a European debt agency, the financial counterpart of an economic union. But if the ESM has its wings clipped from the outset, this will never happen.

There is also the problem inherent in the purely inter-governmental system of policy co-ordination that France and Germany are offering. In such a system, the large countries impose their will on the small. Just witness the arrogance with which Ms Merkel and French president Nicolas Sarkozy presented their six-point competitiveness pact at the last European Council.

But would the financial markets not panic at a failure to agree a deal? Quite possibly. But nobody should fool themselves into thinking that the reaction to a fudged deal would be better. It might come a little later, but it would come. And then you are in a much worse position. Once you get a bad deal in March, there is no way you can crawl back to the Bundestag for a top-up loan in May.

The reason we are in this pickle is, ironically, the lack of market pressure. With their enthusiasm about a deal, the financial markets might have killed it. Eurozone countries only act when under immediate pressure. Germany, for example, has a massive problem in its state-owned banking sector, but apart from a reluctant restructuring of WestLB, this is currently no policy priority. The Bundesbank tells everyone that it is not happy about transparency in stress tests, and there is no law in place to force recapitalisations. The relatively calm market situation also explains why 189 economists find the time to write a long letter, criticising what they clearly consider to be the resolution of someone else’s crisis. I am afraid that without a force majeure event, there will be no crisis resolution. A good example is the Spanish recapitalisation of the savings banks. The Spanish government would never have had the courage to force this without the fear of being next in line for a speculative attack.

The EU’s crisis resolution strategy is to draw attention away from the underlying causes of the crisis: that you cannot have nationally controlled and undercapitalised banking systems in a monetary union with structural current account imbalances. The difficult job is to translate this technical statement into a language understood by politicians and their constituents, and to do so without lying. This is not a fiscal crisis. It is not a crisis of the south. It is a crisis of the private sector and of undercapitalised banks. It is as much a German crisis as it is a Spanish crisis. This acknowledgement must be the starting point of any effective resolution system. A veto in March is thus a necessary first step in crisis resolution.

Wolfgang Münchau, February 27 2011, FT

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In this short RSA Animate, renowned philosopher Slavoj Zizek investigates the surprising ethical implications of charitable giving.

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Recessions are common; depressions are rare. As far as I can tell, there were only two eras in economic history that were widely described as “depressions” at the time: the years of deflation and instability that followed the Panic of 1873 and the years of mass unemployment that followed the financial crisis of 1929-31.

Neither the Long Depression of the 19th century nor the Great Depression of the 20th was an era of nonstop decline — on the contrary, both included periods when the economy grew. But these episodes of improvement were never enough to undo the damage from the initial slump, and were followed by relapses.

We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense.

And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.

In 2008 and 2009, it seemed as if we might have learned from history. Unlike their predecessors, who raised interest rates in the face of financial crisis, the current leaders of the Federal Reserve and the European Central Bank slashed rates and moved to support credit markets. Unlike governments of the past, which tried to balance budgets in the face of a plunging economy, today’s governments allowed deficits to rise. And better policies helped the world avoid complete collapse: the recession brought on by the financial crisis arguably ended last summer.

But future historians will tell us that this wasn’t the end of the third depression, just as the business upturn that began in 1933 wasn’t the end of the Great Depression. After all, unemployment — especially long-term unemployment — remains at levels that would have been considered catastrophic not long ago, and shows no sign of coming down rapidly. And both the United States and Europe are well on their way toward Japan-style deflationary traps.

In the face of this grim picture, you might have expected policy makers to realize that they haven’t yet done enough to promote recovery. But no: over the last few months there has been a stunning resurgence of hard-money and balanced-budget orthodoxy.

As far as rhetoric is concerned, the revival of the old-time religion is most evident in Europe, where officials seem to be getting their talking points from the collected speeches of Herbert Hoover, up to and including the claim that raising taxes and cutting spending will actually expand the economy, by improving business confidence. As a practical matter, however, America isn’t doing much better. The Fed seems aware of the deflationary risks — but what it proposes to do about these risks is, well, nothing. The Obama administration understands the dangers of premature fiscal austerity — but because Republicans and conservative Democrats in Congress won’t authorize additional aid to state governments, that austerity is coming anyway, in the form of budget cuts at the state and local levels.

Why the wrong turn in policy? The hard-liners often invoke the troubles facing Greece and other nations around the edges of Europe to justify their actions. And it’s true that bond investors have turned on governments with intractable deficits. But there is no evidence that short-run fiscal austerity in the face of a depressed economy reassures investors. On the contrary: Greece has agreed to harsh austerity, only to find its risk spreads growing ever wider; Ireland has imposed savage cuts in public spending, only to be treated by the markets as a worse risk than Spain, which has been far more reluctant to take the hard-liners’ medicine.

It’s almost as if the financial markets understand what policy makers seemingly don’t: that while long-term fiscal responsibility is important, slashing spending in the midst of a depression, which deepens that depression and paves the way for deflation, is actually self-defeating.

So I don’t think this is really about Greece, or indeed about any realistic appreciation of the tradeoffs between deficits and jobs. It is, instead, the victory of an orthodoxy that has little to do with rational analysis, whose main tenet is that imposing suffering on other people is how you show leadership in tough times.

And who will pay the price for this triumph of orthodoxy? The answer is, tens of millions of unemployed workers, many of whom will go jobless for years, and some of whom will never work again.

Op-Ed Columnist – The Third Depression – NYTimes.com.

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Published: June 27 2010 19:52

I was speaking recently to a group of investors who forced me – all but at gunpoint – to tell them how long I thought the euro would last. I normally prefer conditional forecasts but, in this case, I was asked to make an unqualified prediction. And so I yielded. My answer was that the eurozone would probably not survive the decade in its current form. As it turned out, I was the most optimistic person in the room, by far.

There are few people in Brussels – where I live and work – who would consider me an optimist. The point is not so much about how policymakers and investors relate to my predictions, but how the two groups relate to each other. They are worlds apart. Europe’s political classes still believe they are in control of the situation – and that a combination of austerity and financial repression will do the trick. Investors, meanwhile, do not understand how Greece, Spain and Germany can coexist in a monetary union.

I have noticed that whenever the European Council meets in Brussels, the European bond markets tend to slump with short delay. Yields are now close to the level they were at in early May, when the European Council set up the €440bn ($540bn, £360bn) European Financial Stability Facility and when the European Central Bank started to buy bonds. This crisis goes on and on.

The reason is that investors have lost confidence in the political economy of the eurozone. European politicians such as Wolfgang Schäuble, German finance minister, praise their own long-termism. But investors ask with some justification: what is long-termist about a bank bail-out without bank resolution? Or a sovereign bail-out without fiscal union?

I recently had an eye-opening experience appearing in the finance committee of the German Bundestag as a witness to testify on the proposed legislation to ban naked short sales. It turned out that the finance ministry could not produce the basic statistics on short selling, let alone provide even an anecdotal link between short selling and the bond crisis. I told the Bundestag that this cynical piece of legislation has contributed far more to the European bond market crisis than the naked short sales it purports to ban. Helmut Schmidt, the former German chancellor, said later that he almost died laughing when he heard about this legislation.

The proposed ban is the latest reminder that European Union members, and Germany in particular, have not learnt a single lesson from their serial communication failures during the crisis. In February, they made the mistake of announcing a political agreement on a Greek rescue package without backing it up for another three months. In May, they hailed the stability facility as a historic breakthrough in political governance; it then turned out to be little more than bail-out facility.

I only hope that they know what they did when they recently announced the publication of the stress tests for 25 banks. Once these are published, the markets will immediately demand to see the tests for all banks. Once that happens, in turn, governments will need to produce a convincing recapitalisation strategy. I fear, however, that they are once again committing themselves to going down a road without a map.

Without an endgame, this exercise will end in disaster. At some point the markets will realise that large parts of the German and French banking systems are insolvent, and that they are going to stay insolvent. You might think that Europe’s policy elites cannot be so stupid as to commit themselves to stress tests without a resolution strategy up their sleeves. But I am afraid they probably are. Europe’s political leaders and their economic advisers are, for the most part, financially illiterate.

Is there a way out? Yes there is, but the chance of a resolution to the crisis is starting to fade. The first step would have to be a serious attempt to resolve bank balance sheets. This is as much a German and French banking crisis as it is a Greek and Spanish debt crisis. You need to resolve both problems simultaneously. Resolution would require a large fiscal transfer, not from Germany to Greece, but from the German public sector to the German bank sector – in the form of new capital. The same would apply to France.

Beyond this restructuring, the eurozone will need to commit itself to a full-blown fiscal union and proper political institutions that give binding macroeconomic instructions to member states for budgetary policy, financial policy and structural policies. The public and private sector imbalances are so immense that they are not self-correcting. And you have to be very naive to think that peer pressure is going to resolve anything.

There is no point in beating about the bush and issuing polite calls for the creation of independent fiscal councils or other paraphernalia. This is not the time for a debate on second-order reforms. I am aware that, at a time of rising nationalism and regionalism throughout the EU, there is no consensus for such sweeping reforms. But that is the choice the EU’s citizens and their political leaders will have to make – a choice between reverting to dysfunctional and, as it transpires, insolvent nation states, or jumping to a political and economic union.

By Wolfgang Münchau

FT.com / Columnists / Wolfgang Münchau – Only a closer union can save the eurozone.

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By George Soros. Published: June 24 2010.

Germany used to be at the heart of European integration. Its statesmen used to assert that Germany had no independent foreign policy, only a European policy. After the fall of the Berlin Wall, its leaders realised that German reunification was possible only in the context of a united Europe, and they were willing to make some sacrifices to secure European acceptance. Germans would contribute a little more and take a little less than others, thereby facilitating agreement.

Those days are over. The euro is in crisis, and Germany is the main protagonist. Germans don’t feel so rich any more, so they don’t want to continue serving as the deep pocket for the rest of Europe. This change in attitude is understandable, but it has brought the European integration process to a halt.

By design, the euro was an incomplete currency at its launch. The Maastricht treaty established a monetary union without a political union – a central bank, but no central treasury. When it came to sovereign credit, eurozone members were on their own.

This fact was obscured until recently by the European Central Bank’s willingness to accept the sovereign debt of all eurozone members on equal terms at its discount window. As a result, they all could borrow at practically the same interest rate as Germany. The banks were happy to earn a few extra pennies on supposedly risk-free assets and loaded up their balance sheets with the weaker countries’ government debt.

The first sign of trouble came after the collapse of Lehman Brothers in September 2008, when the European Union’s finance ministers decided, at an emergency meeting in Paris that October, to provide a virtual guarantee that no other systemically important financial institution would be allowed to default. But German chancellor Angela Merkel opposed a joint EU-wide guarantee; each country had to take care of its own banks.

At first, financial markets were so impressed by the guarantee that they hardly noticed the difference. Capital fled from the countries that were not in a position to offer similar guarantees, but interest-rate differentials within the eurozone remained minimal. That was when countries in eastern Europe, notably Hungary and the Baltic states, got into trouble and had to be rescued.

It was only this year, when financial markets started to worry about the accumulation of sovereign debt, that interest-rate differentials began to widen. Greece became the centre of attention when its new government revealed that its predecessors had lied about the size of the 2009 budget deficit.

European authorities were slow to react, because eurozone members held radically different views. France and other countries were willing to show solidarity, but Germany, traumatised twice in the 20th century by runaway prices, was allergic to any build-up of inflationary pressures. (Indeed, when Germany agreed to adopt the euro, it insisted on strong safeguards to maintain the new currency’ s value, and its constitutional court has reaffirmed the Maastricht treaty’s prohibition of bail-outs.)

Moreover, German politicians, facing a general election in September 2009, procrastinated. The Greek crisis festered and spread to other deficit countries. When European leaders finally acted, they had to provide a much larger rescue package than would have been necessary had they moved earlier. Moreover, in order to reassure the markets, the authorities felt obliged to create the €750bn European Financial Stabilisation Facility, with €500bn from the member states and €250bn from the International Monetary Fund.

But the markets have not been reassured, because Germany dictated the terms of the rescue and made them somewhat punitive. Moreover, investors correctly recognise that cutting deficits at a time of high unemployment will merely increase unemployment, making fiscal consolidation that much harder. Even if the budget targets could be met, it is difficult to see how these countries could regain competitiveness and revive growth. In the absence of exchange rate depreciation, the adjustment process will depress wages and prices, raising the spectre of deflation.

The policies currently being imposed on the eurozone directly contradict the lessons learnt from the Great Depression of the 1930s, and risk pushing Europe into a period of prolonged stagnation or worse. That, in turn, would generate discontent and social unrest. In a worst case scenario, the EU could be paralysed or destroyed by the rise of xenophobic and nationalist extremism.

If that were to happen, Germany would bear a major share of the responsibility. Germany cannot be blamed for wanting a strong currency and a balanced budget, but as the strongest and most creditworthy country, it is unwittingly imposing its deflationary policies on the rest of the eurozone. The German public is unlikely to recognise the harm German policies are doing to the rest of Europe because, the way the euro works, deflation will serve to make Germany more competitive on world markets, while pushing the weaker countries further into depression and increasing the burden of their debt.

Germans should consider the following thought experiment: withdrawal from the euro. The restored Deutschemark would soar, the euro would plummet. The rest of Europe would become competitive and could grow its way out of its difficulties but Germany would find out how painful it can be to have an overvalued currency. Its trade balance would turn negative, and there would be widespread unemployment. Banks would suffer severe losses on exchange rates and require large injections of public funds. But the government would find it politically more acceptable to rescue German banks than Greece or Spain. And there would be other compensations; German pensioners could retire to Spain and live like kings, helping Spanish real estate to recover.

Of course, this is purely hypothetical because, if Germany were to leave the euro, the political consequences would be unthinkable. But the thought experiment may be useful in preventing the unthinkable from actually happening.

The writer is chairman of Soros Fund Management

FT.com / Comment – Germany must reflect on the unthinkable.

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A government debt crisis is ravaging the Eurozone. This column argues that its cause is misunderstood. The culprit is a profligate private banking sector that has put strain on otherwise manageable government finances. The increase in debt has reached crisis point because the Eurozone is a monetary union without being a political union – it has no fire brigade to put out the fire.

A government debt crisis is ravaging the Eurozone. Yet when comparing the development of government debt in the Eurozone with that of the US it is striking to find how much more benign the trends in sovereign debt are in the Eurozone compared to the US.

This is made clear in Figure 1, which shows the debt to GDP ratios in the Eurozone and the US since 1999. Prior to the eruption of the financial crisis in 2007, the two debt ratios were converging, i.e. the Eurozone government debt ratio tended to decline while the US government debt ratio tended to increase. Since the start of the financial crisis we observe a significantly faster increase of the government debt ratio in the US than in the Eurozone. In 2010 the US government debt ratio will be 10 percentage points higher than in the Eurozone.

Figure 1. General government consolidated gross debt

Source: European Commission, AMECO

An outsider looking at this figure would surely conclude that if one country is likely to be hit by a sovereign debt crisis it should be the US, not the Eurozone. If there has been government profligacy (as is now often claimed to be the cause of the debt crisis in the Eurozone) it seems to be the case more in the US than in the Eurozone. Yet it is the Eurozone that is hit by the crisis. Why?

Hidden differences and no mechanism

The answer is to be found in the fact that the average debt to GDP ratio of the Eurozone hides large differences between countries and that the Eurozone does not have a mechanism to deal with these differences. Let us first concentrate on the size of the differences. These are shown in Figure 2.

Figure 2. General government consolidated gross debt

Source: European Commission, AMECO

The differences are striking. Some countries like Greece and Italy have very high public debt levels, others such as Ireland and Spain have public debt levels that are increasing fast. This situation has raised concerns about the capacity of these countries to continue to service their debts in an environment of low economic growth. A majority of countries in the Eurozone, however, experience a debt dynamics that is benign certainly when compared to the US (and also the UK).

Given the overall strength of the government finances within the Eurozone it should have been possible to deal with a problem of excessive debt accumulation in Greece, which after all represents only 2% of Eurozone GDP. Yet it has appeared impossible to do so. The reason is that there is no mechanism to “internalise” this problem, i.e. to automatically organise transfers to the country experiencing these problems. As a result, the Greek sovereign debt crisis was left hanging high and dry, triggering in turn contagion to other countries that the market perceived to be next in line for possible default.

The contrast with the US is stark. Deficit and surplus regions also exist in the US. These divergences however are considerably alleviated by the fact that the centralised Federal budget automatically redistributes to the deficit regions without anyone noticing. It has been estimated that for every dollar decline in income at the state level, between 0.2 and 0.4 dollars flow back to the state through the federal budget (see for example Sachs and Sala-i-Martin 1989, Von Hagen 1991, and Asdrubali et al. 1996).

What is the Eurozone missing?

The heart of the problem is that the Eurozone is a monetary union without being a political union. In a political union there is a centralised budget that provides for an automatic solidarity mechanism in times of crisis. This is absent in the Eurozone (see Asdrubali et al. 1996 and Mélitz and Zumer 1999. For a survey, see De Grauwe 2009).

Automatic transfers do not solve the problem of adjustment of states or countries, but they reduce the need for the deficit state or country to borrow in the capital markets. Thus the existence of a centralised budget creates an automatic solidarity (insurance) mechanism allowing countries to draw on the resources of other countries when facing a negative shock, without the need to organise an explicit decision making process. Many economists have stressed in the past that such an insurance mechanism is essential for a smooth functioning of the monetary union (in the economists’ jargon, to ensure optimality of a monetary union). They appear to be vindicated today.

An explicit fiscal union is not the only way to provide for an insurance mechanism within a monetary union. It can also be organised using the technique of a monetary fund that obtains resources from its members to be disbursed in times of crisis (and using a sufficient amount of conditionality). Such a proposal has recently been made by Gros and Mayer (2010).

The design of the Eurozone, however, completely discarded any form of automatic insurance mechanism. The main reason was that, as with any insurance mechanism, there is the risk of moral hazard. This is the risk that governments will exploit the existence of an insurance mechanism to create excessive debts and deficits. The need to avoid moral hazard was the main reason why the Eurozone was created without any insurance mechanism.

While it is understandable that countries were not willing to automatically transfer resources to deficit countries it is less understandable that so many lived in the illusion that a monetary union could function smoothly without it. The present crisis shows that even if countries never intended to provide assistance to others, events can force them to do so. In much the same way, governments never intended to save banks, but when a banking crisis erupted, their hands were forced. Likewise, at some point a monetary union will force member countries to show some solidarity – whether they like it or not. The trouble with the Eurozone is that when events force countries to practice solidarity there is no mechanism to do this smoothly.

A fire code without a fire brigade

The official doctrine in the Eurozone has been that an insurance mechanism is not necessary for a smooth functioning of the Eurozone. The Stability and Growth Pact would do the trick – just make sure that countries abide by the rules. If they do so, i.e. if they are always well-behaved, there is no need for an automatic insurance mechanism provided by a centralised budget, or by a European Monetary Fund. This is like saying that if people follow the fire code regulations scrupulously there is no need for a fire brigade. The truth is that there will always be some people who do not follow the rules scrupulously, making a fire brigade necessary. And an important detail: This fire brigade should be willing to extinguish the fire before it punishes the guilty.

Thus it can be said that the Eurozone had an elaborate set of rules to prevent fires and decided that therefore it would not need a fire brigade. When it finally set up a fire brigade, the latter was busy trying to punish the guilty before it started extinguishing the fire. No wonder the fire spread to other countries.

The recent proposals developed by the European Commission, under pressure from the German government, continue to follow the logic of strengthening the fire code rules and ignoring the need to create a fire brigade that is willing to extinguish the fire before it punishes the reckless. It is clear that this approach is not workable once a crisis erupts.

Policymakers using incorrect analysis of the fundamentals

In addition, the diagnosis of the causes of the crisis underlying these proposals is wrong. Let me elaborate on this.

  • It is now repeated continuously that the source of the debt crisis in the Eurozone is the profligacy of national governments. As was stressed earlier, prior to the emergence of the financial crisis the government debt to GDP ratio in the Eurozone was declining.
  • During the same period, private debt (households and financial institutions) increased in an unsustainable way. This is shown in Figure 3.

Figure 3. Private and government liabilities in the Eurozone (share of GDP)

Source: European Commission, AMECO, and CEPS

While the government debt ratio in the Eurozone declined from 72% in 1999 to 67% in 2007) the household debt increased from 52% to 70% of GDP during the same period. Financial institutions increased their debt from less than 200% of GDP to more than 250%.

  • With the exception of Greece, the Eurozone governments were more disciplined than the private sector in containing their debt.
  • The explosion of the government debt after 2007 was the result of a necessity to save the private sector, in particular the financial sector.

Those who say that it is government profligacy that is the source of the debt crisis are mistaken. They also fail to see the inevitable connection between private and public debt. This connection is particularly strong in countries like Spain and Ireland that have been hit badly by the debt crisis.

As can be seen from Figure 2, Spain and Ireland were spectacularly successful in reducing their government debt to GDP ratios prior to the financial crisis, i.e. Spain from 60% to 40% and Ireland from 43% to 23%. These were the two countries, which followed the rules of the Stability and Growth Pact better than any other country – certainly better than Germany that allowed its government debt ratio to increase before 2007. Yet the two countries, which followed the fire code regulations most scrupulously, were hit by the fire, because they failed to contain domestic private debt.

A fire code without a fire brigade: Fighting the wrong enemy

The European Commission’s recent proposals continues to follow the philosophy still that the fire code regulations must be strengthened while nothing is done to create an effective fire brigade. In this sense the Commission is fighting the wrong enemy.

This “fighting-the-wrong-enemy” syndrome is even more pronounced in the recent proposal made by the German government to impose balanced budget rules in all the Eurozone countries. Such a proposal, if implemented, would do little to avoid the kind of crisis that the Eurozone experiences now.

This has everything to do with the build-up of major imbalances involving the private sector. As argued earlier, some countries (not only in Southern Europe) allowed unsustainable real estate and consumption booms to emerge and to be financed by bank debt. Much of the financing of these unsustainable booms was done by the “virtuous” countries with current-account surpluses. These imbalances will occur even when all countries follow balanced budget rules. Thus it appears that the German government’s proposal to install balanced budget rules is a major cover-up of its own responsibility in contributing to the imbalance within the Eurozone.

In all fairness it should be added that there is an important new and positive element in the recent Commission’s proposals. This is that not only the government budget debts and deficits must be monitored, but also the private sector imbalances, in particular private debt levels. The issue here is how this monitoring can be made effective so as to avoid new crises. One can have doubts whether this can be achieved without a further transfer of sovereignty to European institutions.


It has often been said, but it cannot be repeated enough that the structural problem of the Eurozone is the absence of a sufficiently strong political union in which the monetary union should be embedded. Such a political union should ensure that budgetary and economic policies are coordinated preventing the large divergences in economic and budgetary outcomes that have emerged in the Eurozone. It also implies that an automatic mechanism of financial transfers is in place to help resolve financial crises. Mutual solidarity cannot be avoided in a monetary union, even if it implies solidarity with the sinners.

Paul De Grauwe, 19 May 2010


Asdrubali, P, B Sørensen, and O Yosha (1996), “Channels of Interstate Risk-sharing: US 1963 – 1990”, Quarterly Journal of Economics, 3:1081-1110.
De Grauwe, P (2009), The Economics of Monetary Union, 8th Edition, Oxford University Press.
Mélitz, J and F Zumer (1999), “Interregional and International Risk Sharing and Lessons for EMU”, CEPR Discussion Paper 2154.
Gros, D and T Mayer (2010), “Financial Stability beyond Greece: On the need for a European Financial Stability Fund”, CEPS, May.
Sachs, J and X Sala-i-Martin (1989), “Federal Fiscal Policy and Optimum Currency Areas”, CEPR Discussion Paper 632.
Von Hagen, J (1991), “Fiscal Arrangements in a Monetary Union. Evidence from the US”, Working Paper, Indiana University.

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