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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.

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