Euro crisis: The Hollow Euro

Twice in the past century Germans have learnt, the hard way, the value of sound money. Between 1921 and 1923 the Weimar Republic, under the strain of massive WW1 reparations, fell into a hyper-inflationary death spiral. The Mark plunged in value, measured against Gold Standard Marks it fell from a ratio of 1:1 to 1:1 trillion in 2 years. After the German defeat in WW2, their economy was in tatters and the Reichsmark once again worthless. In 1948 Ludwig Erhard, influenced by Austrian School economics, instituted the new Deutsche Mark determined that it should be a sound store of value. During the early post-war period, until the establishment of the D-Mark as a successful currency, German citizens appreciated the value of attaining a hard currency such as Dollars or Sterling. They were the only currencies that could be used to purchase valuable imports. The only way to get hard foreign currencies? Hard work creating products and services for export!

The Germans built their Social Market Economy on solid foundations. The hard-as-nails Bundesbank safeguarded the value of German’s savings while their political class took whatever tough decisions needed to be taken to protect long term German living standards and public services. The Latin countries, on the other hand, often allowed their competitive position to deteriorate. For example Portuguese unit labour costs increased 20% vis-a-vis Germany over the last decade, and Greek unit labour costs increased a whopping 11.2% in Q4 2009 compared with a 0.5% drop in Germany.

This crisis pits the interests of the debt laden PIGS against those of the prudent Germans. Last weekend the Irish press howled with pain over percieved losses in economic sovereignty after the introduction of the new Eurozone bailout package and proposed oversight measures. Meanwhile, the German press worries that the ECB will be pressured into printing money unleashing inflation and lumbering them with a dreaded and feared weak currency. Writing in the Telegraph Ambrose Evans-Pritchard sums up the best options for the PIGS

There is a way out of this crisis, but it is not the policy of wage deflation imposed on Ireland, Greece, Portugal, and Spain, with Italy now also mulling an austerity package. This can only lead to a debt-deflation spiral. The IMF admits that Greeces public debt will rise to 150pc of GDP even after its squeeze, and that Spains budget deficit will still be 7.7pc of GDP in 2015.

The only viable policies short of breaking up EMU or imposing capital controls is to offset fiscal cuts with monetary stimulus for as long it takes. Will it happen, given the conflicting ideologies of Germany and Club Med? Probably not. The ECB denies that it is engaged in Fed-style quantitative easing, vowing to sterilise its bond purchases euro for euro. If they mean it, they must doom southern Europe to depression. No democracy will immolate itself on the altar of monetary union for long.

Similarly see David McWilliams’ urging the ECB to print money, and Constantin Gurdgiev here.

While German newspaper Der Spiegel bemoans the creation of debt transfer union and is very cognisent of pressure mounting on the ECB, in particular from the French, for measures that may generate high inflation, suggesting that Money Printing solution will not play well in Germany.

Still, the price for this bailout is high — possibly too high. The events on that dramatic weekend in Brussels marked the birth of a gigantic European transfer union, where previously unthinkable sums of money are made available to rescue southern euro-zone members. But over and above that, a number of determined politicians under the leadership of French President Nicolas Sarkozy have managed to undermine the independence of the European Central Bank (ECB).

Ever since the launch of the euro over 11 years ago, the French have been annoyed that the common currency generally adheres to German principles. While the French central bank is traditionally viewed as an executive organ of government growth and employment policies, the European Central Bank is politically independent and exclusively committed to the goal of achieving price stability, just like the Bundesbank in postwar West Germany.

Over the past few years, Paris has repeatedly tried to bring the European monetary authority to heel. French government representatives complained at times about interest rates that they felt were too high. At other times, they called for a devaluation of the euro to boost their own exports. Their requests were never granted. Until recently, the ECB enjoyed a reputation for combating inflation even more resolutely than the legendary guardians of the German mark.

All of that has changed since last week. Under the mounting pressure of waves of speculation against the euro, German Chancellor Angela Merkel has allowed herself to be talked into a bailout package that is nothing less than a general overhaul of the monetary union according to the agenda set by the French. In addition to letting the European Commission use the central bank to achieve its own aims, the Germans have accepted the fact that several monetary policy principles are being cast by the wayside. The central bankers are making their printing presses available to finance government loans. They have accepted that European countries are liable for the debts of individual states. They are putting more money in circulation, even though there is already so much liquidity on the markets that a number of experts anticipate that this will soon trigger a rise in inflation.

Now the guardians of the euro are purchasing government bonds from troubled countries like Greece, Spain and Ireland — thereby breaking a taboo that the ECB has always tried to respect. The central bank, which has always prided itself on its independence, has capitulated to the wishes of the politicians.

They note that Merkel is determined to get her man into the top spot at the ECB, but question whether or not the Euro can be saved.

If the German government has its way, Bundesbank President Axel Weber will be tasked with preventing the worse, as the successor to the current ECB president, Jean-Claude Trichet, who is due to retire next year. For the past few months, Merkel has been lobbying heads of state and government in Europe to pave the way for the German’s career jump. A week ago Sunday, Weber sided with the ECB’s chief economist, Jürgen Stark, and the president of the Dutch Central Bank, Nout Wellink, by voting against the purchase of government bonds from heavily indebted euro countries — but then had to defer to the majority.

Merkel appears confident that her plans will go through. After all, she has already arranged for Stark to become Weber’s successor as the new president of the Bundesbank. She recently asked Stark about the position and he agreed.

Should Merkel actually manage to push through her candidates next year, the ECB and the largest and most important of its member banks will be led by two staunch monetary hawks who see it as their primary goal to rein in inflation.

But can this actually succeed? And is it even possible to save the euro?

Update: – Another Der Spiegel article well worth reading The Dangers of the Euro Bailout

But the politicians didn’t do any of that. That’s why they — and not the financial markets — are responsible for the decline of the euro. They will also be responsible if the rescue package doesn’t hold and the euro breaks apart.

But the politicians have succeeded in achieving one goal: There won’t be any state bankruptcies in the euro zone in the future. How could there be? When in doubt, the ECB will just purchase government bonds. The money can’t run out, either — after all, the ECB prints it itself. The American and British central banks are already doing just that today.
But that doesn’t make the situation any better — it only makes it worse. A flood of money like that can’t continue without any consequences. The currency’s stability will be undermined and, sooner or later, inflation will ensue.

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  • Anonymous

    The hard-as-nails Bundesbank safeguarded the value of German’s savings while their political class took whatever tough decisions needed to be taken to protect long term German living standards and public services. The Latin countries, on the other hand, often allowed their competitive position to deteriorate. For example Portuguese unit labour costs increased 20% vis-a-vis Germany over the last decade, and Greek unit labour costs increased a whopping 11.2% in Q4 2009 compared with a 0.5% drop in Germany.

    Apples to pears comparison. Germany did not experience the same growth spurts as Portugal, Spain or Ireland. Moreover, Spain (and indeed Ireland) looked fairly well set, fiscal wise, heading into this crisis. It was not simply a matter of wasteful spending. There is also no reason to assume those economies must have living standards permanently below Germany to compete — they started form a lower base and catchig up was, well, what you want to be doing. Basically, the Euro fuelled this on the way up, and is preventing the obvious remedy on the way down.

    No idea if the Euro survives this or not.

  • Mack

    Hi Anon,

    Portugal had below EU average growth rates, but still had wage growth 20% above that of Germany. It didn’t have the same growth spurt has Ireland or Spain – while Ireland had a real growth spurt (along side a bubble) – Spains growth was mostly down to construction – fueled entirely by the now burst credit bubble. It’s highly unlikely that the Greek economy grew 11.2% in Q4 2009 either. FWIW, the fiscal situation in Spain and Ireland only looked good because of the credit bubble (which apparently, even after the event goes unrecognised by many analysts).

    The point I’m making though is that the Germans have been willing – for a long time – to keep costs under control, unlike most of the rest of Europe (including Britain) they haven’t had to resort to devaluations to restore competitiveness. You now have imbalances within the EU (applying much less so – if at all – to Ireland) whereby the Latin countries competitiveness has deteroiated hugely relative to Germany.

    Given that the Germans have a history of behaving prudently, we can estimate that future wage inflation will low (and highly correlated to productivity growth in Germany) – certainly if the German economists get their way. Without the option of a competitive devalautaion the only route left open Eurozone countries that have allowed competitiveness to deteroriate is grinding deflation.

  • Anonymous

    It’s easy to say that you were in a bubble when it has past. I would guess that even you would have pointed to Ireland’s favourable fiscal position and debt-GDP ratio in 2007.

    Whether the Germans get their way is still an open question. Is a 3 or 4 percent inflation target so bad compared to a 2% one? It certainly would have given more room to monetary policy when this crisis hit, and it’d easy a lot of the relative deflation problems countries have. Germany could also do everyone a favour and introduce measures to stimulate its own demand. It is and has been far too low, and the entirity of Europe can’t export its way out of the crisis.

    If Germany does get it’s way it is likely it will mean the end fo the Euro. Deflation is not the only way out. The thought was that leaving the Euro would crush any country that attempted it, but if you are already screwed?

    Also worth pointing out many Baltic states have been through crushig deflations. They are doing worse than Iceland.

  • Mack

    It’s easy to say that you were in a bubble when it has past. I would guess that even you would have pointed to Ireland’s favourable fiscal position and debt-GDP ratio in 2007.

    That’s probably true.

    I wasn’t specifically refering to you by the way, I’ve seen the same argument about the favourable fiscal position prior to the bust pretty frequently (including broadsheets like the FT) recently.

  • Greenflag

    mack ,

    ‘Given that the Germans have a history of behaving prudently’

    This could come as a surprise to older generations of Danes , Poles , Czechs, Belgians , Dutch and others .

    While all eyes are now focused on the Euro the bigger picture for the world is the battle between what we call the free market capitalism of the USA , EU and Japan versus the State (authoritarian) capitalism of China , Russia ,Brazil , Iran and other large population states . The latter control some 70% of the world’s oil supplies and in recent years have been making use of said control . Western multinationals versus State capitalism is and will continue to be the new paradigm .

    The first casualties in this war have been the political elites of the west who are now being impelled on a road of low or inadequate economic growth rates for their ‘populations ‘ and have neither the resources nor the policies nor the political power to reverse their general slide .

    If the Euro were to go that slide will just increase it’s downhill gradient . Look out for anti immigrant xenophobia increasing and a reversion to the class wars of the 1930’s and earlier .

    When people give up on democracy being capable of resolving their economic and societal issues then our elites can’t be surprised if they -the people -look elsewhere for simple and final solutions . Only human nature .

  • Damian O’Loan

    As regards Germany, isn’t part of the problem maintaining its position as an export economy to other EU/Eurozone nations? I understand that trade with BRIC economies is increasing, but not as quickly as their respective domestic markets. Which seems to make depression in Italy and Spain particularly risky.

    Equally, Germany may have controlled wage increases recently, but from a very high base. It remains one of the world’s most expensive countries in terms of labour costs despite mass cheap labour in certain industries.

    I’m not sure that it can continue to operate its economy on the basis is has done, so whether it will seek a solution independently or within the Eurozone surely depends on what solution it seeks.

    It doesn’t seem to me to be in a completely different position to Ireland’s, given its dependance on unstable multinationals (albeit German) and a service economy. Surely as the major emerging economies turn their focus to domestic consumption the Eurozone, perhaps in partnership with Russia, is likely to do the same? It seems we are seeing the short-term emergency measures but not the long-term exit strategy at this point.

    Incidentally, German opposition to the Greek bail-out seemed to change rapidly when the polls closed that Sunday evening. I’m not sure that didn’t play a fairly major role, worrying as that is in terms of any future bailouts.

  • Mack

    Greenflag –

    If the Euro were to go that slide will just increase it’s downhill gradient . Look out for anti immigrant xenophobia increasing and a reversion to the class wars of the 1930’s and earlier .

    When people give up on democracy being capable of resolving their economic and societal issues then our elites can’t be surprised if they -the people -look elsewhere for simple and final solutions . Only human nature .

    I agree. Part of the problem though is that life under the Euro – for some countries – may be far too tough. Not having had the same experiences as the Germans other Europeans place less emphasis on a hard currency, and not having ever had the discipline to have one in the first place they have no experience of it’s benefits. But yet, now they are tasting the pain and the sacrifice associated with one.

    An alternative might be to help – explicitly aid – countries that want to leave the Euro in so doing. So that the Euro itself becomes a more stable and stronger construct and that countries struggling inside the Euro can find away to prosper outside of it.

  • Mack

    Damian –

    As regards Germany, isn’t part of the problem maintaining its position as an export economy to other EU/Eurozone nations?

    Yes, that’s part of the German culture though – a legacy of the devastation of WWII. Japan is similarly export focused.

    I’m not sure the location of the exports matters – if German products displace Italian products in the USA then the effect is the same. Worse – if costs for Italian clothe manufactures become to high – German retailers will switch to Chinese, while their manufactures supply the Chinese clothes makers with new machinary.

    The Germans have high labour costs – but also high productivity to match it.

    Incidentally, German opposition to the Greek bail-out seemed to change rapidly when the polls closed that Sunday evening.

    I think it was more of the fact that with the election out of the way the German politicians could make unpopular decisions. I don’t think the Germans signed up to join the Lira, Peso or Drachma. I’m pretty sure they assumed it would work out the other way around..

  • Greenflag

    If you can still bring yourself to believe anything out of the mouth of Goldman Sachs try this one just in .

    ‘Goldman Sachs Group Inc. Chief Global Economist Jim O’Neill said it is “ridiculous” to suggest that the euro area will break up within the next year and predicted the currency’s decline may be almost over.

    “The simple misconception is people trying to equate pure economic logic with social political reality,” O’Neill said in an interview from his office in London today. “The Germans and French are passionately committed to it whether the rest of us think it’s crazy or not.”

    On the other hand at the centre of the financial storm Mr Papandreou and his cabinet are trying to get to the bottom of the role of Goldman Sachs in it’s role of ‘advisor’ to previous Greek Governmetns as to how they could make economic horse manure look like a gilt edged investment bond ;(

    And if GS could pull the wool over the eyes of the Federal Reserve -the banking regulators and the genii who are elected to the top of the USA’s political hierarchy then surely pulling one over on the Greeks would have been like taking a lollipop from a two year . Easily within Blankenfein and his henchmen’s reach I’d say. 🙁

  • Anonymous

    I agree. Part of the problem though is that life under the Euro – for some countries – may be far too tough. Not having had the same experiences as the Germans other Europeans place less emphasis on a hard currency, and not having ever had the discipline to have one in the first place they have no experience of it’s benefits.

    The benefits would need to be pretty good to balance out soemthing like 25% drops in GDP, along with 20-30% drops in wages needed.

    Estonia example:

    http://blogs.ft.com/beyond-brics/2010/05/14/self-sacrifice-for-the-euro-but-for-estonia-and-its-neighbours-is-the-pain-worth-it/

    Consider how many years it would take to recover those kinds of losses, and the social damage caused. Perhaps doing it the hard would bring long term benefits. I considered that for a while; devaluation or inflation does after all eat away at the wealth of a nation just as effectively. But the consequences of deflation cycles seem much, much mroe vicious.

  • Damian O’Loan

    Mack,

    “I’m not sure the location of the exports matters”

    Finding replacements would seem to be increasingly difficult though, which is what I was touching on when I mentioned the emerging economies. That’s what leads me to believe that the Eurozone has less and less to gain from global free trade.

    The state economy v multinational economy paradigm Greenflag mentions is related. Given that these multinationals have used democracies as secure homes but now appear to be upping sticks as and when suits, I can’t see their influence in the West staying as strong as hitherto. Whether that is replaced by nationalism or a broader European project, indeed at all, is surely up in the air at the moment.

    I think it’s the long-term strategy in response to this dilemma that will decide on the future of the Euro. But I’ve definitely moved position, somewhat, since a while ago when I said to you this was all speculator-founded hype.

  • Mack

    That certainly looks like madness – esp. given they can break the peg and devalue – for a much lower cost than Greece could leave the Eurozone.

    It’s got to be driven by fear of Russia –

    For the Baltic elites, the appeal of the euro has always been as much about politics as economics – the ultimate symbol of integration with western Europe for three former Soviet states still living in Russia’s shadow.

  • Anonymous

    Greece requires an adjustment of at least the same level though. And how far has Ireland still to fall?

  • Mack

    The immediate costs associated with leaving Euro are much higher for Greece and Ireland (never mind the long-term opportunity cost of moving from a hard currency to a soft one).

    Could the Irish government afford to continue guarantee banking deposits. I.e. Citizens savings and day-to-day business accounts ? Even if yes, would the resultant currency be so weak that inflation would wipe out any savings? One time currency investor Jim Rogers (co-founder of the Quantum hedge fund with George Soros) reckons that truly oppresed people don’t revolt – only those who have had their expectations raised then dashed. That hasn’t quite happened in Ireland yet – people still talk of the 1980’s as being worse. But if the middle class and upper-working class really were wiped out?

    There are huge risks whether we stay or go..

  • Greenflag

    ‘when I said to you this was all speculator-founded hype.’

    It was never all hype but don’t assume that there are not economic interests and political powers out there who would rather see the euro ‘fail’ than succeed . Divide et impera is still extant whether by global political or multinational corporations or by emerging economic giants .

  • Greenflag

    ‘There are huge risks whether we stay or go’

    At the end of the gallows drop there may be some comfort in a spectacular solo hanging as against that of being hanged as one only of a gang of 16 🙁

    Next up on the gallows should be Mr Osborne’s sterling soon enough .

  • Anonymous

    I odn’t think Ireland can pull out without the consequences being much worse. But Greece? It’s getting to a point where it doesn’t get much worse.

    The problem is the consequences of them pulling out could push several other countries rapidly to the same situation.

  • Damian O’Loan

    So Mutti has given an interview to tomorrow’s editions of Le Monde, El Pais and Corriere della Sera related to some of these issues.

    Short-term, she says that stability and solidity are inseparable and non-negotiable. She also says that the Eurozone is not a union born of financial transfers, that financial markets need further regulation and that the excesses of speculation need to be tempered.

    The long-term strategy could become clearer at June’s European Council meeting. She says she is in agreement with Sarkozy about the need for a European growth strategy, denies a wish for Germany to become like Switzerland or China, and traces her inspiration to Helmut Kohl.

    Some answers at that point perhaps and a high possibility of more conflict with the UK, especially under Hague’s representation.