Friday, August 22, 2014
10

The Collateral Damage of Europe’s Rescue

MUNICH – The eurozone is now in its sixth year of crisis – and of efforts by the European Central Bank and the international community to end it. Policymakers are becoming ensnared in a creeping interventionism that, as British Prime Minister David Cameron has put it, may alter the eurozone “beyond recognition” and violates Europe’s basic economic and political rules.

The newest demand, loudly voiced by French President François Hollande, is for the ECB to manipulate the exchange rate. Hollande is alarmed by the rapid appreciation of the euro, which has risen from $1.21 at the end of July 2012 to $1.36 in early February this year. The strengthening exchange rate is putting additional pressure on the rickety southern European and French economies, undermining their already low competitiveness.

The cheap credit ushered in by the euro fed an inflationary economic bubble in southern Europe that burst when the financial crisis hit. Credit terms worsened abruptly, and what was left was the thoroughly overpriced rump of economies that had become excessively dependent on foreign financing.

The French economy, in turn, is suffering because its customers in southern Europe are in trouble. According to a study by Goldman Sachs, France would have to depreciate by around 20% relative to the eurozone average, and by about 35% vis-à-vis Germany, to restore external-debt sustainability.

The ECB and the international community – particularly the International Monetary Fund – have tried to deal with the crisis by replacing the dearth of private capital with public credit. The ECB shifted its refinancing credit and money creation – to the tune of €900 billion – toward southern Europe and Ireland, as measured by the Eurosystem’s Target balances. In doing so, however, it put itself in peril, because the only way to implement the shift was by lowering the collateral requirements for refinancing credit. To a large extent, this collateral consisted of government bonds.

In order to stop these securities’ downward slide – and thus to save itself – the ECB bought these government bonds and announced that, if need be, it would do so in unlimited amounts. At the same time, the European Stability Mechanism was established to safeguard states and banks.

These assurances managed to calm the markets and restarted the flow of capital from the eurozone’s core to its periphery. But capital is flowing in from other countries as well. Holding euros and acquiring euro-denominated securities have become attractive again around the world, pushing up the exchange rate and causing new difficulties.

Here, it should be said that the Bank of Japan’s manipulation of the yen’s exchange rate has played only a minor role, notwithstanding Bundesbank President Jens Weidmann’s strong condemnation of the policy. Japanese intervention cannot explain the revaluation of the euro against the dollar and many other currencies.

The ECB can curb the euro’s appreciation through purchases of foreign currency. But, ultimately, it would have to do so by inflating its own currency until confidence in the euro falls back to the level that it had before the assurances were made.

That is why ECB President Mario Draghi rejected Hollande’s suggestion almost instantly. Draghi is well aware of the enormous sums that were lost during the 1970’s and 1980’s, after the collapse of the Bretton Woods system, in futile and costly interventions to stabilize exchange rates, and he does not want to jeopardize the ECB’s goal of maintaining price stability.

The euro’s appreciation lays bare the huge collateral damage that Europe’s rescue policy has caused. The measures taken so far have opened channels of contagion from Europe’s crisis-ridden peripheral economies to the still-sound economies of Europe’s core, placing the latter’s taxpayers and pensioners at great financial risk, while hindering long-term recovery in the troubled countries themselves.

True, Europe’s rescue policy has stabilized government finances and delivered lower interest rates for the over-indebted economies. But it has also led to currency appreciation, and thus to lower competitiveness for all eurozone countries, which may yet turn into a debacle for the southern eurozone and France, which are too expensive anyway, and for the euro itself.

The ECB’s rescue operations have hindered the internal depreciation – lower prices for assets, labor, and goods – that the troubled economies need to attract fresh private capital and regain competitiveness, while the euro’s appreciation is now compounding the challenge. In short, Europe’s rescue policy is making the eurozone’s most serious problem – the troubled countries’ profound loss of competitiveness – even more difficult to solve.

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  1. CommentedChris Parry-Davies

    Hans-Werner-Simm is well known for his anti-Euro views and the incredibly simplistic analysis he uses to back this up. The problem is that beneath such simplifications there are indeed a series of problems where unstoppable economic dynamics intersect with intractable political constraints.

    * Despite all the defects, Germany has in fact gained massively from the Euro - indeed has been and continues to be its greatest beneficiary. The problem is that the German politicians have stolen all the credit (attributing all the upside to their polices rather than the benefits of the Euro). As a result the German people now, mistakenly, see the whole project as a one-sided equation, where they pay and everyone else takes.

    * The Euro was/is built on deeply flawed foundations, where the inherent structural problems of the lack of economic convergence/equivalence were papered over by merely political will (heavily driven by the Germans themselves). As we have seen with the on-going crisis in Southern Europe, these structural problems have not gone away but rather have been compounded by the poor economic and political responses (a endless succession of too little too late).

    * Trying to solve the problems by austerity measures and fiscal consolidation have demonstrably failed, based as they are on deeply flawed understanding of the interdependence of the public and private sectors (simply put trying to balance the books through just slashing public expenditure, particularly while many of the Euro economies are locked into what is for them an over-valued currency, is doomed to fail as demand and growth chase their own tail in a downward spiral - as is now all too clear across Europe). Conversely, trying to solve the problems by yet more debt without resolving the structural problems is equally doomed to failure. Equally, there are limits to how far Germany can indeed keep bailing out the whole sorry system, even if it were not already up against the political buffers with the German voters (as per 1 above).

    * George Soros's solution of issuing Euro-bonds might help in as much as it would it defray some of the burden (or at least perceived risk burden) across a broader base - and if the European Articles are the only problem, he's quite right in saying we should simply change the Articles. The problem is that this is that broadening out the credit base is all that this does: it still fails to address the real structural problems.

    * Conversely, Germany actually leaving the Euro would be monumentally retrograde, defects or not - even assuming it was now actually possible (which is extremely dubious given the web of interdependence that it has now created). It would simply result in a massive appreciation in the new currency, in turn triggering am massive reverse in the German economy (my models suggest something like a 10-12% contraction of GDP, and unemployment soaring to circa 5 million - not to mention the German public finances going massively into the red). And this is before we get into this meaning the Euro would all but inevitably collapse generally, at very least fragmenting the European economies and seriously risking a continent wide economic and political collapse.

    * Taken together we - as in Europe as well as Germany - can't continue with the Euro as it is but, equally, can't afford to lose it. The only workable solution I can come with is to split the Euro into two - a Euro North and Euro South. This would enable the southern economies to make the necessary structural adjustments through currency depreciation; while enabling the Northern economies to continue to benefit from the essential benefits of convergence and common currency. Politically the support for the Southern economies could then be sold to the Northern electors as a one-off reverse dowry that would solve the problem instead of the present drip feed of support that fails to solve the problem and electors rightful fear as never ending

  2. CommentedGreg A

    Another daft and close minded article from Mr Sinn. He seems to live in a fantasy world. What he recommends would surely break up the Euro. Putting the whole eurozone on the edge of a cliff on a permanent basis (or even letting it fall) seems a very dubious way to economic recovery.

    The ECB can surely do more. The ECB has always had a very hawkish approach to rates, always being afraid of inflation and only lowering them when they had absolutely no choice. In fact, the central bank rate in Europe is higher than in the US and Japan despite having a much worse economic situation. When the Fed and the BoJ are saying they will keep rates low in the future, you can be sure that the ECB will try to raise them as soon as it can...

  3. CommentedBasle Jean-Luc

    One of the euro premises, silly as it was, was that Southern European countries would invest the Northern manna which would not fail to materialize into productive investments to increase their competitiveness. It did not happen. There are many reasons for that. One of them is the lack of clusters of manufacturing and metropolitan areas, theorized by Paul Krugman. Another is the geography, history and culture of these countries. Be this as it may, these countries are known for their beautiful, sunny beaches where Northerners love to bathe in the sun. The logical outcome of the new European monetary system was a real estate bubble financed by Northern savings. Once the bubble burst, Northern governments blamed the peripheral countries for their carelessness. But who is guilty: the ones who spent the money or the ones who lent it?
    Within the euro area, member nations are straight-jacketed in a modern version of the gold standard. The only way they may regain their competitiveness is by adopting deflationary measures which translate into lower real wages – an unfortunate circumstance for the folks who bear the brunt of this adjustment even though they are in no way responsible for this turn of event. Yet, German leaders and economists who no doubt know that Chancellor Heinrich Brüning’s disastrous deflationary policies led to Adolf Hitler’s electoral success in January 1933, blindly insist on austerity to restore these countries’ budget and trade balances. But it takes two to tango. If some countries experience a trade deficit, others record a surplus. The trade deficit of Southern countries finds its counterpart in the Northern countries’ surpluses.
    There is another way out. Northern countries could stimulate their economies, starting with Germany. The much lauded Hartz reforms are a subtle form of mercantilism reminiscent of Hjalmar Schacht’s trade policies.* Cognizant of this common flaw in trade relation, John Maynard Keynes insisted at the Bretton Woods conference in July-August 1944 that the obligation to balance trade be the responsibility of both the deficit and surplus countries. A diluted version of his view found its way in Article IV of the International Monetary Fund’s Statutes but was never activated. Applying to the euro zone, Keynes’s principle means Northern countries must stimulate their economies while Southern countries must adopt the structural reforms necessary to put their economies on a sound footing.**
    The idea that pressuring Southern countries is necessary for them to reform is as invalid as the IMF’s ‘stabilizing’ policies which met their fate in the Asian crisis of 1998. This insistence on blaming deficit countries is self-destructing. Germany’s employment depends in part on purchases by Southern countries. Forcing them to adopt deflationary policies can only hurt Germany and the rest of Europe. The end game will be political upheavals and demagoguery. The recent election outcome in Italy is a preview of what to expect in the future. To historians, the stability brought about by the Treaty of Rome will then look like a strange interlude in an otherwise distraught History.

    * Hjalmar Schacht was Minister of economy (1934-1937) and President of the Reichsbank (1933-1939).
    ** While France which is not included in the group of Southern nations, must adopt structural reforms as well.

  4. CommentedStamatis Kavvadias

    "The ECB can curb the euro’s appreciation through purchases of foreign currency. But, ultimately, it would have to do so by inflating its own currency until confidence in the euro falls back to the level that it had before the assurances were made."

    There is no need for this to happen. The ECB need not give any money it prints into circulation to the countries, as it has promissed, by buying their bonds. It is true that such an approach would cause inflation after a while, mostly because of markets in fear of the public in southern countries not backing their insolvent banks and their budget deficits. But this would take a while, as I said, because the euro is also in the northern countries. So, initially the expectation of the markets would be that the north will have to pay for the spending of the south, and bond interests would rise for the north. The ECB does not have any other way to print money, and that is why Mr. Draghi denied manipulation of the exchange rate.

    There is a real problem here, as the eurozone (and the EU more generaly) do not have a way to bound funds in specific directions. This is because there is no unifying political authority with a significant badget.

    But Mr Sinn is not talking about that --no. Nobody is! Nevertheless, I think I know what is in the back of Mr Sinn's mind. He would rather have the private banks buy Spain's and Italy's bonds than the ECB. He would prefer the ECB had another trillion euro program of cheap lending to the banks, so that Italy and Spain can no longger carry the burden of interest payment and become hostages of the north. Northen banks, you see, would rather have banks of the south insolvent, chasing insolvent sovereigns, so that they are eventually bought off for peanuts by the northen banks.

    Am I accusing Mr Sinn with no reason? Let him say clearly what he proposes...

  5. CommentedOdysseas Argyriadis

    Don't know if I'm completely daft, but isn't the exchange rate rising due to the fact that the Fed is printing more dollars???

  6. CommentedJoshua Ioji Konov

    The artificial value of the Euro boosted by the Mr.Draghi last year statement was based on pure perception than on reality in the EU economy, which keeps high unemployment and growing public discontent with dysfunctional ideologically inclined economic policies. Subsidies that go to the wealthy farmers, VAT that hurts the bottom of the society cutting down on the consumption, austerity measures that grow market imbalance...

  7. CommentedFrank O'Callaghan

    While Jose Araujo is correct there is another criticism: Sinn does not mention a salient problem that the bailout countries have in common. They all reduced taxes on the wealthy while deregulating controls on capital. At te same time they enriched sectors of their state sectors and public service.
    The selective enrichment of public servants in Ireland, Greece and Italy in particular with the huge increase in State pensions liability has been almost ignored by economists.
    At the same time there has been a deterioration in the efficiency pf public services.

  8. CommentedZsolt Hermann

    The "rescue policy" does not work, moreover causing "collateral damage", because it was only rescuing the financial lifeline, keeping the banks floating, but it did not do anything for the actual public that are being buried alive underneath the debt burden and austerity.
    This is what happens when people want to delay hard decisions, looking deeply into the problem finding the root causes, and instead they satisfy themselves with superficial solutions waiting for a miracle.
    And this is not a European problem the same thing is happening in Japan, especially in the US, and even in China.
    Leaders, and the lobbies manipulating them only care about keeping the markets, the profit making machine churning until they can, completely ignoring the "collateral damage".
    Which is of course a very short sighted policy, since unless they have an army of robots that will keep on consuming, they have killed the very social layers that could maintain their prosperity.
    Until everybody accepts that our present lifestyle and socio-economic system is unsustainable and is doomed to failure as it goes against the natural laws of the system we live in we, both the 99% and the 1% will sink deeper into crisis until the total desperation forces us to change.
    And then we also have to swallow the next bitter pill, nobody, no individual or nation can escape alone, we are all on the same sinking boat, tied together in the same unbreakable net.

  9. CommentedSteven Tolliver

    While the US Federal Reserve continues policies which keep the dollar low and China keeps the yuan tied to the dollar and now the new Abe gov't. in Japan pushes down the yen, there is nowhere for the Euro to go but up. We can't all devalue our currencies at once!

  10. CommentedJose araujo

    Do people realize that Portugal, Greece, Ireland and Spanish Boom were in the 90's, after the Eu integration but previous to the Euro?

    There is no evidence of inflationary economic bubble due to cheap credit, that's Austrian mumbo jumbo that isn't verified by data.

    Capital movements after 2000 are explained by the trade deficit, consistent with a fixed exchange rate situation.

    Financial crisis in the periphery were motivated by the sudden increase of the default risk associated with end of the perception of Euro solidarity, i.e. when the market realized the ECB was never going to play the role of lender of last resource.

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