Introducing The Latin Euro

By Peter Boone and Simon Johnson

The verdict is now in:  traditional German values lost and the Latin perspective won.  Germany fought hard over many years to include “no bailout” clauses in the Maastricht Treaty (the founding document of the euro currency area), and to limit the rights of the European Central Bank (ECB) to lend directly to national governments.  Last week, the ECB governing council – over German objections – authorized purchasing unlimited quantities of short-term national debts and effectively erased any traditional Germanic restrictions on its operations.  (The finding this week by the German Constitutional Court — that intra-European financial rescue funds are consistent with German law — is just icing on this cake, as far as those who support bailouts are concerned.)

With this critical defeat at the ECB, Germany is forced to concede two points.  First, without the possibility of large-scale central bank purchases of government debt for countries such as Spain and Italy, the euro area was set to collapse.  And second, that “one nation, one vote” really does rule at the ECB; Germany has around ¼ of the population of the euro area (81 million out of a total around 333 million), but only one vote out of 17 on the ECB governing council – and apparently no veto.  The balance of power and decision-making has shifted towards the troubled periphery of Europe.  The “soft money” wing of the euro area is in the ascendancy.

This is not the end of the crisis but rather just the next stage.  The fact that the ECB is willing to purchase unlimited debt from highly indebted nations should not make anyone jump for joy.  The previous rule forbidding this was in place for good reason – the German government did not want investors to feel they could lend freely to any euro area nation, and then be bailed out by Germany.  Now investors know they can be bailed out by Germans, both directly through fiscal transfers and through credit provided by the European Central Bank.  How does that affect the incentives of borrowers to be careful?

Spain’s Prime Minister Mariano Rajoy has now launched the next front in the intra-European credit struggle.  Despite the announcement of ECB support, Mr. Rajoy remains elusive regarding whether he would seek the money.  His main concern is that the ECB is insisting that the International Monetary Fund, along with the European Union commission and perhaps the ECB itself, negotiate an austerity program with any nation that needs funds.  Such an austerity program is the “conditionality” which the ECB had to claim will exist in order to justify the large bailouts they are promising.

So the new battleground moves from whether the ECB can bailout nations to whether austerity programs should be required for bailouts.  The periphery will fight this issue tooth and nail, and they will win.  Unemployment in Spain is now around 25 percent and in Greece it is at 24.4% (with unemployment for young people aged 14 to 24 now at 55 percent).  Both Portugal and Ireland have made progress implementing their austerity programs, but they are not growing and their debts remain very large (gross general government debt is projected by the IMF’s Fiscal Monitor to be 115 percent of GDP next year in Portugal and 118 percent of GDP in Ireland).  The current Italian government is well regarded, but there are large political battles ahead and it is also burdened with big debts (to reach 124 percent of GDP in 2013).

At the same time, European countries that are outside the euro – such as the UK, Sweden, Poland and Norway – are all seen as faring much better.

The Germans will be increasingly drawn towards one plausible conclusion:  Perhaps the euro area is simply the wrong system.  If tough austerity programs do not wrest nations free from high unemployment and over-indebtedness, then how are they to get back on the path to growth?  If a one-time devaluation could help release nations from their troubles rather more quickly, perhaps Germany should instead admit – or insist – that the single currency is a failed exchange rate regime?

The ECB is now fighting for its survival as an organization.  ECB President Mario Draghi and his colleagues have stretched the rule book in order to open the money spigots to purchase troubled nations’ debts.  The leaders of troubled nations will fight hard to get all they can with as few promises in return as possible.  Elected officials must do this, or they will lose elections.

Europe has strong institutions – good property rights and vibrant democracy.  An independent central bank was long seen as an important manifestation of such institutions.  But powerful interests have shifted towards wanting easy credit above all else.  And the more the ECB provides such credit, the more powerful those voices on the periphery will become.

We’ve seen such a dynamic operate time and again around the world.  When strong regional governments are fighting for resources against national governments, there is a tendency for regions to accumulate large debts, and then demand new bailouts at the national level.  Often these battles end in runaway inflations or messy defaults, or both (think Argentina many times or Russia in the 1990s).

The ECB has handed the euro zone’s peripheral governments a great victory at the expense of those who hoped to keep the euro area solvent and a “hard currency” zone through disciplined public finance.

It may be difficult to imagine that wealthy European nations could follow the tragic path to inflation and defaults seen for so long in Latin America, yet with each “step forward” in this euro crisis, Europe moves further along that same route.

An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire column, please contact the New York Times.

20 responses to “Introducing The Latin Euro

  1. Simon, the easy credit you and Peter mention is easy credit for insolvent banks, not for public works programs easing unemployment and building infrastructure, which is the measure of wealth of a nation.

    USA has an analogous credit program here, despite the majority being vastly opposed, like the Germans, to more money funneled into insolvent and zombie banks where moral hazard isn’t seriously considered.

    For the key personnel, bonus payments no matter what, and no real risk on the downside. IT’s unfortunate the rest of us have to be fiscally responsible (OR ELSE), in view of what these behemoth banks have gotten away with.

    Draghi isn’t any good, either, being an alum of GS.

  2. Economists don’t know how to measure the true rate of economic growth, because they can’t model the consumer’s perspective on technological advancement. Alex Gheg has released a new framework that can solve this problem. The hidden thoughts and feelings of people can be indirectly measured using the very accurate internal body clock, that we all have. Pleasure contracts time in the human mind, and we can see how this changes our daily circadian rhythms. See some facts and be amazed. Quantity, quality, variety and convenience in one equation. http://www.youtube.com/watch?v=u6tFLGpcOpE

  3. The previous rule forbidding this was in place for good reason – the German government did not want investors to feel they could lend freely to any euro area nation, and then be bailed out by Germany. Now investors know they can be bailed out by Germans, both directly through fiscal transfers and through credit provided by the European Central Bank. How does that affect the incentives of borrowers to be careful?

    What’s with the ridiculous moralizing here? Investors in Germany, the country with the biggest trade surplus, started lending to trade deficit countries at rates that were far too low a long time ago. That’s why we are having this crisis in the first place.

    The only people the Germans are bailing out are their own damn banks.

    The Germans will be increasingly drawn towards one plausible conclusion: Perhaps the euro area is simply the wrong system.

    As the kids say: well, duh.

    If tough austerity programs do not wrest nations free from high unemployment and over-indebtedness, then how are they to get back on the path to growth?

    Is this entire column some sort of joke?

  4. No more of a joke than the Germans building things that break down faster than they can build them. Is that a good thing for the GDP? Or better for say….the puppet masters??

  5. Or maybe, just maybe, Germany will have to keep bailing out its southern states, the way northern US states keep bailing out states like West Virginia and Alabama. I don’t know how putting Italian and Greek and Spanish students and unemployed and handicapped on the German safety net would work, I don’t see how it can work, but it is how the US has stayed on a common currency at times when its various states were in different economic conditions.

    Otherwise, we’re back where some of us were when Maastricht was written, something entirely forseeable to anybody who remembers the fiasco that was the Articles of Confederation in the US: currency union without political union is madness.

  6. Printing money out of the myst and funneling into the offshore accounts of predatorclass oligarchs will not end well! That thing called inflation will rear it’s ugly head in the form of much higher prices for food, energy, water, healthcare, housing, education, et al., stomping what’s left of the middleclass in formally civilized western societies. These massive cost increases mean nothing to the predatorclass – but to the other 99%, – these increases (inflation) are crippling!

    Germany is the lynchpin of the Eurozone, buttressing and supporting all the failed periphery states. How much are the Germains willing to endure to bailout PIIGS??? Do the simple math and you will conclude that this horrorshow is going to end badly and violently.

  7. We all know this is going to end badly. Why do we keep writing columns about it? Why not join forces to create an economic solution in however small a place. We can then use that small success, wherever it occurs, as an example solution that the rest of the failing states can model their own recovery upon. Use the stocks, bonds and other miscellaneous documents as wallpaper that reminds citizens of papers reckless and foolhardy birth.

  8. The markets have already scented blood in Germany. Their yields on gvt. paper are going up just as the PIGS’ are going down. This at a moment when the Germans are going to have to borrow a lot more to dig the rest out. They might just as well have bought the common debt issuance idea ( Eurobonds) as the implication was that the yields would settle down to a weighted average across Europe and Germany would perforce pay more to borrow. OR they should have packed the whole thing in, retreated to Standort Deutschland and made new friends eastwards with a mighty strong DMnuovo.

    Your comment on Italian debt I beg to say is a bit behind the curve. Both Grilli ( finance minister) and Cofindistria accept that gdp is going to drop by 2.4% this year. We are already at 124% debt to GDP. If the denominator drops to 97.6 this makes the numerator some 127%.. … even if there there is no further addition to national debt this year. Most unlikely ; Italy has the lowest level of unemployment support in Western Europe. The rising army of unemployed will have to be helped in the end as families cease to the strain. This has not been budgetted for.

  9. This is a really terrible piece of rancid neoliberal propaganda. It is chock full of the typical neoliberal logical fallacies. And factual errors.

    In terms of factual errors, Johnson and Boone really seem to think that the problem in Spain, say, is profligate government spending that needs to be reined in. However, that is not at all true. The public debt crisis originates in the State backstopping bad *private* debt, that is the result of the bursting of a humongous property bubble.

    As regards fallacies, I shall outline two key logical fallacies.

    The first is very basic and has to do with the nature of what debt really is. You see, if people owe you money, the IOU’s that you hold are essentially a claim on some part of what those people will produce in the future. To try to force people to starve themselves to death in the name of getting your money back is self-evidently absurd. If the debtors obligingly starve themselves, how can they pay you? So how much is your claim on their future productivity then worth?

    Now, I grant that using absolute starvation in the analogy could be seen as hyperbole. I would say it is still a valid point, since it shows up the absurdity of the austerian argument. Somehow you will get your debts honored by forcing people to starve themselves. The point stands. Even if falling short of full starvation, the austerity policies, the extreme cutbacks in education, for example, mean less investment in human capital, and thus less productive capacity in the future. Aside from formal education, more importantly, accepting long-term mass youth unemployment means that the human capital formation that occurs when people are employed in their formative years is not occurring. Again, this is putting the economy on a trajectory of much lower productive capacity in the future than would otherwise be the case. And note that these losses of productive capacity will NEVER be recovered. Another factor is that in this kind of high unemployment economy, many of the most productive, talented, enterprising people will emigrate and establish themselves in other countries, thus reducing the productive capacity of the economy in the future. To get your debts paid back by forcing people onto a path where they will be far less able to pay back any debts — is this not contradictory? Does the article address this key issue?

    The other key logical fallacy is the notion that, because something is a sound policy guideline in ordinary circumstances, that, therefore, it should be adhered to in a crisis situation. In essence, they are argue that this kind of massive credit creation by the central bank is inflationary and undesirable under normal circumstances, and then make the logical leap that it is therefore the incorrect policy in a severe crisis situation. But this is completely fallacious. If an airplane is airborne and stable at cruising altitude, the guidelines for what a pilot does are completely different from when the same airplane is in a tailspin, going down fast. In the latter situation, the pilot has to consider options that would not make any sense at all in a non-crisis situation. Similarly, if I am driving on an icy road and the vehicle is skidding out of control, the basic rules of staying in my lane and so on obviously no longer apply. I might have to veer off into an empty field or do some such thing to try to get control of the situation.

    This kind of fallacious reasoning from the general to the specific is really quite cringeworthy. It is one thing to believe, as a *general* proposition that excessive extension of credit by the central bank will be inflationary and debase the currency. However, do the authors really believe that inflation is a big problem when you are in the middle of a deflationary balance sheet depression??? When most of the money creation is being used simply to plug holes in balance sheets, it is even hard to see where the inflation transmission mechanism is! (Note that I am not saying that this policy of keeping zombie banks on life support is necessarily optimal, just that it hardly looks inflationary. Look at Japan over the last 20 years or the U.S. over the last several years. See all the inflation?)

    The other aspect of the article (not unique to this article, of course) is the way it desires to reduce complex issues into some simplistic morality tale. The story of the serious, frugal Germanic people versus the spendthrift Latins…. It is hard to believe that Johnson and Boone are ignorant of basic accounting identities. Do they not understand that for Germany to run a surplus as a matter of policy means — by accounting identity (akin to 2+2=4 !!!) that other countries must be in deficit? So this is the result of a conscious mercantilist policy on the part of the Germans.

    It is as if Johnson and Boone have regressed to preschool level, all the decades of ivy league education melting away, leaving them at the level of the picture book “Story of the Ant and the Grasshopper”. They should take care. If they continue regressing, they will soon find themselves back in their respective mother’s wombs!

  10. So in short John what you are trying to say is that by tomorrow it won’t pay to die, and you won’t have anyone to help you in your golden years. I think that much was already predicted by the mappers and surveyors, and i’m even down to my last 2 maps.

  11. @Jonathan R

    Interesting comment. I have two suggestions for improvement. One is that it is the underlying bookkeeping that identifies the facts, not the accounting. Accounting is a strategy employed subject to a properly identified book-of-accounts.

    My other suggestion is that in place of ‘Bubble’ you, and others, would do well to use the term ‘Ponzi Scheme’. The Ponzi Scheme is easy for the bookkeeper to identify early on in its life-cycle, when the accountant works from a properly identified bookkeeper’s balancing of ‘value’s count’ set equivalent to ‘ownership’s account’.

  12. One of the key things to note is that countries which are not part of the euro-zone are faring better. Germany is now stuck in bailing out the “PIGS”. This was actually its main concern during the introduction of the Euro. The gap between the wealthy European nations and the poor ones was bond to create the problems we are now witnessing. In order to work, the Euro-zone should have been limited to countries with comparable strong economy.

  13. @filbt I have no idea what you mean. I was making the simple point that it is nonsensical to demand that somebody starve himself to be able to pay their debts. This is the fundamental absurdity of the “austerity economics” that Boone and Johnson seem to be preaching.

    @Dan I am not sure what you mean when you say: “One is that it is the underlying bookkeeping that identifies the facts, not the accounting.” Well, at least I know what *I* meant to say. And that is that it is a simple tautology of national income accounting that Germany’s large trade surpluses must be reflected in other countries’ corresponding deficits. They are two sides of the same coin. To turn this into some childish morality play about virtuous Germans and profligate Latins really, in my eyes, intellectually discredits the authors.

    As for your other point, about replacing “Bubble” with “Ponzi Scheme” I do not believe I agree with you. There is a basic point in common between a Bubble and a Ponzi; that is that both require an influx of new money, actually ever increasing amounts, to keep the scheme afloat. However, there are significant differences. Your Charles Ponzi or your Bernie Madoff is consciously running a fraud. The people involved in a bubble, at least most of them, are acting in good faith. They sincerely believe that what they are doing makes sense and that belief is reinforced because, up until the bubble bursts, it is extremely profitable for the various participants.

    But, perhaps more importantly, I disagree that it is trivially easy to identify a bubble, particularly in the early stages, as you seem to suggest. A Ponzi scheme, like Madoff’s scam, yes, should be easy to see through, since it is a pure fraud. However, an asset bubble is harder to identify, since the assets in question typically have some genuine value. A house in Spain (like most anywhere else) really does have some real value. In the early stages of the bubble process, the price may not even have been inflated too much beyond the true value. Granted, at the later stages of the bubble it *should* be obvious that it is a bubble, since the prices just get so outrageously crazy, but human nature as it is, even then, it is not trivial to identify bubbles.

    But, anyway, back to the morality play. I believe the money that fueled the property bubbles in Spain and Ireland was, by and large, money accumulated in German banks from all the accumulated trade surpluses. So, in a sense, the German banking system was recycling large parts of the German surpluses into fueling property bubbles in the periphery countries. This naturally was not going to end well. There is doubtless blame to go around in the situation. For the German banks (and their intellectual neoliberal hitmen such as Boone and Johnson) to present themselves as the innocent, virtuous German victims of these profligate, immoral Latins — this really should be laughable.

    Also, Boone and Johnson present a moral hazard story, which is that if the Spanish state is “bailed out” (apparently, the European Central Bank acting the way a central bank is supposed to act, that’s a bailout) this creates a moral hazard. There is some truth to that, but really, the moral hazard story only goes so far. By the same token, it is true that if a lifeguard jumps into the sea and saves me when I am drowning, it creates the moral hazard that I can swim out of my depth and expect to get saved. Conclusion: I should be allowed to drown. And that’s obviously crazy.

    In any case, the authors construct a phony moral hazard story, as far as I can see, as a distraction from the real one. which is the problem of banks fueling bubbles and when the bubble bursts, expecting State actors to make them whole. What then is their disincentive from fueling the next bubble with all the malinvestment costs and disruption when the bubble bursts and so on? They construct a completely phony morality story about profligate governments that should not be bailed out, yet banks that blew bubbles and were the real underlying cause, should get bailed out. Go figure…

  14. I was afraid of that?

    If there will be ice in November that will bear the weight of a duck,
    there will be nothing there after, but sleet and muc.

    Later Jon!

  15. @Jonathan, “…To turn this into some childish morality play about virtuous Germans and profligate Latins really, in my eyes, intellectually discredits the authors….”

    Indeed. Cut and pasted from wiki:

    http://en.wikipedia.org/wiki/Neanderthal

    “…The term “Neanderthal”, a shortening of “Neanderthal man”, is sometimes spelled Neandertal, the modern spelling of the Neander Valley in Germany where the species was first discovered….”

    I would suggest that the “species” was discovered long before modern DNA sequencing techniques. While the PIG nations were bona-fide civilizations at least 10,000 years ago, what were the Neans up to…?

    And wasn’t the modern German economy set up after WWII to continue to be the “producers” of militaristic hardware?

    Since everybody loves abstract math so much, what would the “average” be of Planet Earth today when the range of civilizations is from mysterious tribes hiding from everyone (street smarts on their part, no? – too bad they don’t realize there’s 7 billion crazies now) in the tropical jungles of South America to China and India to northern Africa and EU to North America and the Pacific Rim of Fire? I guess the average would be comparable to the Dark Ages of the European “tribes”. Is that why Germany perceives itself to be in the “middle” of the power vortex today and knows where to apply economic discipline on others with a different memory from 10,000 years?

    At any rate, ain’t gonna happen….I’d be more inclined to invade Iran if it was threatening Greece with extinction and hunger, but then Russia likes war water ports, eh? So no worries – like I noted already, people have different memories of 10,000 years of history…

  16. oops, typo – “Russia like warm water ports…”

  17. Everything in German, what great spellers these Germans be!!

  18. @Bond – what? u don’t read German? LOL

    Forget about using google translator – it’s the most amazing “FAIL” when it comes to translating German to English! Could start a war or something with a translation as bad as google’s – seriously. Which is odd, isn’t it? After all the mixing and merging of Germans with the English, post the industrial revolution, you’d think they’d have an “efficient” translator on the internet….guess there is more to understanding “languages” than we assumed :-))…and then there is that common thread of “sound” – there is a long lost cultural origin to all the peoples who still use that clear-the-throat, hhhhockundgob sound when speaking to another…and that “sound” might really HAVE caused a war among tribes if a gob really did go flying in a FTF negotiation :-))

    Of course, WHY all this focus on Germany in a Latin America thread, one might ask….?

  19. Peter and Simon,

    I am very surprised at the content of this post. I thought that so much that was in your post had been thoroughly discredited. After years — YEARS! — of reading your books and blogs (with James Kwak), I’m shaken by the possibility that at last your close ties to Pete Peterson have finally forced you to abandon all truth in the name of the sort of “fiscal conservatism” that Mr. Peterson espouses.

    First, you should very well know that the whole “morality play” view of the EU crisis is nonsense. It is true that Greece has spent far beyond its means and shown lack of will to collect taxes. But Spain, for example, was doing quite well before the great asset bubble — just like the US asset bubble — burst in 2007. And as others have pointed out, it is the very German banks that have fed that bubble by lending to the periphery in a reckless and irresponsible manner. Germany is, more than anything else, bailing out the mistakes of German banks. That view is widely held in reader comments.

    In addition, Germany is in such a strong position because it purposely undertook a “beggar thy neighbor” policy 10 years ago — a combination of business and unions who undertook a strategic goal of exporting to the rest of the EU, financed by German banks. Basic economics tells you that such an intentional policy will create balance of trade problems, the flip side of the balance of payments problems that are at the heart of the EU debacle. Germany says, “If everyone had been virtuous like us, there wouldn’t be such trouble.” But they neglect to see that it was impossible for everyone to have been like Germany — they can’t ALL be net exporters within the Eurozone.

    Germany deliberately worked to gain advantage over the rest of the EU, especially the periphery. They succeeded. But they forgot to understand that by beggaring their neighbors, they were indeed hurting themselves — because at some point, their beggared neighbors would no longer be able to pay.

    In actuality, it’s the same thing that’s happened here. The top 1% had done well; the other 99%, not so much. But when wealth inequality gets so distorted, there is not enough of a middle class to maintain the demand that prosperity requires. As the 1% has beggared the rest, they will continue to find out that a 99% that is unable to buy goods and services, and unable to pay its bills, is not such a good thing, even for the 1%. Just as it’s not such a good thing for Germany.

    I’m amazed that you guys don’t get it. It’s got to be Peterson.