The Tragedy That Is Greece

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On May 5th,
three bank workers died in a blaze at their Athens office block
after violence broke out in a mass demonstration against the Greek
government.

This was the
tragic result of a decision taken in 1992, to impose a single currency
on twelve very different economies.

The European
political elite had always wanted a single currency. From 1979,
most members of the European Economic Community (the precursor to
the European Union) participated in the European Monetary System
or EMS. This was an arrangement whereby the member states linked
their currencies to prevent large fluctuations relative to one another.
This led to the creation of the European Currency Unit or ECU, which
was the precursor to the Euro. The participating countries had to
prevent movements of more than 2.25% (although Italy had a much
wider band of 6%) relative to the other participating currencies.

Periodic adjustments
raised the values of strong currencies and lowered those of weaker
ones, but after 1986, changes in national interest rates were used
to keep the currencies within a narrow band.

Britain finally
joined the EMS in 1990, but the strains of keeping the Pound in
a tight band relative to the other currencies soon began to show.
By 1992, Britain was forced to raise interest rates to punishingly
high levels. George Soros saw the writing on the wall. By September
16th, 1992, (Black Wednesday) his fund had sold short
more than $10 billion of Pounds Sterling, as he gambled that the
British government would have a limit to how much money they would
be prepared to lose in supporting the Pound.

On September
16th, the British government announced a rise in Base Rate from
an already high 10% to an eye-watering 12% in order to tempt speculators
to buy pounds. Despite this, and a promise later the same day to
raise Base Rate again to 15%, dealers kept selling pounds. By 19:00
that evening, Norman Lamont, the Chancellor, announced that Britain
would leave the ERM with immediate effect. George Soros (in)famously
walked away with a profit of over $1 billion.

At the same
time, Ireland was forced to raise their key interest rate to 17%
in order to keep the Irish Punt within its EMS band, while Italy
threw in the towel and withdrew from the EMS on the 17th
of September 1992

Ironically,
1992 was also the year in which the European political elite officially
imposed their desire for a single European currency on nearly 300
million people under the terms of the Maastricht
Treaty
.

Despite the
problems suffered under the EMS, and clear breaches of the convergence
criteria set down in the Maastricht treaty, the Euro project went
ahead in January 1999, as eleven EMS member states (including Italy
which had re-joined the EMS at a later stage) had their currencies
fixed at the rate they were trading at as part of the ECU. The Euro
thus became the successor of the ECU, and the European Central Bank
(ECB) became the de facto central bank for the Eurozone member states.

Greece became
the twelfth member of the Eurozone in 2002. Ominously, it was not
able to join the Euro in 1999 because it could not meet the convergence
criteria.

Even in 2002,
no-one seriously believed that Greece had met the convergence criteria.
This credibility gap has always been a major problem with the Euro
project. The political elite were determined to carry on with their
master plan, no matter what. They assured the people of the Eurozone
that they knew what they were doing. They hoped that ordinary people
would be so disinterested, or confused, that they would not object.

The ECB's primary
aim was to ensure the acceptance of the Euro by the 300 million
people suddenly having to use it. They decided that the easiest
way to do this was to keep their key interest rate artificially
low from the start — far too low, as it turned out, for many of
the new member states.

For decades
prior to joining the Euro, short-term Irish Punt interest rates
traded around 11%. Short-term rates reached a high of 17% in 1992,
as Ireland struggled to keep the Punt inside its EMS bands. As conversion
to the Euro loomed ever closer, short-term interest rates in Ireland
gradually dropped until by January 1999, they were 3% in line with
the rest of the Eurozone.

Spain, Portugal
and later, Greece, all suffered the same fate as Ireland — a massive
expansion of credit, as the banks in those countries actively expanded
deposits and loans. The property markets in all of these countries
went through the roof as the ECB did nothing to rein in the credit
expansion, despite the ECB President's constant refrain, u2018We are
firmly anchoring inflation expectations.'

In fact, the
ECB was not only expanding credit by intervening in the market to
keep their key interest rates artificially low, they were also debasing
the Euro by indirectly financing the ever-growing debts of profligate
member states.

This is due
to the way the ECB prints money.

As Phillip
Bagus explained in his article of February 11th,

The European
Central Bank accepts Greek government bonds as collateral for
their lending operations. European banks may buy Greek government
bonds (now paying a premium in comparison to German bonds of more
than 3%) and use these bonds to get a loan from the ECB at 1%
interest — a highly profitable deal.

The banks
buy the Greek bonds because they know that the ECB will accept
these bonds as collateral for new loans. As the interest rate
paid to the ECB is lower than the interest received from Greece,
there is a demand for these Greek bonds. Without the acceptance
of Greek bonds by the ECB as collateral for its loans, Greece
would have to pay much higher interest rates than it does now.
Greece is, therefore, already being bailed out.

The other
countries of the eurozone pay the bill. New euros are, effectively,
created by the ECB accepting Greek government bonds as collateral.
Greek debts are monetized, and the Greek government spends the
money it receives from the bonds to secure support among its population.

His outlook
for the Euro was bleak.

The future
of the euro is dark because there are such strong incentives for
reckless fiscal behavior, not only for Greece but also for other
countries. Some of them are in situations similar Greece’s. In
Spain, official unemployment is approaching 20% and public deficit
is 11.4% of GDP. Portugal announced a plan to privatize national
assets as its deficit is at 9.3% of GDP. Ireland’s housing bubble
burst with a deficit of 11.5% of GDP.

The incentives
for irresponsible behavior for these and other countries are clear.
Why pay for your expenditures by raising unpopular taxes? Why
not issue bonds that will be purchased by the creation of new
money, even if it finally increases prices in the whole eurozone?
Why not externalize the costs of the government expenditures that
are so vital to securing political power?

Despite, or
more likely, because of the spending undertaken by the previous
Greek government, Greece has been in a recession since the credit
crisis of 2007/8. Aside from problems accessing credit, the Greek
economy has suffered from the strength of the Euro over the last
three years. Greece relies heavily on tourism to bolster its economy
and the strong Euro was a deterrent to many tourists. Turkey, right
next door, was a much cheaper holiday destination.

Many Greek
people may not have identified the Euro currency as the source of
their problems but they knew that they needed a different government.
So, in October last year, they voted in a new Socialist government,
headed by George Papandreou, who pledged to fight corruption and
tackle Greece’s worst economic recession in years. It was only once
the Socialist party took office that they realised how bad the fiscal
situation was.

It has fallen
to George Papandreou and his Finance Minister to sort out the mess
left by the previous government, and this will entail drastic cuts
in government spending, higher taxes and an increase in an already
high unemployment rate, at least initially. This is why the Greeks
are rioting.

Unfortunately,
their anger is directed at the new government even though this crisis
was caused by the previous government, aided and abetted by the
ECB.

LVM and Hayek
would be horrified but not surprised by the inflationary activities
of the ECB and by the profligacy of governments prepared to do anything
to stay in power.

Sally
Copperwaite [send her mail]
studied Politics, Philosophy and Economics at Oxford University
before joining Credit Suisse First Boston. She later became a Director
of Merrill Lynch International in London before taking time out
to bring up her children. She is now an Independent Financial Advisor.

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