Your dreams were your ticket out
To that same old place you laughed about…
– “Welcome Back Kotter”
This week kicked off with more political crisis in Europe.
I know, we’ve heard all we can stand on Europe… but now things are getting serious again (hence the market’s non-trivial reaction on Monday). It’s a good time to revisit the basics of the situation.
In France, Nicolas Sarkozy lost the first election round to a socialist, even as the far-right party saw a historic showing; in the Netherlands, a budget crisis led to resignation. Both these items are directly related to the eurozone crisis, and a growing disgust on the part of the populace in respect to current policies.
Some quick recaps:
- Le Pen Shocks France as Far Right Hits Historic Heights (France 24)
- French Elections: How Democracy Could Destroy the Euro (Time)
- Dutch Prime Minister Resigns (WSJ)
What is happening in Europe right now can roughly be described as a fiscal war between Germany and the periphery countries.
- Germany, the “deep pocket of Europe” (to use a Soros phrase), wants strict austerity, harsh budget cuts, and all-around “fiscal discipline” for the struggling periphery countries. The shared credit card was abused; now Germany wants spending privileges harshly cut back (if not outright revoked).
- Meanwhile the periphery countries — Spain et al — are sinking into deflationary downward spiral, headed for deep recession or worse. Citizens of these countries (now add France) are saying “give us room to breathe.” Germany is saying “nein!”
What’s worse, too much austerity can actually accelerate fiscal collapse.
This happens when government cutbacks and tax hikes lead to business closures and revenue declines.
Imagine a barber dependent on government employees coming into his barbershop; the government employees get laid off, the barbershop goes under, and the tax base declines further.
This problem is especially serious in heavily government-supported economies (like those in Europe). Government spending cannot simply be “withdrawn” without entrepeneurial dynamism to replace it, or the economy shrinks.
So, at a certain point in the spiral, “austerity” (budget cuts etc) actually accelerates the problem: If cutbacks lead to revenue declines, the remaining government debt burden becomes larger than before (relative to debtors’ ability to repay).
So, in a very real way, by demanding harsh cuts and minimal stimulus at such a delicate time, Germany is asking Spain, Greece et al to commit fiscal suicide. In the struggling periphery countries, that is the increasing perception of both government leaders and citizens.
But what else is Germany to do? Via the UK Telegraph, Germans are already 1) “boiling mad” over back-door bailout payments, and 2) dealing with “the lowest unemployment in 20 years and an incipient housing boom.”
This leads to another age-old problem — one that critics hammered on long before the euro was even introduced. It is very hard to have functional currency union when various economies in that union are operating at vastly different temperatures.
Imagine you have multiple pots on the stove, but only one knob to set all the burners at once. One pot is extremely hot and close to boiling over. Three other pots are ice cold and desperately in need of more heat. But you only have one burner knob, i.e. one monetary policy, that sets them all. What do you do?
It’s not a trick question. There isn’t any good answer. Which is why many euro skeptics (including yours truly) thought the project would be doomed to failure from the very start.
Markets are convulsing over Europe once again — welcome back crisis — because it is becoming newly apparent just how deadly serious this problem is. Someone is going to have to budge. Either Germany relents and cuts the periphery countries some slack, or one or more periphery countries leaves the eurozone and the experiment goes down in flames.
Spain ultimately gets a massive bailout — courtesy of Germany — or an exit visa, with all the fiscal horror that entails. France, too, is now feeling a similar form of political pressure. Notice how it keeps spreading?
In a recent Le Monde interview, George Soros — “The Man Who Broke the Bank of England” and a guy who knows a thing or two about currencies — articulated his belief that Germany is quietly seeding the crisis by being pig-headed (emphasis mine):
“The introduction of the euro has led to divergence instead of bringing about convergence.
“The most fragile countries of the eurozone have discovered that they are in a Third World situation, as if they were indebted in a foreign currency, with a crucial effect that there is a real risk of default.
“Trying to make them respect rules that don’t work just makes matters worse. Sadly, the authorities don’t understand this.
“Mario Draghi has launched extraordinary measures with his €1 trillion injection of liquidity through three-year loans. But the effect of this operation has been broken by the counter-attack of the Bundesbank.
“Watching the growth of the ECB’s balance sheet, the Bundesbank has realised that it risks heavy losses if the euro blows up and is therefore opposed to the (LTRO) policy. Let us hope that this does not become a self-fulfilling prophesy.”
Soros Le Monde interview, via UK Telegraph
Jens Weidmann, the head of the Bundesbank, of course flatly denies the self-fulfilling prophecy bit. “What we are doing is… preserving the stability foundation of the monetary union,” he says. “I am deeply convinced that the monetary union can only survive if the euro remains a stable currency.”
Sure, of course. How else would one expect Germany to respond?
It’s an ugly and dangerous situation because nobody wins and something will have to give. Again, either Germany is going to cave and write some big checks, or the Soros “self-fulfilling prophecy” will come about and the whole show will implode.
The Sarkozy loss in the first round was a big deal because of the “Democracy Destroys the Euro” argument. The current crop of pro-euro leaders (like Sarkozy) are being threatened by anti-euro challengers who stand with an angry populace in opposition to more austerity policies.
A gradual shift in political climate — with pro-euro leaders getting tossed out and hardline euro-skeptics voted in — could thus be enough for a critical mass of players to tell Germany to take their austerity and shove it.
And what happens after that, when all this sturm und drang hits a climax?
Does Germany cave in the face of full-on rebellion and a fiscal nightmare scenario?
Or does Spain turn into a country-sized Lehman Brothers — the scenario where everyone figures “oh they’ll get bailed out, they HAVE to…” and then they don’t?
Does the euro go into freefall and the $USD skyrocket? Or does a new “core” euro emerge, causing the reverse?
Nobody knows, really, and that’s why the market is so freaked out.
Funny old world innit,