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TMFPostOfTheDay (< 20)

Euro-zone Kicking the Can?



July 27, 2012 – Comments (1)

Board: Macro Economics

Author: lobodoug

I have thought for a while that there were really only two options going forward for the Euro-zone: either the ECB prints money and buys the member's sovereign bonds, or they break apart, either dumping insolvent sovereigns, or the more solvent ones choose to go their own way.

So, at the moment they seem to be choosing the former of the above options. Will it work? On the surface, it should work as good as it has in the US. But a little more thought raises a myriad of problems and questions.

The first problem is the same one the Euro-zone has been facing since this mess began: currency union without political union. This raises the ante on the currency union without making any change in the political situation. Spain has already chosen to toss aside their agreed-upon spending limits once. Does anyone think they will get their budget under control if they think the ECB will buy as many bonds as they wish to print? Does anyone think Germany is going to just stand by idly while Spain, Italy, and maybe Greece get rewarded for their profligate living? While Germany may be familiar with the Christian parable of the prodigal son, I do not think that will prevent them from feeling like the older brother! So, perhaps, instead of pushing out the insolvent countries, Draghi's assurances increase the risk of Germany taking their ball and going home alone.

The second problem is that this action is pretty much outside the mandate of the ECB. However, this has not stopped the ECB from doing this in modest amounts so far. Clearly, under the stress of the recent financial crises, the role of the ECB is expanding. I doubt the fiscal conservatives in the Eurozone have the votes to prevent a further liberalization of the ECB's role.

The question that begs to be asked, both for the US and for the Eurozone: is this a solution? Or are they merely kicking the can further down the road with just a much bigger boot? I think the answer is a little hard to discern, as I am not sure we have been in a similar situation before. The Austrian School economists and gold bugs would have us believe that a fiat currency without gold or some other tangible value is doomed to failure. Historically, this is not quite the case.

I think, at the heart of this question, are several other questions: what will the country do going forward. "Kicking the can down the road" is not wrong, SO LONG AS THE COUNTRIES USE THE TIME THAT CREATES to get their financial house in order. Along with the kick, there needs to be a plan to get the economy moving in the right direction and get spending under control. It seems to me, however, that so far everyone has been kicking the can, but ignoring the real issues. The problem is not finding buyers for these countries. That is a symptom. The problem is increasing debt with stagnant or even shrinking economies.

The spending part: it is extremely difficult to substantially reduce spending, other than by ceasing foreign wars. This is not a political statement, it is historical one: look at the end of WWII or any other major war, then try to find other periods where government spending decreased similarly. They exist...but only because of total failure, and the consequences were not pleasant. Of course, ending foreign wars creates other problems: soldiers returning home seeking work, factories needing to shift from military to domestic production, etc. Besides, of the major economies currently dealing with these issues, only the US and Britain, I think, are currently spending amounts significant enough to benefit substantially by ceasing foreign wars.

In recent history only one POTUS has run budget surpluses. Now, there are many small factors that we can point to that have an impact on this, most of which are not allowed on METAR as they are contentious issues in our current political debate. However, I think there is one we can agree on, and one that will mostly get agreement: President Clinton avoided costly foreign wars (I think most will agree this helped him achieve budget surpluses). And President Clinton served during a period when the US economy was undergoing a solid expansion: in short, our economic growth and the associated increase in tax revenue exceeded our increasing costs of government programs. So, instead of focusing so heavily on how to reduce our budget by huge amounts, I think a more viable alternative is to focus on "stabilizing" spending while stimulating our economy. I hear the cheers of the crowd....oh, wait.... they are not cheers? Oh...they are shouting "how are you going to do that, Dumbace?"

So, OK, my solutions, following the major can-kick to give them time to work: First, hiring freezes. It is very difficult for a country to lay off government employees, even if the are not really needed. OK. Fine, let them stay. But, when they retire/die/quit, do not replace them. This CAN work as I have seen it succeed in North Carolina's downturns in past years. Like most states, NC has a mandatory balanced budget requirement so had to take action along these lines. Call it a "palatable" form of austerity. And, since it occurs slowly the impact on the economy does not have quite the same impact of a torpedo hitting the Lusitania.

Government pay freezes: Also used by NC and many other governments in hard times. In the US in recent years the pay/benefits for government jobs has steadily risen against that of equivalent jobs in the private sector. I think the same think is true among the PIIGS. This IMO needs to be corrected, but to do so suddenly will probably cost too much political capital, and have other expenses involved (witness the "costs" of saving money for the Governor of Wisconsin, both in money and in political capital). So, freeze pay and benefits. There will be grumbles, but people will mostly understand the need. And you are not TAKING something away...just saying you can not give more going forward.

Economic stimulation: It is well known that growth in the economy comes mostly from the small business sector. This is where the attentions of Spain, Italy, Greece, and the US needs to be focused. I am sorry, but I think the so-called "JOBS" Act utterly fails in this regard, but you may disagree. I will say that it will take far more than this act to accomplish what needs to happen. What does NOT need to happen is the continuing Government free money to major corporations, financial institutions, etc. They do not stimulate our economy. The are not the solution, they are the problem, IMO (by expecting, like GE, to earn record profits but get a tax credit and not pay 1 cent in taxes). OK, they are not the problem...the politicians OF BOTH PARTIES that give them these favors are the problem. But it needs to stop.

Part of the issue in Europe, as has been discussed here before, is the difference in cost of labor vs. productivity in Club Med as opposed to Northern Europe, particularly Germany. These imbalances have to be addressed or any other attempts to resolve things will fail.

So, I think it can work, but rate the chances as slim. If you see continued focus only on selling bonds to finance debt, and no focus on the root problems, you will know it is doomed. Even more important, I have to wonder to what extend Germany is willing to allow the ECB to print at will to allow Club Med countries to finance their unsustainable debt without a mechanism to rein that debt (and the growth of debt) in. Promises of austerity have failed to work, and are unlikely to going forward. Opinions will differ on this, I know, but I think actual, immediate and serious austerity will also not work: it will push the economy further into depression, and any loans will only be able to service existing debt. The countries would be far better off to just default and move on...and it will not take too long for them to realize it. And, by that point, most of the debt could be held by the ECB, so a default, say, by Spain could easily rock the whole Euro-zone... a dangerous path indeed.

Currently, Club Med countries are like people who keep accepting new credit cards with the nice teaser rates, and use them to pay off the last card whose teaser rate has expired.... They keep borrowing, but nothing is actually reducing their need to borrow more. It works for a while, but one big problem brings the whole house of cards down.

My point in posting this is not the believe I know the answers or have everything right, nor to start arguments along political fault-lines. I am hoping to get a discussion going on likely outcomes, time-frames, etc on the Euro-zone in light of the Draghi's commitment to increase the ECB role.



1 Comments – Post Your Own

#1) On July 28, 2012 at 7:12 AM, ath002 (< 20) wrote:

Dear Doug,

Thanks for your thoughts. I am about to leave Portugal after a 3 week holiday, where I tried to follow the situation closely.

Portugal is trying to be the anti-thesis of Greece in that it has adopted the good pupil approach. It has accepted austerity and cut back on salaries, public spending, etc.

The problem is that it has only gone for the low hanging fruit, such as taking away the 13th and 14th paychecks of their public servants (yes, they get 14 pay checks here per year), and is trying to streamline state spending in the health and education sector.

While they are achieving their targets on the spending side, it is on the revenue side that things are not playing ball. Tax collection is down, due to less sales, unemployment is approacing 20%, emigration of the young and well educated is a big issue.

The other problem is the politically well connected are resisting cuts to their rentals. They have a lot of public + private deals, that got them to improve their road and infrastructure networks, but now there are heavy rentals to be paid. Those companies refuse to see their take reduced.

The constitutional court has just ruled that the cutting of the 13th and 14th pay cheques to the public servants are constitutional for this year, but will not be constitutional next year or thereafter! Go figure.

The local politicians are resisting cuts to their little fiefdoms.

Despite all this, it would be possible to achieve their goals, with a lot of sacrifice from the middle class. The problem that I see is the neighbourhood. If it was just Portugal, Greece and Ireland, you could kick the can down the road for long enough to give them time, with a LOT of pain to achieve sustainable levels of debt.

However, now that Spain is in the limelight, soon to be followed by Italy and maybe France, I seriously doubt that time will be given to kick the can long or far enough to give these countried time to go through the process you mention.

I think that they will be forced to walk away from their debts, as the German voters are getting antsy and dont look forward to financing all these debtors. Even though Germany will be severely affected if they do leave the Euro. Their exports will take a big hit.

Pain everywhere, the top Portuguese songs at the moment are all about young people rebelling against the austerity.

How will it end? No one knows for sure, but I think there is little chance that they will be able to carry thru to a good end.



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