Friday, June 8, 2012

The euro end game?

by Michael Roberts
The crisis of the euro seems to be heading to another climax, perhaps even to the end game. Banks and other purchasers of government bonds increasingly refuse to buy more Spanish government paper, driving the cost of borrowing each extra euro for the Spanish government towards 8% a year, an interest cost that will make it impossible to meet the fiscal targets on the budget deficit and the public debt set by the Euro leaders. At the same time, corporations and households are beginning to worry about the safety of their cash deposits in Spanish banks, as they are told every day in the press that these banks are holding huge amounts of bad debts from defaults on mortgages and loans to building developers, now that the Spanish property bubble has burst big time. So deposits are leaking out of the Spanish banking system – nearly €100bn in the last three months (see graph below) – a similar sort of pace that the Greek banks have experienced in recent months.

It looks increasingly likely, despite the desperate efforts of the Spanish government to avoid it, that Spain will have to ask for Eurozone funding to get it through its loss of ability to borrow in bond markets. But here’s the problem. Spain’s government would need about €500bn over the next three years (budget deficit: €130bn; sovereign bond rollovers €150bn; regional debt rollovers €100bn; T-bills €75bn and bank recap €100-130bn). The bond markets are not closed to Spain yet, but even allowing for this, the combination of budget deficit, regional and bank re-financing would add up to €330bn. If you add in Italy, which the markets would focus on next, that could be another €400bn. If that amount has to come from the existing Eurozone fund mechanisms, the EFSF (the current temporary funding mechanisms) and ESM (the permanent one supposedly starting in July), it will use up all the funds being contributed by the Eurozone governments and borrowed by them in the bond market.

Spain will then have to comply with draconian fiscal measures demanded by the dreaded Troika, just as Greece, Ireland and Portugal have to now. And, given the difficulties that the Troika programmes are having in trying to meet the fiscal targets set, despite the huge efforts of these governments to impose austerity on their people, private sector creditors are not convinced that they will work. Instead, after Spain, Italy would come into the firing line. And if Italy is forced into a bailout, the game would be up. There is just not enough money in the current Euroland kitty to handle that for three years.

On top of this, of course, is the serious risk that the Greek people will elect a government totally opposed to its existing Troika austerity package, or at best pledged to ‘renegotiate’ the package. Then that would pose the issue for the Euro leaders about whether to continue to finance Greek banks and the Greek government through the ECB and the EFSF. If that ceased, then Greece would default and the issue of its exit from the euro would become immediate.

The Greeks are furious. A recent poll showed that 42% of Greeks ‘blame themselves’ for their situation as opposed to only 26% of Spaniards and only 19% of Italians and Britons. They are really referring to their leaders, in both public and economic circles. The poll also found that the Greeks thought they are the hardest workers in Europe. And as I have reported before in other posts (see An alternative programme for Europe, 11 September 2011), the statistics show that in 2010 a Greek worker worked an average 2,109 hours per year, well ahead of the average slacking German who works only 1,419 hours and ahead of the UK worker (1,647 hours) and indeed even the two-week holidaying US worker (1,778 hours, incidentally the same hours as Italy!). So the answer to why Greeks think they are the hardest workers in Europe is simple. The Greeks think they are the hardest workers because they are! The Greeks’ economic misfortune is attributable to other factors (e.g. low tax collection and corruption from the rich and lack of capital investment by the weak Greek capitalist sector among other things) and not due to the stereotypical laziness of the nation that so suits the German tabloids.

Also 80% of Greeks want to stay in the euro. They know that leaving the Eurozone and the European Union would be no solution. Re-adoption and devaluation of the drachma would cause the value of Greece’s government debt, already at 160% of GDP, to soar, probably doubling or trebling. So any devaluation would have to be followed by a default. Also, devaluation would not save Greece’s exports of shipping charters – which are priced in dollars anyway – but default would cause great harm to Greek banks and Greek savers who own the greatest proportion of Greek government bonds. They would be wiped out by an outright default. Converting their assets and liabilities into drachmas, like the pesofication of deposits in 2000 in Argentina, might keep Greek savers and banks afloat for a while. But a huge devaluation would also drive up inflation, making Greek savings worthless.

The point is that Greece’s real income and wealth will fall sharply in any case, regardless of whether Greece exits the Eurozone or not. The choice is between an economic slump with inflation or one without inflation. A devalued drachma will not help Greece’s economy recover faster from the deep recession. In the last drachma period before 2001, there was a recurrence of currency crises resolved through devaluations that did not improve the ‘competitiveness’ of Greek capitalism on a lasting basis. Indeed, no country has ever devalued its way to prosperity. What Greece needs is relief on its burden of debt and new investment in technology and jobs, not devaluation.

If Greece drops out of the Eurozone, the inevitable adjustment to a lower standard of living will be unfairly distributed because it will happen through inflation. Citibank economists have estimated that Greece would experience 20% inflation and a 20% decline in GDP from 2007 to 2016 (see graph below). The majority of working Greeks are the most exposed to inflation because they do not own foreign bank accounts or other inflation-protected assets. It is also doubtful that Greece would attract much investment from abroad. Who would guarantee the stability of the drachma after its devaluation? No Greek exporter, hotel, or restaurant would convert euro income into drachmas, knowing that the drachma tomorrow would be worth less each day. The drachma would be the main currency for government employees and pensioners only.
The flipside is that ‘letting Greece go’ will also hit the rest of the Eurozone, with direct losses of up to 5% of Eurozone GDP, along the dynamic losses of output and incomes (see my post, Greece: heading for the exit?, 17 May 2012).

So is there any way out for the Euro leaders from a Greek exit, a Spanish and Italian bailout and the eventual break-up of the euro? Well, the history of currency unions that have survived like the US dollar or the UK pound shows that they only do so after political as well as economic integration. Political means moving to a federal government where the fiscal powers of the centre are strong enough to control the bulk of taxation and spending – a fiscal union. Economic means a banking system that is integrated across all the region. Both the US and the UK took hundreds of years of conflict and agreements to achieve that. The US dollar is a ‘successful’ union of 50 states after a turbulent history of more than 200 years that included defaults of eight US states on sovereign debt in the early 1840s; the Civil War; the emergence of the Fed as a key institution and the greater fiscal role of the federal system following the Second World War. The Eurozone is a ‘baby union’, facing its first major crisis.

The Euro leaders need to find a way to move towards fiscal union and a pan-European banking system. Fiscal union would mean that budgets, taxation and spending policies would be decided by a supranational body. Banking union would mean a a pan-European government guaranteeing bank deposits (to stop a run on banks) plus a pan-European regulator to impose common rules for capital and risk. Then the ECB could become a proper lender of last resort for European banks and governments, as the US Fed, UK Bank of England or the Bank of Japan are. At the moment, the ECB is not legally able to be so or willing to do so, when there is no fiscal union.

This euro crisis has created powerful centrifugal forces that threaten to kill the baby euro currency union in its relative infancy. The extent of these forces is revealed by the ‘Target 2′ settlements between the various central banks of the Eurosystem. These are the net balances of euro credits and debits in the various countries in the Eurozone. Before the crisis began, there was little or no difference between the German Bundesbank’s net balance of claims or liabilities with the ECB/Eurosystem than that for the Bank of Greece. But now the Bundesbank has a massive credit with the Eurosystem, while the peripheral weak states in the euro area have combined accumulated net liabilities of equivalent size (see graph below).

What this shows is that the trade deficits being run by the likes of Greece, Spain or Italy with the likes of Germany and Holland are no longer being funded by cross-border private sector bank loans or corporate investment. German banks will not lend to Greek banks and German corporations have stopped investing in Greece, So the deficits are having to be covered by each national bank printing euros and lending this to importers and banks in the weak deficit economies. That is a necessary process as long as the euro is one currency, where a Greek euro is equivalent to a German euro. Stopping this funding would mean the end of the currency union. But the fast-growing imbalances in

Target 2 settlements show that the currency union is being stretched to breaking point.
Achieving fiscal union and banking integration are momentous tasks in such a short time - and time is running out. The ‘financial markets’ (banks, pension funds hedge funds and the rest) may still be convinced that a euro break up can be avoided if the bailout funds are doubled and there is a euro-wide agreement to support Spain and Italy through their austerity measures, along with new fiscal controls.

But as Mick Brooks put it in his excellent account of the euro crisis (,”the EU decision-making process is hopelessly flawed. …. The survival of the Euro is not, and never was, a matter of pure capitalist economic rationality. No such thing exists. The Euro’s future will be the outcome of a complex interaction of political and economic factors. (We may have) underestimated the collective stupidity of the EU authorities .. (so) the Euro’s survival hangs by a thread.”
Apparently, the Euro leaders are drawing up plans to move towards fiscal and banking integration in time for discussion at the Euro summit at the end of this month. But the Germans will only agree to a banking union and ECB support for Spain and Italy if the measures for fiscal union and more supranational control over government taxes and spending are agreed. The French want the former, but not the latter. They want German money, but not German control. The Germans want more control for more money. Mrs Merkel could not sell more funding to her electorate without that.

Things are coming to a head.

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