Sunday, November 23, 2014

A Crisis in Full Flight

MUNICH – For a while, it looked as if the European Central Bank’s €1 trillion credit program to pump liquidity into Europe’s banking system had calmed global financial markets. But now interest rates for Italian and Spanish government bonds are on the rise again, closing in on about 6%.

Of course, this may not be the breaking point beyond which the debt burden becomes unsustainable. After all, interest rates in Southern Europe were well above 10% in the decade before the euro was introduced. Even Germany at that time had to pay bondholders more than 6%. Nevertheless, the markets are clearly signaling growing doubt about whether Spain and Italy will be willing to bear their debt burden.

The main problem is Spain, where private and public-sector foreign debt is larger than that of Greece, Portugal, Ireland, and Italy combined, and, as in Greece, is in the neighborhood of 100% of GDP (93% to be precise). A quarter of the labor force and half of Spain’s youth are unemployed, reflecting the country’s loss of competitiveness in the wake of the real-estate bubble inflated by cheap euro credit in the pre-crisis period. The current-account deficit remains at 3.5% of GDP, despite the recession-induced decline in imports, while economic contraction will cause Spain to miss its budget-deficit target again.

Moreover, Spain’s debt with the ECB’s TARGET settlement system rose by €55 billion ($72 billion) between February and March, because capital outflows of that amount had to be compensated. Since July 2011, Spain’s TARGET debt has grown by €199 billion. Capital is in full flight, more than offsetting the inflows from 2008-2010. The cumulative total since the beginning of the first crisis year (2008) means that Spain has financed its entire current-account deficit via the printing press.

The picture is little better in Italy, where the current-account balance has swung from a surplus of around 2% of GDP to a 3%-of-GDP deficit over the last ten years. The country’s TARGET debt grew by €76 billion from February to March, with the total since July 2011 reaching €276 billion. Italy, too, is being drained of capital; in fact, the flight of investors accelerated after the ECB’s liquidity injection.

It is now clear that the ECB itself has caused a large part of the capital flight from countries like Spain and Italy, because the cheap credit that it offered drove away private capital. The purpose of the ECB’s measures was to re-establish confidence and bring about a recovery of the inter-bank market. In this, too, it has not really been successful, despite the huge amount of money that it put on the table.

Indeed, now the French are looking wobbly. As capital fled the country between July 2011 and January 2012, France’s TARGET debt increased by €95 billion. France, too, has become uncompetitive, owing to the cheap credit brought by the euro in its initial years. According to a recent study by Goldman Sachs, the country’s price level must drop by an estimated 20% vis-à-vis the euro average – that is, depreciate in real terms – if the economy is to regain competitiveness within the eurozone.

Italy will have to depreciate by 10-15%, and Spain by roughly 20%. While Greece and Portugal face the need for deflation totaling 30% and 35%, respectively, the figures for Spain and Italy are high enough to justify fears about the future development of the eurozone. These imbalances can be redressed only with great effort, if at all, and only if one accepts a decade of stagnation. For Greece and Portugal, staying in the eurozone will be a tight squeeze.

There are many who would solve the problem by routing more and more cheap credit through public channels – bailout funds, eurobonds, or the ECB – from the eurozone’s healthy core to the troubled South. But this would unfairly force savers and taxpayers in the core countries to provide capital to the South on terms to which they would never voluntarily agree.

Already German, Dutch, and Finish savings amounting to €15,000, €17,000, and €21,000, respectively, per working person have been converted from marketable investments into mere equalization claims against the ECB. No one knows what these claims will be worth in the event of a eurozone breakup.

Above all, however, the permanent public provision of cheap credit would ultimately lead to a lingering infirmity, if not to Europe’s economic collapse, because the eurozone would become a central management system with state control over investment. Such systems cannot work, because they eliminate the capital market as the economic system’s main steering mechanism. One cannot help but wonder how thoughtlessly Europe’s politicians have started down this slippery slope.

Read more from our "Central Banks in the Firing Line" Focal Point.

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    1. CommentedRoman Bleifer

      We assure the hope that the current crisis is financial. Here we give the banks a trillion 1-2-3 and will overcome the crisis. Gave trillions, and the crisis is not over. And no improvement in sight. The more central and international banks have given loans to banks, the bigger speculative trading. A necessary investment in the real economy as there was no and no. We are looking for an analogy in the recent past crises, the Great Depression. Try recipes previously used, but they do not help. And all because this is not a financial crisis and the global systemic crisis ( ). This is a crisis of transition to a new system of production. If you find the correct analogy, then the analog would be the beginning of the formation of the capitalist machine production. New realities require new solutions. Old recipes do not work and will not work. They only aggravate the situation.

    2. CommentedWilliam Wallace

      There are some rather quick-and-dirty comparisons here, such as avoiding real rates of interest. No treatment is given to Spain's pre-crisis debt levels and the impact of French and German banks pumping investment into the Spanish housing bubble. The author then summarizes with a blanket condemnation of politicians.

      The fundamental weakness is of a single currency absent fiscal and labor unification. In the US, states hit harder by recession get automatic transfer payments (unemployment), with net flow from healthy areas to those that are doing poorly. In Europe, we merely get this sort of booing from the peanut gallery. Those who most benefited from the euro (Germany) now scoff at those who effectively made pre-crisis wealth transfers to them.

      No wonder Germany is entrenched in empty moralizing and is truly clueless about what is coming, if this is the caliber of discussion there. It scares me to see so many pundits today pimping analyses for a price.

      The "crisis in full flight" will lead to a "full fight" if we don't break this nasty habit of willful misdirection and, say, stick to the hard data.

    3. CommentedGreg A

      Once again, Mr Sinn gives us his narrow minded and short sighted views about the Euro crisis.

      He basically says that everyone needs to deflate massively which is completely unrealistic and very noxious economically. How about trying to have a higher inflation in Germany so that it is easier for other countries to regain competitiveness?

      He says that interest rates were much higher before the creation of the euro but that mainly reflected short term rates anticipations, not the risk premiums we are seeing now.

    4. CommentedFriedrich Böllhoff

      I wonder how long the citizens in the Euro area are willing to accept this mess with their currency. The Euro is convenient for holidaymakers. But all of us have a heavy price to pay. Southern Europeans are prevented from regaining competitiveness, getting jobs and generate income.
      Northerners work hard and hand over parts of their income to the rescue. Nobody should believe there, that those who save for their retirement could get back their money in full from over-indebted borrowers. If the liable party cannot pay, it will not pay.

    5. CommentedJulian Silk

      I think this is a fine article on the problems of the euro. But I just want to ask a question, which seems obvious to me. Members in the euro were admitted under the premise that they could sustain the policies prescribed. For Spain, this seems to be less and less likely. Why can't Spain be demoted from euro membership for a given period of time, say 5 years? During this time, Spain would agree to pay a tariff on international transactions with the euro countries (a Tobin tax), but would be allowed to re-establish its own currency. If you wanted to go further, you could have a Tobin tax rebate for euro countries that transacted with Spain, providing it met certain conditions, which might be decided by the World Bank or IMF as a neutral referee. These would be reparations of a sort. If maintaining the euro is as much in Spain's interest as it is of other countries, Spain will be willing to do this and take its own independent steps to recover fiscal balance.

    6. CommentedJohn Doe

      The information in this essay was extremely useful.

      However, Hans-Werner Sinn is equally disingenuous.

      First, he omits to explain why all this happened. Currency unions without political integration, as often explained (and best explained by Martin Jacomb in the FT) are doomed to failure. He ought to have affirmed that this entire mess was started by the slippery slope of rescue packages, it was started by the slippery slope of the Euro.

      Second, he implies that the Euro should break up, given the price adjustments needed in France, Spain, Italy, and Greece (and he doesn't even mention Eastern Europe). On this point what he doesn't say is disingenuous.

      Where does he stand on the question?

      He says that as to France, "These imbalances can be redressed only with great effort, if at all, and only if one accepts a decade of stagnation."

      Who would accept such. China, in 10 years, will be in the 22nd Century by comparison

    7. CommentedZsolt Hermann

      We are trying to cheat the system.
      It is like filling the petrol tank of a car where the engine has stopped, it does not work and the petrol tank is also leaking, but when we fill the tank we close our eyes and hope that a miracle would happen.
      This is not a Greek, Spanish or Italian problem, it is not even a European problem, simply the dominoes started falling starting with the "weakest" ones, but we can see even the previously galloping developing market countries have slowed down, and are expected to stop in their progress.
      This is why neither austerity nor further injections can work, and even the German solution, trying to stabilize the structure is futile, because even a stabilized structure is limp without the engine.
      The expansive, constant growth economic model is not sustainable, we live in a closed, finite system, which has now become totally interconnected and interdependent. Moreover our previous growth has been due to excessive, and mostly unnecessary production, producing and consuming goods that are needles and harmful. This machinery was kept going by a clever, sophisticated marketing machinery, but we played poker, always raising the stakes and we lost, as it turns out we do not have anything in our hands.
      We have to rethink the whole system, our basic attitude, the network we exist in, what laws operate in such analog, integral networks, and how a human being can contribute to the overall harmony and homeostasis of our network.
      All the scientific information is ready, we are only missing the willingness to put the puzzle together.