Project Syndicate, June 30th, 2011.
“It’s not the euro that’s in danger, but the public finances of individual European countries.” One hears this everywhere nowadays, but it’s not true. The euro itself is at risk, because the countries in crisis have, in recent years, been running the eurozone’s monetary printing presses overtime.
Some 90% of the refinancing debt that the commercial banks of the GIPS countries (Greece, Ireland, Portugal, and Spain) hold with their respective national central banks served to purchase a net inflow of goods and assets from other eurozone countries. Two-thirds of all refinancing loans within the eurozone were granted within the GIPS countries, despite the fact that these countries account for only 18% of eurozone GDP. Indeed, 88% of these countries’ current-account deficits over the last three years were financed via the extension of credit within the Eurosystem.
By the end of 2010, ECB loans, which originated primarily from Germany’s Bundesbank, amounted to €340 billion. This figure includes ECB credit that financed capital flight from Ireland totaling €130 billion over the past three years. The ECB bailout program has enabled the people of the peripheral countries to continue to live beyond their means, and well-heeled asset holders to take their wealth elsewhere.
The capacity for continuing this policy will soon be depleted, as the central-bank money flowing from the GIPS countries to the core countries of the eurozone increasingly crowds out the money created through refinancing operations there. If this continues for two more years as it has for the past three, the stock of refinancing loans in Germany will disappear altogether.
Indeed, Deutsche Bank has already stopped participating in refinancing operations. If German banks drop out of the refinancing business, the European Central Bank will lose the direct control over the German economy that it used to have via its interest-rate policy. The main refinancing rate would then only be the rate at which the peripheral EU countries draw ECB money for purchases in the center of Europe, which ultimately would be the source of all the money circulating in the euro area.
The GIPS’ enormous current-account deficits – and the massive exodus of capital from Ireland, in particular – would not have been possible without ECB financing. Without the additional money that GIPS central banks created in excess of their countries’ requirements for internal circulation, trade deficits could not have been sustained, and the GIPS’ commercial banks would have been unable to prop up asset prices (which all too often were those of government bonds).
Last year, with the ECB running out of tools to keep Europe’s troubled banks from precipitating a financial crisis, follow-up financing was agreed upon, and from 2013 onwards the European Stability Mechanism (ESM) is meant to take on that responsibility. This may relieve some pressure, but it only shifts the problem from the ECB bailout fund to the community of states. The ESM is a sure way to bring Europe to its knees, because the longer bailout loans continue, the longer the GIPS’ current-account deficits will persist, and the more their external debts will grow. Eventually, these debts will become unsustainable.
The sole exception is Ireland, which is suffering not from a lack of competitiveness, but from capital flight. Ireland is the only country that has lowered its prices and wages, and its current-account deficit is about to swing into surplus. By contrast, Spain’s external deficit is still above 4% of GDP, while Portugal and Greece recently recorded astronomical figures of around 10%.
What Europe is trying to do in Portugal and Greece is reminiscent of central banks’ futile efforts in past decades to keep exchange rates away from the market equilibrium price level. Some central banks, such as the Bank of England in its unsuccessful fight against George Soros in 1992, got burned; when it became clear how much money was required to buck the market, the policy was abandoned.
Apart from China, central banks don’t intervene to protect their currencies anymore. Europe, too, will get a bloody nose if it keeps trying to artificially prop up asset prices in the periphery. The sums required for this could ultimately run into trillions, according to an estimate by Citibank. This would shatter Europe.
Apart from financial restructuring, which is crucial, Greece and Portugal must become cheaper in order to regain their competitiveness. Estimates for Greece assume that prices and wages need to come down by 20-30%. Things won’t be much different in Portugal.
If these countries lack the political consensus they need to pull this off, they should in their own interest consider leaving the eurozone temporarily to depreciate their currencies. The banking system would not survive this without help, so the EU’s bailout activities should be refocused accordingly.
But these countries’ real economies would benefit from a furlough from the eurozone. Depreciation inside the eurozone in the form of deflation, on the other hand, would drive large parts of the real economy into excessive debt, because only the value of assets, not that of bank debts, would decline.
The transitional independent privatization agency proposed by Jean-Claude Juncker for paying the Greek debt is not a good idea. First, it would at best aim to solve the debt problem; it would not increase competitiveness. Second, Germany’s experience with this kind of agency shows that it is impossible to sell off large parts of an economy simultaneously. Europe’s banks would make a killing without reducing Greek debt in any meaningful way.
It is time to face the fact that Europe’s peripheral countries have to shrink their nominal GDP to regain competitiveness. The only question is whether they will take the euro down as well.
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