Southern Europe's Fiscal Crisis

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The euro is the focus of attention these days. This is because of a fiscal crisis in Greece, and looming crises in Portugal and Spain. Italy could follow.

What is the problem? Greece is running a huge deficit in the range of 12.7% of its Gross Domestic Product. The investment world regards a deficit of this magnitude as unsustainable. There are rumors of default.

Spain is running a deficit of 11.4% of its GDP. This is considered a threat to the nation’s financial structure. There are rumors of default.

The United States government is expected to run a deficit of $1.6 trillion in an economy with about $14 trillion GDP. This means the deficit will be about 11.4% of GDP. Of course, this is seen by American economists as all right. After all, the United States is not Spain. Treasury Secretary Geithner assured the viewers on ABC News on Sunday, February 8, that there is no possibility that the rating on U.S. Treasury debt will ever fall below AAA. “That will never happen in this country.” Unfortunately, he neglected to say whether it could happen in other countries, whose credit-rating agencies are not regulated by the United States government.

The euro is officially issued by the European Central Bank. This central bank acts on behalf of all 16 European nations that are part of the European Monetary Union. Non-members are Great Britain and Switzerland.

This system is now an aspect of the European Union, which has been in existence since December 1, 2009, when the Lisbon Treaty went into effect. Yet the legislatures of each of the member states of the EMU have independent fiscal policies. They do not control monetary policy, but they control taxes and spending.

Always before, monetary affairs have been conducted by central banks that represent central governments. The euro is an experiment in a central bank that officially operates on behalf of 16 nations.


In 2005, Milton Friedman commented on the problem facing the euro and Western Europe.

The euro is going to be a big source of problems, not a source of help. The euro has no precedent. To the best of my knowledge, there has never been a monetary union, putting out a fiat currency, composed of independent states.

There have been unions based on gold or silver, but not on fiat money — money tempted to inflate — put out by politically independent entities. (New Perspectives, Spring 2005).

His admission that there have been unions based on gold was significant. He did not pursue this, because he rejected the gold standard. He made his reputation as a monetary theorist for his opposition to a gold standard. He was a faithful disciple of the American theorist who was most adamantly opposed to the gold standard, Irving Fisher. Friedman’s monetary theories were an extension of Fisher’s.

Fisher believed in fiat money unconnected to gold. So did Friedman. Fisher saw a stable price level as the primary monetary goal. So did Friedman. Fisher was willing to accept central banking in principle, because he believed that central banks are more reliable than legislatures. So did Friedman. Fisher never came up with a theory of civil government or economics that showed how central banks could be trusted with control over fiat money. Neither did Friedman.

Friedman believed in the free market, but not a free market in money. He did not believe in a full gold coin standard that is enforced only by the law of contracts. On this point, neither do defenders of a traditional, government-run, government-guaranteed gold standard. The question always arises: How can citizens prevent the government from cheating? What protects them from a government’s decision to allow commercial banks and central banks from confiscating the depositors gold? So far, there has been no answer, other than the usual one: defeat at the next election. But, because the confiscations happen during emergencies — major wars, economic breakdowns — the public meekly consents. Always. Friedman offered this criticism of the present arrangement in Europe. In an interview during the boom phase of the economy in 2003, he said this.

What’s going to make the difference is the productivity of the different countries. But personally, as I say, I believe the Euroland is going to run into big difficulties. That’s because the different countries have different languages, limited mobility among them, and they’re affected differently by external events.

Right now for example, Ireland and Spain are doing very well, but on the other hand Germany and France are doing very poorly. The question is; “Is the same monetary policy appropriate for all of them?” Germany and France on one hand and Ireland and Spain on the other: it’s very dubious that it is. That’s why you’re having increasing difficulties within the Euroland group. As you probably know Sweden, which had not joined the European Monetary Union, voted down doing so and will keep its own currency.

He asked what he imagined was a rhetorical question: “Is the same monetary policy appropriate for all of them?” He answered no. That was because he was a fiat money economist.

The free market-based answer would be this: “There should be no monetary policy. There should be only the enforcement of contracts.”

Friedman assumed that there must be economic policy. This begged the question: “Set by whom?” The various parliaments? The various central banks? A combination? He opposed a single central bank. He also opposed gold. He opposed a single European parliament. That put him in a dilemma. There is only one answer remaining: competing parliaments. This is what we have now. This system is not working.

In 1999, he wrote a letter to an economist. The economist used it and other sources to write a paper on Friedman’s view of the euro. On March 9, 1999, he wrote:

As you know, I am very negative about the euro and I am very doubtful about how it will work out. However, I am less pessimistic about it now than I was earlier simply because I never expected that the various countries would display the kind of discipline that was required in order to qualify for the euro. The convergence in inflation rates, interest rates, and so on was greater and more rapid than I would have expected.

Still, he hoped the deal would not go through. He wrote on April 17, 1999,

What most troubles me as it does you is that members of the euro have thrown away the key. Once the euro physically replaces the separate currencies, how in the world do you get out? It’s a major crisis. As a result, I would strongly agree with your view that the euro should be abandoned before January 1, 2002.

At the same time, the odds are very great that it will not be abandoned. The defects of the euro will take some time to show up; nothing happens very rapidly in this area. There are fewer than three years to go. Even if difficulties deriving from the euro occur in those three years, the political system is unlikely to react quickly enough to end the euro. As a result, I think it would be very desirable for some systematic thought to be given to devising some way to get out of the straitjacket of the euro after 2002. The least Italy should do is to keep intact the plates which are used to produce lira.

No nation got out. They all surrendered monetary sovereignty to the European Monetary Union and the European Central Bank.


The crisis over Portugal, Italy, Greece, and Spain — PIGS — continues to escalate. Because they have surrendered their monetary policy to the ECB, these nations are unable to inflate their way out of the fiscal crisis. This leaves the following options.

1. Default on some or all of their debts2. Pay higher interest rates3. Cut spending4. Raise taxes5. Withdraw from the EMU6. Withdraw from the EU7. Wait for a bailout by the ECB.8. Choices 2-7

There is a legal question regarding withdrawal. These nations have surrendered their national sovereignty to the New Europe. How can they regain it? At what price?

If they leave, the EU will have to impose sanctions. Military invasion is out of the question. Want to fight Spain across the Pyrenees? How about fighting Greece in the hills? So, the sanctions would be economic. A major one would be to impose high tariffs on these nations. The borders would be closed.

These four nations are ruled by politicians who cooperatively sold their nations’ sovereignties for a mess of pottage: access to northern Europe’s capital and markets. They are highly unlikely to secede.

Then what? The EU has restrictions on the fiscal deficits: 3% of GDP. Total debt cannot go above 60% of GDP. This goes back to 1993: the Stability and Growth Pact. In 2005, the rule was adjusted at the request of Germany and France. No European Union nation has honored these restrictions. In a report, “Public Finances in EMU, 2009,” the authors described the effects of the big bank bailouts.

Member States have supported their banking sectors with measures amounting to about 13% of GDP and have approved funds worth another 31% of GDP. The largest share (7.8% of GDP in terms of measures taken; 24.7% of GDP in terms of measures approved) are guarantees on bank liabilities, which do not affect public debt and deficits unless they are called upon. The rest pertains to relief of impaired assets, liquidity support and capital injections (p. 2).

So, there are no cross-border sanctions. The rules are being violated.

This raises a problem: the threat of a national debt default by one of the PIGS. Greece insists that it will do no such thing. But the rates on insurance against Greece’s national default have been rising.

The Greek government is trapped. It cannot secede. It cannot inflate. So, it has to decide: default, higher interest rates, or run a budget surplus. The latter is out of the question in any European nation. So, it is down to default or raise interest rates. I think the latter is most likely.

Or it can wait and see if the ECB comes through with a bailout. If the ECB does bail out Greece, this will send a clear signal: the end of any need for fiscal responsibility by the PIGS. It will also end any legitimate hope that the euro will become a stable, reliable fiat currency.


The PIGS have no ability politically to cut the costs of national government. The welfare state mentality is universal. Politicians refuse to slow the rate of spending. Raising taxes will tank their economies. Politicians may try it, but there will be painful economic repercussions.

Rising interest rates will tank their economies.

This leaves only one possible solution: kick the can. Promise stability and growth. Promise that they will get their financial houses in order.

The welfare state is based on promises. All over the world, it is facing bankruptcy. But the voters believe in the promises, and politicians dare not tell the truth.

The PIGS are getting no help from the European Central Bank. The capital markets are raising interest rates. Their economies are still declining.

There is an answer: open default by the welfare state. I mean across-the-board default, all over the world. “We are sorry to inform you that, contrary to our expectations and yours, Social Security and Medicare are no longer solvent. The IOUs in the trust funds can no longer be met. They have been shut down.” This would be coupled with the refusal of central banks to buy further debt, anywhere, for any reason.

This will not happen.

Rising rates and recession in southern Europe look likely. That recession will spread across the borders.

February 10, 2010

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2010 Gary North