Eurozone crisis, Season 3, episode 4

“Banking union” is a backdoor to fiscal union. That is why it will not come any time soon. The Eurozone crisis is potentially worse than the Great Depression for peripheral countries (including Spain and Italy). Policymakers still underestimate the risks, to put it mildly. 

The Eurozone crisis is again on the agenda (with Spain officially asking for assistance, first for its banking sector) and an EU summit is planned for June 28-29 regarding the new miracle cure, “banking union”. Below I give a bit of a background to the crisis (we will write about that in more detail) and also the verdict on the latest solution. Bottom line: don’t hold your breath. 

A brief history of peripherals in the Eurozone: over-borrowing sharply reversed

At the outset, the Eurozone involved peripheral countries that never had, in living memory, low inflation, free movement of capital and a well functioning labor and other markets. Not even separately, let alone all of these. The common currency rewarded them with unjustified good conditions, and allowed them to gather enough rope to hang themselves. The currency union was credible in its first 10 years, which meant that in peripheral countries real interest rates were “too low”, compared to inflation expectations and what would have prevailed in case of a separate currency. This resulted in over-borrowing by the governments (e.g. in Greece) or the private sector, households (e.g. in Spain), or both, and consumption and non-productive investment outpacing incomes. If something is artificially cheap, the economy will use too much of it.  Incomes were boosted by over-consumption and over-investment. The resulting boom increased domestic inflation in peripheral countries, further lowering the real interest rate and hiding a deterioration of underlying fiscal positions. This whole process was superimposed on lax global credit conditions.

The last few years saw this process reverse during the crisis: with the drying up of cheap financing and risk appetite, peripheral countries could no longer cheaply (or at all) finance consumption and investment above income. What is more, they would need to de-leverage, meaning paying back debt accumulated in the past. Domestic wages and prices would need to decline to restore competitiveness. This is proving difficult, and investors have their doubts whether it can be done. They demand higher interest rates, and with a declining price level that can lead to very high real interest rates. 

Worse than the Great Depression 

The above description is very simplified one, but it captures the essence of the story. 

Thus peripheral Eurozone countries face a triple problem at the same time: 

  • They have to restore competitiveness (in a currency union the only way to do that is reducing nominal domestic price and wage levels).
  • They have to restore government finances and reduce deficit/debt levels.
  • They have to implement structural reforms to have an even remote chance of eventual growth (and to do the first two without a revolution)

In the meantime, the banking sector of the whole of the Eurozone is in deep trouble as well – reflecting the fact that the private sector accumulated too much debt as well. Many Eurozone banks probably don’t have sufficient capital, and individuals and firms are taking out their money, suspecting this much. This (and tightening regulation like Basel III) is forcing banks to restrict lending and try to regain confidence and somehow raise capital. In the problem countries, capital raising is mostly from governments as no one else would be forthcoming.   And the fact that the troubled countries are in a deep recession and a slowing global economy is not exactly helping either. 

If you think about it, the magnitude of the problem in peripheral Eurozone countries could be worse than the problem in the US during the Great Depression. The 1930s United States “only” had to reduce its domestic price level due to the Gold Standard, and had a lost decade in terms of growth. The Gold Standard is in many ways very similar to the Euro if it is operated by a strict (German-like) central bank. The US on the other hand did not have a government debt or deficit problem during the Great Depression: the US debt to GDP ratio was 16% in 1929 and 44% in 1939. The peak budget deficit during the Depression was 5.9% of GDP in 1934. The peripheral Eurozone countries have much worse numbers. And the US labor and product markets in most aspects were better functioning than the overregulated ones in most Eurozone peripheral countries right now (although initially the New Deal moved that in the wrong direction). 

Full union or falling apart 

At this stage, forecasting the Eurozone’s future largely involves guessing political processes and preferences, both in peripherals (think of the Greek elections) and in ‘core’ countries (“what are Merkel’s plans?”). That is by nature uncertain – anyone who pretends to be sure is probably just trying to influence expectations. But the pressures are so huge that we can venture guesses, based on historical parallels. The first statement is that most peripheral countries (including Spain and Italy) will not be able to adjust on their own, without either default and/or inflation. There are the following possible outcomes: 

  • Fiscal union (assuming of/joint liability for debts)
  • Deleveraging through sovereign/corporate/private defaults (probably all three)
  • Deleveraging through inflation
    • Eurozone as a whole generates inflation
    • Breakup, some countries go through default/inflation, different combination in different countries 

What I deliberately left out is some kind of muddle-through, which is the main scenario of EU policymakers. In this, problem countries grow out of their problems while at the same time tighten fiscal policy and do structural reforms, and all they need is a liquidity assistance. I think that is day-dreaming. In the case of Greece it already proved so (there was a debt-write-down, even before the election). Muddling through will prove unworkable in other weak countries as well, for political reasons – these countries cannot live with 10 years of austerity. The question really is if France can escape, not that if Span or Italy can. This sounds extreme, and as I stressed before, we are largely forecasting politics. But so far (apart from the temporary bounces) “extreme” forecasts have been more right than the usual wishful thinking. 

We will write about these topics in more detail. But if we accept the above, it t follows that the Eurozone will fall apart if political preferences about a full fiscal union and/or ECB inflation policies do not change radically. And it would be a mistake to try to keep it together without such a change in preferences. 

Try to imagine a common Eurozone budget or Germany agreeing to change the ECB’s (implicit) inflation target to, say 5% (which by the way would mean even higher inflation in Germany right now). Quickly you will conclude that this is fantasy for the time being. 

Political preferences only change slowly, and the current crisis is currently exacerbating political centrifugal forces among countries. So the best bet at the moment is an eventual Eurozone breakup. This itself will probably be a longer process, (and not a big bang next month), but with several financial panics, defaults and countries leaving/being forced out on the way.    

Greece to leave first 

In the rest of the EU, there is no political will to keep Greece inside the Eurozone (maybe not even the EU). In the recent month, it has not been a taboo among EU politicians to talk about a Greek exit any more. And there is no political will in Greece to adhere to the bailout deal. So Greece is likely to exit the Eurozone, (or be ejected). A “positive” election outcome would only delay that, and not by much. 

But if Greece leaves the Eurozone, then it will be difficult to persuade markets that no other country will leave/be forced out. Risk premiums will become permanent. This will make interest payments higher and more difficult to reduce the budget deficits in problem countries. 

A Greek exit could give a competitiveness boost to the country. And since its primary deficit is relatively small (but probably bigger than the official 1% of GDP), the enforced fiscal tightening after a total default would not be huge. Eventually the boost from the weak currency would fade if there is no structural reform, and the total lack of credit and likely protectionist policies would hurt the private economy. But the initial good (or not as bad as feared) results may make euro-exit (and total repudiation of debt) tempting for other countries as well – provided there is no civil war after the exit in Greece. 

“Banking union” – not a quick cure

 But the road to falling apart is not straightforward and littered with emergency summits and promises to solve the crisis once and for all. The recent Spanish bank-bailout just means that the government assumes the debt of the insolvent banks, but will itself probably not be able/willing to fulfill all its obligations later on. The latest buzzword is “banking union”. There will be an EU summit discussion about it as a potential solution on June 28-29. This would presumably mean a common bank recapitalization fund, common supervision and regulation, and common deposit insurance. Otherwise it would not achieve its aim, stopping the current slow motion bank run on peripheral banks. But translated into simplistic language, that would mean German taxpayers guaranteeing deposits in weak and very likely insolvent peripheral banks, while those banks could still presumably buy the bonds issued by their own (weak and probably insolvent)  government. German taxpayers will see through this not-very-complicated scheme, and will oppose it, for the same reason that they oppose a full fiscal union. They do not want to pay for other people wasting their money. And who could blame them? I think the amount of Germany-bashing in this crisis is both amazing and unjustified, but I am digressing. 

A “banking union” would work under the same conditions as a fiscal union: if control and responsibility are at the very same place where the decision is about spending. That means a common budget and a political union - yes, one common Eurozone government which decides about important stuff. Very few European country would go for that at the moment. That may change, slowly. But not by the end of this month. So the outcome of the summit will be some kind of enhanced supervision of banks and agreeing to study the possible solutions.  That will not convince markets (for more than about two days). The Eurozone crisis will continue.




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