The Eurozone: Self-Inflicted Depression
Well it is always difficult and rather speculative to explain the motivations of political actors, especially when they do things that are not obviously in their own political interest. I mean, the economic crisis in Europe has already toppled the governments of the UK, Ireland, Greece, Spain, Portugal, and Italy. So, one would think that governments in power now would want to be re-elected, and that the best way to get re-elected would be to bring about an improvement in the economy. Yet they are mostly pursuing policies that can be expected to make their economies worse, and even risking a more serious crisis. How can this be explained?
I think it is different in each country, but it is generally some combination of ideology, politics, incompetence, and of course powerful interests who want certain things. In Germany, things are not so bad. Unemployment is at 5.5 percent, lower than it was before the world recession. The standard analysis in the financial press is that the Germans haven’t recovered from the hyper-inflation of 85 years ago, and they are therefore more afraid of inflation than they are of having a second European recession in less than three years. And of course there is all the usual stuff about how Germans and other northern Europeans don’t want to “bail out” other countries, especially southern Europeans who they see as not sharing their work ethic, fiscal prudence, etc.
Personally, I think these views are highly exaggerated. For one thing, whatever the prejudices of any people – and I think there is also a lot of sentiment against bailing out the banks that goes unnoticed – it is not the people that are making these decisions. Policy for the eurozone is currently being made by the so-called Troika, which includes the European Central Bank, the European Commission, and the IMF – in that order of importance. The ECB is really the main player here, because they hold the key to resolving the crisis. In fact, they could resolve it quite quickly if they wanted to, simply by announcing that they would set a target interest rate for Italian and Spanish bonds, and pledge to buy those bonds as necessary to keep their interest rates below, say 3 percent. Why don’t they do this? The answer to this question was made clear in December of last year, when Mario Draghi, newly appointed head of the ECB, indicated that he might take steps in this direction, “if political leaders took more radical steps to enforce spending discipline among members.” (NYT) But within a day or so he walked back from his remarks.
So by then the ECB’s strategy was clear: they weren’t going to end the crisis because if they did, they wouldn’t have the leverage to force Italy, Spain, and other countries to adopt “reforms” – like raising the retirement age, shrinking the size of government, privatizations and other unpleasant things that people would never vote for.
So the ECB, together with the other two members of the Troika, is playing a somewhat risky game. On the one hand, they want to use the threat of allowing bond yields for Spain and Italy to rise to unsustainable levels, in order to force these governments to do as they are told. On the other hand, if they really allowed this to happen for a certain length of time, it would cause a financial meltdown in Europe. Remember, Italy and Spain are “too big to fail,” in terms of the size of their public debts. Ireland, Portugal, and Greece are already out of the financial markets and borrowing from the European authorities and the IMF.
All this is just to explain what the Troika is doing. They are also playing another game of chicken, and that is with the Greek debt. In this case, the private creditors are heavily involved, since they want to squeeze as much out of Greece as they can. A default, or restructuring with a haircut of at least 60 percent, is already accepted as inevitable; but of course the risk here is that the Greek government falls and there is a chaotic default. The European authorities have been trying to prepare for this possibility and build something of a firewall around Greece, but so far it is still a threat.
So, why are they doing these things? For the ECB and their allies in the Troika, part of the motivation is that they see the crisis as an opportunity to force “reforms,” much like the IMF has done to low-and-middle-income countries for the past thirty years. For some in the ECB, there is also a resistance to create money – as the Federal Reserve has done in this U.S., creating more than $2.3 trillion dollars since 2008 – in order to do what is obviously needed, i.e. stabilize the Italian and Spanish bond yields. Some of this involves ideology and incompetence, in terms of economic reasoning. And some of it is attributable to a strong prejudice toward the interests of creditors as a class: these people want to make sure that any country that has “borrowed too much” pays a price for doing so. Of course the crisis was not caused by the weaker eurozone countries “borrowing too much,” since all of them except Greece had been lowering their public debt/gdp ratios until the world recession; and even Greece’s debt would have been manageable had the Troika responded differently to the crisis in the first quarter of 2010. But that is how it has been spun, and the European authorities are mainly pretending that this is true.
Finally, with regard to the UK, that is a somewhat different story. It is more like the U.S., in that it has its own Central Bank and currency. And it has benefitted some from both the fall in the pound, and the Central Bank’s “quantitative easing” – using money creation to push down long-term interest rates. But the government is too conservative to use a fiscal stimulus in order to revive the economy in the face of everything that is pushing it into recession; in fact it has tightened the budget and committed to do more. This is a combination of incompetence and politics.
The main difference here is between the ECB and the U.S. Federal Reserve. The Fed has been willing to use quantitative easing and push down long-term interest rates. It should also be noted that when the Fed creates money and uses it to buy U.S. Treasury bonds, the resulting debt has no interest burden, because it is owned by the Fed and the interest is refunded back to the Treasury. In other words, it is net debt creation that matters, not gross debt. This is of course what the ECB needs to do, but it has refused to do it. Even the bond purchases it has made have been “sterilized,” that is, the ECB sells other assets so as to avoid increasing the money supply. How to account for this difference, which makes the Republican Fed Chairman Ben Bernanke look like a socialist in comparison with the ECB? It is partly a difference in the people in charge – Bernanke has studied the Great Depression and learned some lessons from it. But it is also a difference in the institutions – the ECB and the monetary union that created the euro was set up under a neoliberal, right-wing objective – its job was seen as to control inflation and there was not much of a mandate to promote full employment. And it wasn’t really created as a lender of last resort to the sovereign governments. Of course, that is no excuse – the rules are loose enough so that the ECB could do whatever is necessary – and Mario Draghi pretty much said that in December when he said that the ECB’s mandate to insure “price stability” also applied to avoiding deflation. In other words, they could do what the Fed has done in order to avoid a recession. And of course there are German politicians who push the ECB not to do what other central banks would do in this situation.
With regard to fiscal stimulus, it should be kept in mind that U.S. fiscal stimulus has been just a fraction of what was needed, about one-eighth the size (taking into account the fiscal tightening of the state and local governments) of the loss of demand from the bursting of the housing bubble. Of course, Europe has been even worse, but that is mostly because of the ECB and its allies, and the pressure that they have exerted on governments to engage in pro-cyclical fiscal tightening.
The eurozone is forecast by the IMF to be in recession this year, and it is clear that the economies are mostly getting worse. How deep the recession gets is of course difficult to predict. I am not of the school that predicts financial meltdown, the break-up of the euro, or any kind of catastrophe in the foreseeable future. That is because I think the ECB and Troika will probably do what is necessary to avoid that. I say probably because they could screw up. But so far, when push comes to shove, over the last two years they have repeatedly taken further steps – sometimes doing things that they had pledged not to do – in order to avoid a Lehman-Brothers type of crisis. Most recently, in December, the ECB loaned $638 billion to European banks, easing a liquidity crisis that was threatening the banking system. It was also a back door way of pushing down yields on sovereign debt, as the banks – borrowing from the ECB at one percent – used the money to buy sovereign bonds. The ECB is set to do more of this later in February.
Of course, preventing a financial meltdown is not the same as pulling the eurozone out of recession and high unemployment (22.9 percent in Spain, 19.2 percent in Greece, 14.5 percent in Ireland, 13.6 percent in Portugal and 10.4 percent for the eurozone as a whole). So the near future of the eurozone economies is bleak, and likely to get worse until there are some significant policy changes.
I should emphasize there that the outcomes in the near future are not pre-determined, and will be largely determined by political struggles. Since Italy and Spain are “too big to fail,” if either of these governments were to stand their ground against budget tightening imposed by the European authorities, the European authorities would very likely back down. The smaller governments (Ireland, Portugal, and even Greece), also have a lot of bargaining power if they were to use it, since the european authorities want to avoid a major financial crisis and also the break-up of the euro. They should be using the threat of default and exit from the euro in order to force the European authorities to stop punishing them.
As I noted above, the solutions are not that difficult. The ECB would have to do what the Fed has been doing, although it is much more urgent in the eurozone for three reasons: (1) there is already a recession and (2) the threat of financial meltdown is slowing the eurozone economy, and also the world economy and (3) the main way to stabilize the financial system and remove the threat of meltdown is to stabilize interest rates on sovereign bonds, especially for Italy and Spain but also for the other eurozone countries, at a low level. It is when these interest rates rise that things get panicky.
There also needs to be a restructuring of the Greek debt with a bigger haircut than what is being negotiated now, which is intended only to lower Greece’s debt/GDP ratio to 120 percent by 2020. This is not enough to avoid more crises and default by Greece. And the interest rates for the Greek debt have to be lowered drastically, to a sustainable level.
Finally, and most importantly, the whole eurozone needs to reverse course and implement an expansionary fiscal policy, to bring the region out of recession.
Germany has responded fairly well internally with its work-sharing policies, which as noted above have brought unemployment down to below pre-recession levels. This should be a model for other countries, with the government subsidizing employers to keep employees on the job at reduced pay. Shorter work hours, as they become institutionalized, are also a great potential weapon against climate change. Europe uses about half the energy per capita as the United States does, and a big part of this is due to the fact that Europeans have taken a significant share of their productivity gains over the years in the form of reduced hours, rather than increased consumption. For a developing country, China responded best to the world recession. In 2009, the slowing world economy knocked 3.7 percentage points off of China’s GDP growth from reduced net exports; but China was able to keep growing at 9.1 percent, partly due to a 20 percent increase in capital formation. There are other examples of successful counter-cyclical policies during the last recession; it remains to be seen what countries will adopt sufficient stimulus policies to counter-act the slowing economy this time around.