The euro is falling. It is at the lowest exchange rate to the dollar in four years.
Confidence in the euro is falling because it is becoming clear that the region's commercial bankers have made the same sorts of bad decisions that American commercial bankers made after 2000. They loaned money to debtors in Eastern Europe who will not be able to repay. These loans were collateralized by real estate, which rose. Real estate prices in Eastern Europe are now falling. The bubble has popped.
The bankers also lent to the Greek government. After all, interest rates were high. The Greek government's deficit-to-GDP ratio was low: a reasonable 3.7%. That was the official report of the Greek government in April 2009. That government lost the election in October. Then came the announcement of the new socialist government in October: this ratio was a gigantic lie. The real ratio was in the range of 12.5%.
That estimate was too low. On April 23, the Greek government announced that it was 13.6%, and the government needed a bailout. This announcement triggered the crisis of the euro. The politicians in Northern Europe are in disarray. They don't know what to do. They told the public that Greece needed a $60 billion bailout. Then, overnight, this went to $145 billion. Then, over a weekend, it went to $900 billion. This is the sign of leadership in disarray. They have no idea what they are facing. If they did, they would not have paid any attention to the announcement a year ago that the deficit-to-GDP ratio was 3.7%.
The official rule of the European Union nations is that this ratio must not exceed 3%. This is binding on all EU governments. It was agreed to by EU members in 1997. It is called the Stability and Growth Pact. It has never been enforced. Its limit was officially reduced in 2005 at the request of France and Germany. The recession that began in 2008 has destroyed that agreement. Southern Europe is in double-digit rates. So are Ireland and the United Kingdom. The most fiscally conservative euro nation, Germany, went to 3.3% in 2009, and is expected to hit 5% to 5.5% in 2010, according to official government estimates.
In short, none of the EU nations is paying any attention to the 3% rule. It is obvious to the world that the rule is not enforceable politically. There is no EU agency that is able to impose sanctions on the politicians, who decide to run deficits in a recession. This is the universal prescription, and it has been ever since 1930. Keynes in 1936 merely provided the seemingly scientific proof that justified what all of the governments were already doing. This is unlikely to change.
Yet the justification of the planners who imposed the common currency and common central bank on Western Europe was that fiscal policies would not violate the 3% rule. Without a common government that can establish the fiscal limit on the entire euro-currency region, there is no central planning agency. This was well known in the years leading up to the euro in 1999. Economists and politicians debated this. But the conspiratorial groups that had been planning the unification of Europe since before World War I dismissed all objections. Their spokesmen assured the Europeans and the world that this step toward political unification was not premature, that a common currency would lead to a common political structure.
They were wrong. They never were able to persuade voters in all the countries to accept full unification. Voters refused to adopt the 300-page constitution. So, the unification was achieved through treaty. The treaty does allow sanctions to be imposed on member nations: fines. These sanctions have never been imposed.
In the first half of the decade, Germany and France ran deficits above the 3% ratio. They pressured the EU to relax the rule. The EU did so in 2005. In a classic speech by a member of the European Central Bank's Executive Board of the ECB Conference on "New Perspectives on Fiscal Sustainability" (13 October 2005), we have a masterful presentation of bureaucratic waffle.
The speech affirmed the legitimacy of fiscal rules. These rules are vital. The European Monetary Union had a very good rule. The rule prohibited high deficits. Here is why: high deficits are bad for economic growth.
Such high deficits and growing debt levels are a cause for concern. If unchecked, they are liable to have a detrimental impact on economic growth and welfare. In particular, the need to finance a large stock of public debt pushes up interest rates and discourages private investment. This causes a loss of output over the long run.
High deficit and debt levels can also have implications for monetary policy. Firstly, fiscal expansions, which boost domestic demand, can give rise to inflationary pressures. Secondly, and of greater concern, unsound fiscal policies have the potential to undermine confidence in a stability-oriented monetary policy. When a government persistently overborrows and runs up increasing levels of debt, this can lead to expectations that government borrowing will ultimately have to be financed by money creation. This could result in higher inflation expectations.
The Maastricht Treaty contains safeguards to help prevent spillovers from fiscal policies to monetary policy. The European System of Central Banks has been granted a high degree of independence. The monetary financing of government borrowing by the central bank is prohibited. And under the so-called "no-bail-out clause," the bailing out of a Member State in financial difficulty, either by the European Union, or by another EU Member State, is strictly prohibited. In EMU, it is the responsibility of each government to keep its own fiscal house in order.
It was clear from this analysis that any policy of long-term fiscal deficits would threaten the stability of the euro. Nothing like this would be permitted. No, siree Bob!
But there is a problem with rules. They are restrictive. Sometimes, they are too restrictive. So, there has to be flexibility in enforcing rules. I mean, if you enforce rules, people will be forced to change their behavior. Sometimes it is best to let people change more slowly.
Fiscal rules should be adequate with respect to the underlying objectives they are intended to achieve. This means that EMU fiscal rules should be stringent enough to ensure and maintain confidence in the soundness of the public finances. But they should also be flexible enough to allow for appropriate policy responses in case of exceptional events beyond the control of governments, thus providing some insurance without inducing moral hazard. A rule that is not consistent with rational economic policy actions is unlikely to be viable in the long run. On the other hand, rules also need to be clear and enforceable, which requires transparency and a certain degree of simplicity.
The simpler a rule is, the easier it is to monitor by the markets and the citizens. But this may come at the cost of prescribing an overly simplistic fiscal policy in the context of a much more complex economic reality. The more sophisticated a rule is, the less likely it is to be criticized as lacking economic rationale. But this may come at the cost of making it difficult to monitor compliance, thus undermining the effectiveness of the rules as a constraint on fiscal policy. This problem may become more acute in a context featured by "soft law" and non-independent arbiters in charge of enforcing compliance with the rule.
This was bureaucratic window dressing for the new policy in 2005, a policy of not enforcing the 3% rule on Germany and France. That sounded good to Germany and France.
Was this a retreat? Not according to the speech-giver. Was this a policy failure? Why, nothing could be further from the truth. He ended his announcement of the new policy with this stirring declaration.
But it would be wrong to concentrate only on the Pact's failings. We should also give the Pact credit where credit is due. During the protracted slowdown experienced by many euro area countries over the last few years, deficits have not risen to the heights often experienced during past downturns. The euro area deficit ratio of just below 3% over the past three years is higher than we would like, but it is still considerably better than the 5% peak reached during the recession of the early 1990s. And while the euro area debt ratio has not been falling, the upward tendency of recent decades does at least seem to have been brought to a halt. To sum up, I am quite certain that fiscal policies with the Pact have been more disciplined than they would have been without it.
REPLACE THE CANARY
French commercial bankers went on a buying spree of Greek government debt. Lo and behold, they now find themselves sitting on a pile of IOU's that Standard & Poor's has declared as junk bonds. This has enraged Sarkozy. He is enraged, not at the lying Greek government that told the world in April 2009 that the ratio was 3.7%. He is enraged at S&P. He and Merkel have issued a joint declaration that Europe needs its own credit-rating service. There are now plans to set up such a service.
In short, shoot the messenger. Then replace the canary in the coal mine with a breed of bird that resists the effects of potentially explosive gas. The EU wants a credit-ratings agency that it can control, just as the United States Congress wants credit-rating agencies that it can control. Congress has this; Europe does not. Europe wants parity.
The canary in Europe's coal mine is lying motionless, feet up, in the cage. Europe's politicians are unhappy with the canary. They are determined to replace this canary as soon as possible. Meanwhile, they have decided that 14% is not too high for Greece. It has ponied up almost a trillion dollars' in euros worth of bailout money in order to contain the looming default of the PIIGS, which would threaten the solvency of Northern European banks.
There is no 3% rule. There will never be such a rule. It was officially abandoned in 2005, and there is no possibility that the EU is going to enforce it. The Keynesian model is again totally dominant. Moral hazard is alive and well in Europe. The commercial banks will be protected from the foolishness of bankers in trusting Greece and the other PIIGS.
German and French politicians laid the foundations of this disaster when they refused to balance their nation's budgets in the early 2000's. They decided that they should have a little fiscal leeway in a period of a boom economy. Then came the recession of 2008. The PIIGS's deficits have soared. Northern Europe's voters now find that they have been saddled with an extra trillion dollars' worth of new debt, with the possibility that this will be only a down payment on the bailouts of PIIGS. The bankers will be protected. The voters will not.
THE BEST-LAID PLANS
The planning for the new Europe preceded World War I. The key figure was Jean Monnet. He spent his career working for European political integration. He died in 1979. Two decades later, the euro was officially born. It was the supreme mark of European economic integration. A common currency and a single central bank in charge of monetary policy replaced the old Europe. There are still national central banks, but they have as little power as 11 of the 12 regional Federal Reserve Banks. The New York FED is dominant, just as the ECB is dominant. The others are for show, just as the national central banks in the EU are.
The goal of the centralists was to use economic integration as the wedge for full political centralization. The strategy seemed to work, decade by decade. The euro was to be the capstone of this economic centralization.
The unofficial deadline was the year 2000. As a fall-back position, 2010 was the outer limit. I recall a speech by Richard Cooper in 1974, in which he mentioned both dates. Cooper was a young expert in international economics, then at Yale, later at Harvard.
The plan seemed to be on track in 1999. The euro became the new currency for Western Europe, except for the pound sterling and the Swiss franc. It appeared that the euro would function as a stabilizing, integrating force for the new Europe. That hope is now smashed.
The crisis of the euro is making full political unification even less desirable to Northern European voters. The EU must now escalate its centralization rapidly in order to keep Greece and the other PIIGS from bankrupting the semi-solvent nations of the north. There is a political revolt brewing in the north. The EU must gain control over the fiscal policies of all EU nations. But what sanctions does it have? It can expel member nations. To assess the relevance of this threat, you need to view a scene in Mel Brooks' movie, Blazing Saddles. It ends with the words, "They are so dumb."
The centralists have spent a century in an attempt to create a new European order in which central panning, especially in the area of monetary policy, will transfer power to the unelected bureaucrats. The model has been the Bank of England. It has been ever since 1694. The goal is to short-circuit local political sovereignty by means of cross-border bureaucracies that are shielded from direct political influence. This is the monopolist's dream come true. In the United States, the Federal Reserve System achieved this goal in 1914. It has never surrendered it.
But Europe has reversed the sequence. Instead of establishing political centralization first and then transferring control to an independent central bank, it established an independent central bank before it attained full political sovereignty. The conspirators did not understand that there must be central government with real sanctions in order to enable the central bank to regulate commercial banks. This has been the history of U.S. banking: the slow but steady replacement of state bank regulation in favor of Federal regulation, and from the Federal government to the Federal Reserve System.
We are in the final stage of this transfer of regulatory control. Congress is ready to transfer this authority to the FED. The financial reform bill introduced in mid-March by Senator Dodd (retiring) transfers control over large financial holding companies to the Federal Reserve, centralizing this control in two FED banks: Chicago and New York.
In Europe, the politicians are scrambling to keep large commercial banks solvent indirectly by bailing out member nations' governments, thereby preventing open default on their bonds. It is not clear yet if there must be more bailouts to maintain this solvency.
The accounting game of preserving asset solvency on the commercial banks' balance sheets was solved in the United States by having the FED swap toxic debt for Treasury debt at face value in 2008, and by the Financial Accounting Standards Board's decision a year ago to modify rule 157 so that banks need not write down bad assets to market value. In Europe, it is not clear if their approach will work: to bail out the Greek government, so that it does not default.
Europe made a strategic error: to move to political centralization by way of the economic sector, including the monetary authority. The independence of national governments over their finances now threatens to undermine the great experiment.
THE FUTURE OF THE EURO
The euro faces the problem that every cartel faces: cheating by its members. In a cartel of goods, members secretly sell below the agreed-upon price. In a monetary cartel, members cheat fiscally. They run up the bill, then threaten to default if the other members do not fork over the money. This is Europe's problem today. The cartel is breaking apart.
The key to any cartel is its ability to impose painful sanctions on cheaters. It is now clear that the European Union has no negative sanctions that are taken seriously by member nations. The voters in each nation can inflict negative sanctions on politicians who impose austerity programs, such as higher taxes or cuts in spending. Politicians fear voters more than they fear the EU.
Europe is facing a revolt of national Keynesian governments, whose voters want Keynesian deficits. The EU itself is willing to run Keynesian deficits to bail out national Keynesian governments. This was not clear until Sunday, May 9. The huge bailout announced that day sent a clear signal to the world: the EU is willing to adopt Keynesian deficits in order to support national deficits. This is a positive sanction for national deficits. It is moral hazard for governments in order to extend moral hazard to commercial banks.
The European Central Bank had resisted buying Greek debt directly. It promised only to lend against Greek debt held by commercial banks. Its reversal on May 9 indicated that the positive sanction of subsidized debt sales is now ECB policy. This is moral hazard for national governments.
There are no negative sanctions against member nations whose parliaments adopt full-fledged Keynesianism. The ECB is ready to abandon monetarism. It is ready to inflate. Keynesianism has moved up the chain of command from member states to the EU and the ECB. The voters in the south want bailouts by governments, and they are in control. The negative sanction of national default is greater than the negative sanction of expulsion from the EU. In this game of political chicken, the PIIGS have won.
Investors can see this. They have a choice: stick with the euro or sell it. They have been selling it. They believe that the EU and the ECB do not have the power to rein in the spending of the PIIGS. The PIIGS are now in control. Investors bought the euro on the assumption that northern Europe, which has the capital, was in control. It isn't. The PIIGS are. They owe too much money to the large banks of northern Europe. The northern commercial bankers are in charge. Local voters in the north are not.
Northern Continental Europe's small-deficit Keynesianism has capitulated to the South's high-deficit Keynesianism. This will lead to a lower euro until such time as the commercial banks in the United States start lending, thereby converting the FED's monetary base into M1. Then we shall see which form of Keynesianism is dominant. It will then be a race to see whose currency can depreciate faster.
Anyone who thinks that we are facing imminent price deflation does not understand how effectively central banks can depreciate a currency. The Europeans are ahead of the race at present.
Meanwhile, China is facing a property bust, as is Singapore. Japan is experiencing a mild price deflation. Its central bank has resisted inflating, although the new government has pressured the bank.
Keynesianism is in the saddle, all over the world. The politicians favor deficits. These deficits are accelerating everywhere. Lenders still lend. They trust Keynesianism. They trust IOU's issued by governments. They see government IOU's as productive. Until this trust wanes, national debt will increase like a plague.
It is clear where this will end: default. The investors who trust government bonds will be ruined. Also, voters who rely on government deficits to maintain their above-market incomes will be ruined. Both groups trust Keynesianism, and they are going to get it, good and hard.
May 19, 2010
Copyright © 2010 Gary North