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Saturday, August 3, 2013

Seeing the erred ways of my thinking... (11a)

My recent admission that I erred when thinking that the Euro in its present form could survive in the longer term earned me a lot of criticism. Above all in the blog comments of Prof. Varoufakis who was kind enough to give my article wide distribution. This is why I want to clarify some points which were/are behind my reasoning (and it’s going to be a long clarification…).

1. The headline of my article quoted Lord Dahrendorf as saying, back in 1995, that "The idea of a common currency union is a big mistake, an adventurous, reckless and mistaken goal which will not unite Europe but, instead, divide it". I had linked Dahrendorf’s original statement in my article. I could also have linked the Delors Report of 1995 which, essentially, said the same thing. Sadly, Dahrendorf’s quote (and its timing!) was ignored by my critics and what incited their criticism was my reference to the book "The Euro Liars” and, particularly, to the author of that book.

2. The author’s conclusion was that the solution to the Eurozone would be a split into a North-Euro and a South-Euro. I had not subscribed to that solution. If anything, I would have my doubts that the problems of one common currency could be solved by creating two common currencies. However, I had totally subscribed to the author’s diagnosis.

3. That diagnosis (and the essence of the book; thus it’s title) was that there has been consistent lying since the outbreak of the crisis. Lying mostly on the part of EU-politicians but also on the part of national governments. We normally digest the news of a year in portions of 1/365th. By mid-year, we have forgotten what was said at the beginning of the year. When one gets 3 years in a condensed version of a couple of hundred pages, then one really gets worried because one really becomes aware of all the lying which has taken place. At least, that's what happened to me. I really didn't learn anything new from the book. However, it became clear to me that when liars run the show, the show won't have a good ending. Now, ‘lying‘ is an offensive term. More polite people would call it ‘denial’.

4. Do I think that the Euro was doomed from the beginning? Not necessarily, but it would have required the management of macro-economic trends within the Eurozone. Maastricht alone was not enough because it only addressed national budgets. What matters much more than national budgets (even though they may be a consequence of them) are national macro-economic trends. To manage those would not have required a United States of Europe but it would have required EU-institutions and, above all, EU-politicians who paid attention to macro-economic trends and who would act in consequence.

5. The most important indicators of cross-border macro-economic trends are national current account balances because they drive net cross-border capital flows. Or, one could say that net cross-border capital flows drive national current account balances. This is a chicken-and-egg process. It is an irrefutable mathematical fact, however, that in a world of local currencies, there can be no net cross-border flows of foreign currency capital if there are not current account surpluses/deficits. In the world of the Euro that’s quite different because the foreign currency (i. e. the Euro) also acts as the local currency.

6. Current account surpluses/deficits can be good or bad; that depends on the situation. However, excessive and chronic current account imbalances are bad; regardless whether they are positive or negative. When they are positive, it is not so easy to understand that because one is led to believe that the role of an “export world champion” is a virtue whereas the role of an “import world champion” is evidence of profligation. In financial terms, both have the same consequences.

7. Current account surplusers are (and have to be) net exporters of capital and current account deficiters are (and have to be) net importers of capital.

8. There were net cross-border foreign currency capital flows before the Euro. However, in a world of local currencies, there were brakes on them, the most significant of which was that one might run out of foreign currency capital (because foreigners were no longer willing to transfer foreign currency capital and/or made it too expensive).

9. The real kick-off to the misery was actually EU-membership. Two of the four “EU-freedoms” were the free movement of products/services and capital. Still, these two freedoms did not cause undue damage prior to the Euro because of the brake I described above.

10. The Euro did away with that brake. By intention? No, by default instead. Theoretically, the no bail-out clause should have cautioned capital to flow excessively to weaker economies. But financial risk is not an objective criterion. It is very much in the eyes of the beholder. And those beholders were the owners of capital.

11. Capital always flows to areas where its beholders assess the risk-adjusted return to be the highest. The owners of capital assessed the risk of Greece & Co. more or less the same as the risk of Germany & Co. This was not the case prior to the Euro because Greece, for example, had to pay 5-7% more on foreign currency loans than, for example, Germany.

12. In consequence, capital (much of it German and French capital) flowed to the South and the "5-7%" eventually became less than 1%. Political leaders at the time praised this on the grounds that “convergence” was evidence that the Euro was very successful. And in the South, it facilitated excessive current account deficits.

13. Thus, what used to be a ‘brake’ became a ‘gas pedal’. Banking regulations accelerated the process because Basel-2 classified sovereign debt of EZ-countries as ‘risk-free’, thereby not requiring equity to support sovereign loans. Deutsche Bank today has about 5 times as many ‘risk-free’ as it has ‘risk-weighted’ assets. In the absence of leverage controls on banks, banks went overboard with lending to ‘risk-free’ borrowers (because it often tended to be more profitable than lending to ‘risk-weighted’ borrowers).

14. Maastricht would have contained this a bit if it had been adhered to (i. e. if Germany and France had not been the first two countries to violate it). But Maastricht could not have contained the net cross-border capital flows into national private sectors. Spain and Ireland did not get into trouble because of government profligation. They got into trouble because they wanted (or were forced) to bail-out their over-indebted private sectors.

15. Thus, the two critical macro-economic indicators which should have been regulated as much as Maastricht regulated the budgets were the current accounts and the net cross-border capital flows. One could have said, for example, that current account deficits must be limited to 3% of GDP and net foreign debt to something like 100% of GDP. I don’t know how one could have enforced that in a framework of free movement of products/services and capital (should the Spanish government have prohibited foreign loans to their private sector?), but without it, we got the results which we have today.

16. Would the same results have happened without the Euro? It cannot be ruled out. After all, capital had ‘gone crazy’ (the local currency country Iceland was viewed as the new Wall Street of the North Atlantic; the local currency country of Hungary ended up financing 80% of housing loans in CHF). But I would argue that, without the Euro, common sense would have surfaced sooner. And it certainly would have surfaced sooner if banks had been limited in their leverage.

17. All of this, as bad it sounds, would still not have needed to end up in the situation where we are today. That, however, would have required EZ-leaders, back in 2010, to recognize the problem instead of lying about it. Or rather: instead of denying it.

18. If the problem began with exuberant net capital flows into the wrong direction and the resulting current account imbalances, one would have had to reverse these processes. One would have had to strengthen the weaker economies through investments (even if that meant less investments in the stronger economies) and to put them into a situation where they, out of their own efforts, could reverse these macro-economic trends (obviously, the weaker economies would have had to be prepared to do that).

19. However, if one reduces the problem to the phrase that “If Greece fails, the Euro fails and if the Euro fails, the EU will fail”, one is off on the wrong track. The proper phrase would have been “If Greece fails, many of our banks will fail but we will deal with that separately. Our first priority is to re-establish macro-economic balances in the economies of the Eurozone”. And one lie (pardon me: I should have said ‘denial') led to innumerable more. That’s what the book which I referenced pointed out.

20. The Euro (or any other currency) is not an end in and by itself. It is a means towards something. The end should have been defined as increasing the living standards, on a balanced basis, of the people living in the Eurozone. Instead, the end was defined (on purpose or not) as meaning that "The common currency project should drill the countries to German behavior" (Dahrendorf); or that the common currency would, by force, lead to a United States of Europe. Such ends can never be accomplished by mandate.

21. I don’t remember whether it was 2010 or 2011, but a rumor had erupted that Jean-Claude Juncker had called for an emergency meeting with the Greek Finance Minister Papakonstantinou. Juncker vehemently denied that. Unfortunately, he was subsequently filmed on his way to the meeting. He justified that afterwards (I still remember that interview) that "when things get serious, one has to lie”. That is not uncommon in politics but what is inexcusable is that one publicly says so. After all, there is an invaluable good called ‘the confidence of people in government’. If one willingly destroys that good, one is responsible for the consequences. This and similar incidences had prompted me to write an article, back in November of 2011, titled “A Nueremberg Trial for EU-Elites”.

22. As far as I can tell, there are no significant animosities between the people of Iceland and the rest of Europe today. Yes, a lot of banks lost a lot of money in Iceland and the Icelanders had a very rough time for a while. However, would Iceland have been able to choose the course it had chosen if it had had the Euro as its currency? Or would the 300.000 or so Icelanders today be liable for the foreign debt run up by a few mad bankers?

23. I would agree with Uwe Bott when he says that “In theory the flaws in the construct are fixable, in reality there is not enough time or political will”. Yes, the problem could still be fixed but no, there are, in my opinion, exactly zero indications that there is the political will on any of the sides involved.  That would require responsible politicians to recognize reality; admit mistakes; and go from there. That preparedness is not recognizable as far as I am concerned and this is why I had a change of mind, after extensive pondering, regarding the future of the Eurozone as it is.

24. I principally don’t expect the Eurozone to fall apart any time soon. Instead, I expect a continuation of the process of ‘muddling through’. Such a process can go on for quite some time unless it is interrupted by unforeseen events. The most dangerous unforeseen event is civil unrest in one of the countries concerned.

25. In my first year at an American college back in 1968, economics professors explained to us why, from an economic standpoint, the economy of the Soviet Union was doomed. Still, it lasted for another 22 years (and it might have lasted even longer if there hadn’t been Gorbachow). However, the point is: the longer an artificial system is maintained, the faster it will collapse once it collapses.

In summary, my ‘admission of defeat’ was not an expression that there could absolutely be no solution for the Eurozone as it is. Instead, it was based on my assessment that, after observing the situation for 3 years now (and after reading a condensed summary of all the lies which have been broadcast so far), there are no indications whatsoever that there can be a ‘European Initiative’ which Prof. Galbraith referred to. Nor a Modest Proposal. And without an initiative of that (or similar) type, there is no hope in the longer term.


PS: previous posts in this series: P1, P2, P3, P4, P5, P6, P7, P8, P9, 10, 11.

4 comments:

  1. Thanks, very interesting notes to your blog-post.

    I, as it happens, am not so pessimistic. The limiting factor does appear to be european political courage and willingness to go out and sell necessary reforms to a sceptical national electorate. Essentially the limit that Juncker noted. "We know what we have to do. We just don't know how to be re-elected if we do it".

    And that complete lack of faith of european politicians in the economic understanding of their own electorates? How's that coming along.

    It appears to be dwindling. I can give you any number of indications of that: the peaking of the five star movement in italy, the failure of AfD to break the 5% mark. Most importantly: the lack of widespread social upheaval. It isn't (nor should it be) the fact that greeks, or italians, or spanish, have accepted austerity. But they do appear to accept the necessity of slow and frustrating multilateral negotiation, to change that.

    A spanish journalist put it best, in a throw away comment. "Financial Crises are God's way of making us all learn economics".

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    1. Yes, Juncker has a wonderful talent for making quotable quotes. If there were a prize for the greatest public chatterbox, it would have to go to him.

      Sadly, he was wrong on this account. The EU-elites definitely DID NOT know what had to be done back in the spring of 2010. No surprise. They never had any experience with member countries' running into external payments problems.

      All they would have had to do was to seek advice from those who had such experiences but for that, the EU-elites were too arrogant. As the Chief Economist of Citibank (the world's most experienced bank with sovereign debt crises) put it at the time: "The Europeans did not know that, outside of Europe, debt reschedulings have come a dime a dozen in recent decades".

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    2. Dear Klaus,

      "The Europeans did not know that, outside of Europe, debt reschedulings have come a dime a dozen in recent decades". I guess you know personally the individual who came up with the aforementioned phrase....

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    3. Don't know how you would get the idea that I know this man personally. He is the Chief Economist of Citibank. Neither do I know Bill Rhoders personally but he was the one who, literally singlehandedly, developed and implemented solutions for the Latin American debt crises during the 1980s. And since I represented on location the 8th largest foreign creditor both in Chile and Argentina, I had the unique opportunity of learning from Bill Rhodes everything I know about sovereign debt problems today. Had Bill Rhodes been the Chief Adviser of the EU from the start, the Eurocrisis and everything associated with it would be long over by now. Read up on him in the internet!

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