Eurozone Crisis: Will PIGS Get A Blanket ???

By David Caploe PhD, Chief Political Economist

, Economy Watch.com The current crisis in the Eurozone is not particularly easy to understand, but not impossible either.

By David Caploe PhD, Chief Political Economist

, Economy Watch.com The current crisis in the Eurozone is not particularly easy to understand, but not impossible either.

By David Caploe PhD, Chief Political Economist

, Economy Watch.com The current crisis in the Eurozone is not particularly easy to understand, but not impossible either.

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Let’s start by remembering the term “Eurozone” refers to 16 members of the European Union that use a common currency, namely the Euro. The only major European economy that does NOT use the Euro is Great Britain, which retains the pound sterling.

The key fact about the Eurozone is that it represents a MONETARY – not a fiscal, ie government budget – union, whose policy is set by the European Central Bank or ECB. The main job of the ECB is to set interest rates for the entire Eurozone.

Ever since its inception, Eurozone members have been aware of a potential conflict between the fact that monetary policy is set by the ECB for the entire Euro-area, while government spending, ie fiscal, policy is managed by each country.

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This divergence between monetary and fiscal policy remained merely potential, however, until the eruption of the global financial crisis in Black September 2008 –

symbolized by the collapse of Lehman Bros, and the attendant lending freeze instituted by American Too-Big-To-Fail [TBTF] banks and insurance companies, who are refusing to lend again until reassured the US government will take responsibility for their losses, while they keep their profits.

As a result of the extensive financial inter-connections between US and European banks – significantly, although not exclusively, in the still completely NON-transparent derivatives market, above all the so-called “mortgage backed securities” or MBS – the problems in the US housing market set off a chain of potential defaults in European banks, notably in Iceland, the UK, and Spain.

While the UK was able to devalue the pound sterling as part of its policy response to this crisis, such a move was not available to members of the common currency area.

It was at this point a division began to emerge for the first time between the “stronger” economies – notably Germany, France, the Netherlands, and other smaller northern European countries –

and the “weaker” economies, most of which were located in Eastern and Southern Europe, and became known collectively as the PIGS – Portugal / Italy / Greece / Spain – or PIIGS, if Ireland is included as well.

You may note we have quotation marks around “stronger” and “weaker”. This is because we don’t think Germany / France / the Netherlands et al are, in fact, particularly strong:

the heavily export-oriented German economy did show some growth, due to a slight rebound in world conditions AND a stimulus package, but no forecast puts it above 3%, as noted here / here / and here;

and the more domestically-centered French expect even more anemic growth, and, in contrast to Germany – where employers have used government stimulus funds to preserve jobs, even while reducing hours –  with official unemployment figures – again, almost always understated – hitting well above 10%.

The problem with the PIIGS countries is that conditions there are even worse, albeit not necessarily for the same reasons.

As noted previously, the significant problems for Spain and Ireland are quite similar to the US – collapse of a bubbled housing market, leading to massive unemployment, and a stagnant, if not contractionary, economic dynamic.

For Italy, Portugal and above all Greece, the main problem is government, aka “sovereign”, debt – not structurally dissimilar to the crisis that hit Dubai just a short while ago, from which it had to be rescued by its oil-rich UAE brothers to the south in Abu Dhabi.

And the Dubai reference is significant because it points to the problem in the Eurozone – how is it possible for a group of countries joined monetarily, but NOT in government spending policy, to deal with a situation when one government gets into trouble ???

As the Dubai / Abu Dhabi situation indicates, there’s really little choice but for “rich uncle” to help bail out the more “troubled” family member.

But what happens if the leaders of the “rich uncle” know a move like that will drive their taxpayers crazy – thereby risking their own political futures ???

That, in a nutshell, is the dilemma facing the leaders of Germany / France / the Netherlands today:

if they DO help out the PIIGS, they know they put their own political situation into serious peril – especially since, as we have noted, they themselves are doing “well” only in a comparative sense;

if, on the other hand, they DON’T help out their PIIGS-y neighbors to the south, they risk one or both of two bad things happening:

either the common currency IMMEDIATELY breaks apart in an orgy of political recrimination and even more economic de-stabilization;

0r they have to call in an outside organization – ie, the International Monetary Fund – to orchestrate a bail-out, in which case the fundamental weakness of the Eurozone experiment becomes blatantly obvious, and questions about how long it can last bubble up to the surface anyway.

This, then, is the structural background for the explosion of problems in the bond markets for the most immediately vulnerable of the PIIGS – Greece, whose weakness has been an explicit concern for weeks now, as well as Portugal – which had to suddenly the limit of government debt it was making available for sale, after its initial offers failed to attract buyers – and Spain, whose problem is not its “sovereign debt” per se, but its on-going recession, which shows no sign of ending.

In the immediate, as this NYT piece – again, published on Friday / the weekend – notes, potential buyers of government debt have, in effect

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challenged those relatively weak governments to raise taxes and impose harsh spending cuts on a restive populace to bring down their deficits from over 10 percent of G.D.P. to the benchmark levels close to 3 percent of G.D.P. called for in the European treaty that created the euro.

While such moves are highly unpopular politically, a failure to do so could send government borrowing costs soaring, enriching those who are betting that Greece, Portugal, Spain and perhaps even Italy will not be able to follow through on their commitments.

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That said, there are some voices arguing this maneuver – and the ensuing crises it seems likely to provoke – is unnecessary and destructive:

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Joseph Stiglitz, the international economist who is an adviser to the Greek government, sees the investor demands as lacking in merit.

Indeed, he points to the inherent contradiction in allowing the richer countries in Europe to borrow heavily to pull themselves out of recession while the poorer countries are forced to take a knife to the very programs intended to soften the blow of an economic downturn.

“If you tighten the way the markets seem to want you will get a political response that is non-viable,” he said, drawing a comparison to Iceland, where popular discontent forced the country’s president to abrogate a controversial agreement to repay foreign creditors. “These are democracies — not dictatorships.”

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Again, making our continuous point that politics and economics CANNOT be separated, either in general and ESPECIALLY in crisis situations like this immediate one in Europe, and the protracted, TBTF derivatives / lending-freeze blackmail bedeviling the US since at least Black September 2008.

In this way, the Eurozone crisis is definitely the most serious to date in the monetary union’s history.

But to end on a – rare – optimistic note, two British professors have offered at least a technically feasible solution, even if it’s not totally clear how both the “poor” and “rich” governments involved would react to it:

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retain the euro for all external payments, but issue non-convertible local currency to be used for all domestic financial transactions …

The result will be a sharp increase in government holdings of euros, and a scarcity of euros in the private sector – hence devaluation of the newly minted local currency.

This will produce a reduction (in euros) of wages and prices, boosting competitiveness

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There are certainly major issues to be resolved – eg, as the article notes, in what “currency” would taxes be paid – but it just MIGHT offer at least a temporary way out of this increasingly frightening Eurozone crisis.

And given the general political economic mess the world is in, that could offer at least some slight relief.

David Caploe PhD

Chief Political Economist

EconomyWatch.com