Thursday, September 9, 2010

The Eurozone pact with the Devil and its risks

Peripheral Eurozone countries effectively made a Faustian pact with the Devil foregoing their economic freedom in exchange rates and monetary policy tempted by easy credit and EU transfer money that resulted in consumption and real estate bubbles. The Euro was always a political tool to force European integration rather than sound economics. The EZ created structural distortions increasing divergences. Without an exit mechanism, "Abandon every hope, ye who enter here" as Dante would put it....

The Trilemma in international economics suggests that it is impossible to have all three of the following at the same time:
  • A fixed exchange rate.
  • Free capital movement (absence of capital controls).
  • An independent monetary policy.
A flexible exchange rate and independent monetary policy are means to manage trade balances and promote growth, which is critical in an open market environment and free capital flows - something that EU periphery politicians sadly overlooked.

These hapless countries were reduced to the status of US state governments but without any equivalent of the US Federal redistribution system. EU members in the north like the UK, Denmark and Sweden prudently passed on these risks, preferring their independence. They were unjustly and ruthless maligned by the Brussels elite, but today time has proven the wisdom of their judgement.

Unlike sovereign governments, who can create monetary reserves through their central banks, the peripheral Eurozone members unwittingly exposed themselves to the risk of insolvency and bankruptcy with the illusion of a sovereign guarantee from Brussels that allowed them to rake up public debt in amounts and at rates that they would not normally be entitled. Once the bond vigilantes moved in and popped this illusion, credit spreads started to widen with restoration of proper risk pricing and crisis broke out.

The Brussels elite initially compounded the crisis with their very poor management, blaming the markets for their own shortcomings and policy failures. They were only bailed out with the tacit cooperation of the US, who winked at the unprecedented expansion of the IMF charter by facilitating  them with a financial backstop because the Americans feared the systemic risk. The ostensible mission of the IMF is to support individual countries in trouble, not a badly constructed and questionable currency union. This should have been the sole responsibility of the European Union, not other IMF members collectively.

The unsustainable trade imbalances that this currency union has created have in no way been addressed to date. It is virtually taboo in the EU even to raise the subject. The reason for the lack of demand-side adjustment is that much touted Europe’s internal market is not fully functioning, certainly not at the consumer level. As FT's Wolfgang Munchau points out, Germany entered the Eurozone at an uncompetitive exchange rate and embarked on a long period of wage moderation where it benefited from a real devaluation against other members.  Meanwhile southern European industry lost competitiveness and withered.  Consumption soared and real estate bubbles were fueled by the cheap credit until the bond vigilantes spoiled the party. A large part of the German trade surpluses are reflected in peripheral member deficits.

Over time, these intra-Eurozone imbalances will not only persist, but probably increase. This will make the economic adjustment for Spain, Portugal or Greece even more difficult than it already is. Those persistent imbalances, as well as the alarming build-up of debt, raise cause of concern about the long-term health of the Eurozone. Solvency is defined as the ability to finance debt in a sustainable way, and is affected both by the amount of debt, and future income through which the debt is repaid. Already several EZ members like Greece, Ireland and Portugal are bordering on insolvency.

For the Greek austerity plan, it hard to imagine a realistic estimate of a trajectory that foresees a stabilisation of the Greek debt-to-GDP ratio at tolerable levels. Optimists like Olli Rehn in his recent article 'Greek Renaissance' tend to pull the joker of some massive above-average growth forecasts for the future without explicitly stating where this growth is coming from. Normally in these IMF work-outs the growth comes from exports spurred by devaluation and structural changes. Even Swedish restructuring in the late 1990's resulted in currency devaluation. In Euro Hell, Brussels will not give Greece this option in defense of their sacred cow, the Euro.

The other side of the German exports to weak peripheral members and the resulting trade deficits is the mounting debt crisis. The austerity measures of 'infernal' devaluation is largely a Brussels concoction of untested crank economics that in practice downsizes GDP and deprives the failing country of tax base and income needed to repay and reduce its debt. Coupled with the 'pretend and extend' debt pyramiding of the IMF/ EU 'bailout' facility for insolvent borrowers, this risks bringing the whole Euro currency union down like the Tower of Babel. In the case of defaults, other weak EZ members will be liable for the backstop facility, pulling them under as well.

To guarantee the solvency of the Eurozone’s periphery would require not a few quarters of solid growth, but an entire decade. Where is this joker of massive above-average growth going to come from? Who is going to accept the trade deficit rebalancing?

Presently the Brussels elite seem very much in self denial. They remain unwilling to accept that one day a Eurozone state might either default, or, more likely, be forced to restructure its debt. Not only do they adamantly refuse to accept the principle, but also stubbornly insist on avoiding any institutional preparations for an orderly default of a Eurozone member or departure from the currency zone.

It is as if the Devil has possessed their minds in the hell (with no exit) that they have created with their currency union.... Is it a coincidence that the Faustian legend came from Germany? Can purgatory bring salvation?

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