Germany resists sense

Those who have been following my blog for a while will understand I consider Europe’s “fiscal compact” to be both dangerous and counter-productive because there has been a large and significant miscalculation in what implementing fiscal austerity means in already depressed economies.

As I stated back in December last year:

So while there is no credible counter-balance for the effects of supra-European austerity any attempt to implement the new “fiscal compact” will make Europe’s economic issues worse. The continent is already on the way to recession and unless we see some additional action from the ECB, or a huge swing against this new framework, the push to implement the outcomes of the summit will simply accelerate that outcome. My assumption is that, if Europe does ratify this framework (there are a few stragglers), after 12-24 months of trying the effect will be so disastrous that they will eventually give up. But until then my base case for Europe is a significantly worse economic outcome.

And that is pretty much what we have seen.

The ECB’s LTRO was successful in providing some short term relief to the financial markets, but only in such a way that it has more tightly coupled weaker sovereigns and their now zombified banks. None of the fundamental issues in Europe was actually addressed during this short lull in the crisis, in fact the competitiveness of many of the nations went further backwards as unemployment continued to rise and industrial production fell further. This in turn has led continuing falls in national income and GDP which has meant that arbitrary fiscal targets slowing move further out of reach which ultimately bring about calls for even larger fiscal cuts.

We were reminded of this once again on Friday by Spain:

Spain was forced to revise its 2011 budget deficit upwards on Friday, after three of the country’s regions restated their own figures, exposing the struggle the autonomous communities have had curbing spending even ahead of deeper cuts this year.

Spain said its 2011 public deficit now came in at 8.9 percent of gross domestic product, up from the 8.5 percent initially stated. The country had already widely overshot its deficit target of 6 percent for last year

Over the last week we have seen the situation flare-up again with the governments of both Spain and Greece having to deny claims that their banking system are unstable and suffering from banks run. We haven’t heard much from either Cyprus of Portugal, but my assumption is that both of these nations are coming under similar pressure given their close ties with the two countries, and obviously, similar economic issues of their own.

Given the situation Greece now faces, it is very difficult to determine exactly what will happen next. There is much talk about Greece exiting Europe, the so-called “Grexit”, but as this point in time my reading of the situation is that Greece holds many of the cards and Europe is likely to make concessions due to the weakness of much larger economies. We saw a clear message from the G8 that Greece should stay in the Eurozone.

Obviously the next Greek election, to be held on June 17, has the potential to bring about renewed uncertainty , but there is also the unanswered question as to what the effect will be of Francios Hollande’s presidency in France. We’ve already seen the statements from his finance minister that France has no interest in subscribing to the “fiscal compact” as it sits, and it was obvious that was the message Hollande took to the G8.

Other reports out of the G8, however, suggest that even though they are becoming increasingly marginalised in their position, nothing has changed in the German camp:

Obama and Merkel held one-on-one talks after a two-day G8 summit at the US president’s retreat in Camp David, Maryland, that was marked by competing views on how to bring the Europe’s sickly economy back to life.

The president, who faces US voters concerned about the economy ahead of November elections, has pushed Europeans to put growth on top of the agenda but the German leader has championed austerity to combat the eurozone debt crisis.

But after the Merkel-Obama talks, a White House official said there was an understanding that the push for growth was “not to take the place of fiscal reform,” but that the two go “in tandem.”

I hope that this is code for an adjustment of the fiscal compact to take into account economic reality, but I remain doubtful. The other problem is that no one has really defined what “focussing on growth” actually means and in the meantime the continuation of  aggressive “expansionary fiscal contraction” in the absence of a fail safe leaves weaker nations exposed to speculative attack by the credit markets which ultimately leads back to yet another full-blown crisis.

Given the renewed political tension, it is becoming increasingly difficult to see how Europe is going to arrest the crisis as it slowly but surely makes its way to Italy. The steps required from here are large, politically painful and increasingly bold yet once again Europe appears to be drifting further apart, both economically and politically.  I would hope that the new “growth compact” leads to something measurable, but given the conflicting messages going into, and coming out of, the G8 it is very hard to find anything that has really changed.

Comments

  1. There’s a difference between ‘staying in the Eurozone” and “staying in the Euro”; and ‘growth’ is not an ‘alternative’ to austerity. Growth is an outcome, not an alternative.

  2. It is all a bit mystifying.

    I have no doubt most of Eurozone want to stay together.

    It is just remarkable how clueless their performance has been to date.

    Possibly, the plan is to forge a untied states of europe but they know only the verge of chaos will provide the required tempering heat.

    • Their performance is clueless because there are far too many people making decisions who don’t have either the skills or background to do so. The ones with the skills (ECB) have been virtually gaged so far.

      I’m thinking the ECB will eventually have to print and buy any new debt of the PIIGS.

  3. The bank run has already started in Greece and it now appears to be kicking off at the weaker state backed banks in Spain. Without serious intervention by the ECB & IMF this week, Greece will be forced to exit the Euro and re-default, regardless of what they or their fellow governments in Europe want. If the ECB does not act now, they are going to be dragged backwards through the shrubbery by people pulling their money out and it is going to hurt – a lot!

  4. Restoring GDP ‘growth’ means restoring all the things that brought us to this debt driven, over-consuming society in teh first place.
    Real reform cannot be instituted without dislocation. Govt, Financial, service sectors must shrink. Industries that produce goods must grow. The latter cannot grow without stopping the parasitism on the economy of the former.

    If you try to reduce PS privilege as per Greece you get riots…why? France votes out Sarkozy because he was asking for the smallest sacrifices. So what we will get is a further explosion of privileged classes in France…by privileged classes I don’t mean those super-rich who are the smallest minority. I am talking about the vast population of France that goes to work but doesn’t. Even those who do work are largely involved in non-productive activity.
    How do you do a short term restore of the economy of Spain without going back to building hundreds of thousands of houses whether you need them or not?
    Spain needs to re-orient its people, not just its ‘economy’, to work producing ‘stuff’ so that its economy has some sort of balance.
    How is this to be done? Hell I don’t know! It’s simply too big a problem now. But the solution is NOT to restore what brought us to this disaster in the first place.

    It will be the same here in Aus. We will continue to over-consume live off debt and selling the country off. When it stops as indeed it must, Stein’s Law universally holds, we will not have the capital we need to build the industries we need to survive. Nor will we have any population with either the skills or the willingness to change. At the polls we slaughter anyone who dares to try to take our honey soaked dummy away from us.

    What’s happening in Europe is bad and will be terrible. I have been accused of having an apocolyptic view however events are running on an apocolyptic track. Each move and swing is entirely predictable.

    I find it rather strange to be on the other side of the argument with DE in the case of Europe and I’m no expert on Europe (understatement). However I do believe that we must face reality. The reality is that what we now do, and the way we live, is unsustainable. We must change and we must change NOW.
    It’s already too late.

    The answers lie 50 years back in time.

    • Here, here, flawse. It’s bound to happen that you, I, disagree with DE from time to time. Those who criticize Germany are castigating the wrong party in my opinion. Whatever ‘rules dodging’ they also engaged in previously, they are where they are today. And which of any country would not choose that as an alternative to just about where any other European country is today?

    • flawse you are absolutely right IMO. We cannot continue to consume things we do not need, funded by debt and call it sustainable.

      you question “How is this to be done?”. Once again you are right and not apocalyptic when you say “hell I don’t know”. If more where honest and said they didn’t know the answer and clearly the current ones aren’t working maybe we could all collectively find and answer.

      Honesty is a missing part of the current debate.

    • Flawse. Your time machine awaits. Destination 1962. You have President Kennedy’s ear, Menzie’s earnest attention. But bear in mind, you have a Cold War to win, anti-Communist allied economies in Japan and Germany to rebuild, and this geo-political reality is non-negotiable. What is your policy response ?

      • Interestingly, for those that do not understand why Greece is part of the EU…

        Just consider its location and when it joined. Quite an important ally to have during the cold war!

        • Dug in for a long Cold War, with heightened consumption – credit driven consumption, and its accordant obsolescence and mindless consumerism – as one of the chief weapons against Communism and keeping those allied economies strong & growing.

    • I agree Flawse, the approach of just pumping money into the economy to me seems just a way to hide the real issues for 10 more years.

      I think that reform, which includes austerity, is a necessity for long-term sustainability. The Netherlands went through the same thing in the 80s (due to our Dutch disease in the 70s) and that put down the basis for the incredible growth and wealth in the 90s.

      However, I do agree with DE that the soaring (youth) unemployment in Europe is a huge risk. Reality therefore seems to dictate at the moment that Europe needs to pace its reforms and also invest in projects that support the economy and reduce unemployment.

      Sustainability is useless if there’s nothing left to sustain. A balanced approach, including austerity while keeping an eye on employment would be my preferred approach.

      • Alex Heyworth

        Sensible comments. Some reforms I think are urgently necessary:

        Wage flexibility. Greece and other southern european nations have awarded themselves completely unsustainable wage increases over the last ten or so years, at the same time as Germany has been exercising extreme wage restraint.

        Removal of barriers to forming and running businesses. Unfortunately a lot of this is regulation churned out from Brussels by the Eurocrats. Too bad. Get rid of it. These countries need to recognize who their real competition is. Hint: it is not Germany. It is not even in Europe (well, not western Europe, anyway).

        Cut unrealistic levels of pension and unemployment payments. Maybe unemployment payments could gradually reduce the longer you are unemployed.

        Get rid of subsidies for inefficient industries (may need to be done gradually in some cases).

        Incentives for saving. Maybe interest on savings tax free up to a certain level.

        Reduce taxes on labour (eg payroll tax, income tax), increase taxes on comsumption.

        That lot ought to be a reasonable start.

        • It makes so much sense you wonder why people are still arguing over this stuff. 😛

          The Northern members states are a lot further (more willing) in this regard than Southern member states.

        • competition between the various regions is what make economies. Compare Europe to the Swiss model, with each of the cantons trying to be as productive as possible where the region is rewarded for increasing sustainable GDP as opposed to the European, eg the portugese no longer have a fishing fleet as it was decided that Spain would be the dominate fishing country.

          • I’ll add, should the boom bust, much of this will very quickly become recognisable on home turf…

    • Flawse, others sorry for the delayed reply I’m having on of those days.

      Flawse said:

      >I find it rather strange to be on the other side of the argument with DE in the case of Europe and I’m no expert on Europe (understatement). However I do believe that we must face reality. The reality is that what we now do, and the way we live, is unsustainable. We must change and we must change NOW.

      Actually we aren’t too far apart on this one IMHO, my point however is that the economic structure of the Eurozone won’t actually lead to a “sustainable” outcome for nations who attempt to play by the rules of the fiscal compact.

      I do believe we must change, but you need to be clear about what you are asking for.

      The basic idea spoken by most people is that Greece and Co. should simply stop spending money, decrease debt , work on production and basically “stop living beyond their means”. All fair enough and quite logical under normal circumstances.

      However, and this is where the current structure of the EuroZone comes in, by doing so they will initially significantly lower their economic output which will mean that their ability to service their existing debts will come under pressure. Under normal circumstances this situation would lead to a steep re-valuation of the currency which would therefore rebalance the country’s economy towards exports. However, for a periphery Euro-nation this cannot occur.

      So the nation gets lower GDP, but no compensation for that outcome which ultimately means that it will struggle to meet its outstanding debts as its GDP falls. Also, given the fact that GDP is falling along with industrial production the country will come under pressure for international markets as bond markets ask for higher premiums to guard against the fact that the nation is struggling.

      So now we have a country that has attempted to “stop living beyond its means” but all that has really happened is its GDP and national income has fallen, its costs of servicing its existing debts has risen and its overall competitiveness against its creditors has gone nowhere at all. In order to actually deflate wages to a level to make it competitive while staying with the Euro would require not just “spending cuts” but significant defaults on existing debts.

      But the “fiscal compact” want none of this. It simply asks that all nations outside arbitrary limits stop spending in unison, all become more export focussed at once, and during this transition, and associated downturn, somehow meet their existing obligation while fending off speculative attacks against their existing funding.

      Basically it is a recipe for disaster, which is what we have seen, and has very little to do with “living beyond one’s means”. Yes, that created the situation, but Europe was in that together. It needs to get out of it that way.

      As I have said before the issue is that the fiscal compact is the wrong way around, it is fine if you creditor nations want debtors to become more competitive but they must give them a realistic and workable economic structure in order for that to occur. That means matching deficits to current economic output, providing investment, doing some heavy lifting themselves, and be willing to stand by them when they come under speculative attack.

      If the rest of Europe isn’t willing to afford struggling nations these things then, as Alex said above “too bad”. You’re in this together or your not. If Europe can’t cope with the moral hazard then these nations should be cut lose of the Euro because if they are not then they will slowly bring down the whole ship.

      • Alex Heyworth

        Realistically, it is pretty clear that there are only two ways this is going to be resolved – either Germany leaves or Greece leaves (probably followed by the rest of the PIIGS). It seems unlikely that Merkel could persuade German voters to underwrite the restructuring you are suggesting, even if she wanted to. Bottom line, Germans don’t believe they have any responsibility for this mess.

        • Well I’m not exactly an expert of how the average German feels about any topic, but it wouldn’t surprise me at all if that was the case. Germans on the whole are very intelligent people but financial literacy of the kind required to understand exactly what it going on in Europe is lacking the world over. Just look at the conflicted G8 waffle to get some idea of the trouble we are all in.

          On top of that there is the inflation obsessed Bundesbank and its ECB reps who to this day are still pushing hard with their normal agenda of suppressing everything and anything that could some time, anytime now you just wait!, lead to inflation. Even the German government had a scrap with them in the early 90s over East German unification.

          Note here for today’s example.

          http://www.guardian.co.uk/business/2012/may/21/eurozone-crisis-greece-elections-growth?newsfeed=true#block-6

          I did however note with some interest over the weekend a protest against austerity in Frankfurt, but it is hard to tell how many of them were actually German nationals.

          http://www.reuters.com/article/2012/05/19/us-germany-protests-idUSBRE84I08720120519

          However, at the end of the day, it is these people who will have to live the consequences of their own policy. If Germany insists on pushing periphery Europe towards the edge of a cliff and then demanding they don’t dare jump that is ultimately their own problem to deal with the consequences. They are in this thing just as much as everyone else.

          • Alex Heyworth

            I agree with you, DE, just that I don’t think the Germans get it (yet). Just as the Greeks don’t get that their choice is between current levels of austerity and far worse, not between current austerity and the subsidized golden years.

      • I totally agree with the above. I’m all for austerity for Greece,Italy, Spain etc but there is a time and place for it to occur. Trying to implement spending cuts during a time of double digit unemployment and rapid GDP decline in the case of Greece is economic and social suicide. In hindsight, Germany should have been flogging the rest of Europe to get their books in order 5 or 6 years ago when the tax take was significantly better than it is now and there was the presence of sustained economic growth. I remember when Greece was under consideration for entry to the EU and their finances were in disarray even then. The writing was on the wall, ignore it at your peril.

        • > In hindsight, Germany should have been flogging the rest of Europe to get their books in order 5 or 6 years ago when the tax take was significantly better than it is now and there was the presence of sustained economic growth

          Well that is part of the hypocrisy of the situation. They were all doing it, Germany couldn’t have flogged anyone without first flogging itself.

          http://www.macrobusiness.com.au/wp-content/uploads/2011/11/Euro_Debt.png

          and in terms of the private balance-sheet, German banks were lending all over the place.

      • Thanks for the reminder on that one DE. Valuable insight.

        The problem I see is that there is an unquestionable need to reform. Everyone here seems to agree that Greece, Italy and Spain have been living beyond their means and that simply can’t go on.

        But how do you help a nation in the current situation without introducing a moral hazard?

        • Alex Heyworth

          You can’t. All that can be done is to accept the moral hazard, try to put in place mechanisms to prevent it happening again, and get on with helping them out.

          • Thanks DE Appreciate your thoughts and your effort.
            Re time…we all get short of that and I’m late here.

            Alex. The point is but how? Restore Govt wages? Restore housing in Spain? Employ more Govt people in France?
            It’s not an argument about moral hazard as such. The only way to get short term relief is to re-inforce the existing structures that we already know are unsustainable.
            Suppose we get the Germans (basically the only ones with any money)to take a big credit write-down. This writes off debts in Greece, Spain et al. Ok we still haven’t got any economic activity going. So as far as the poor bloke in the street goes ther eis still no change. How do you get change that helps him in the short term. You have to then use your spare credit to stimulate the sectors that you really need killed to have a healthy economy.

            So I still don’t have a clue re a solution. In terms of Europe, judging by all comments here, the Germans seem the only ones who can mount any sort of rescue. My vies is that France is a total basket case on its last legs as an economy and indeed as a nation. Will Germany save France from itself while saving Greece Spain Portugal et al?
            In that case Alex? would seem to be dead right, it will be Germany that leaves the Euro. Where that leaves us heaven only knows.

            I’m not sure that we all need to suddenly export all at the same time. When I look at Aus, and my own industry, I look at quite a lot of simple things we used to make not long ago. An A$ level that balanced the external account would have seen many still made here. I expect the same still applies to Europe. There’s not so much a need to export so much as not to import every blessed trinket the television advertising can create a market for…and therein lies a major part of the problem…over-consumption, self-indulgence and entitlement creatred by 50 years of TV advertising telling everyone, every night, for hours on end, that they deserve to have everything…that’s the sort of stuff I mean by complex. Sorry for the diversion! Just one of my favourite peeves.

            Given that the value of the currency plays a big part and we are saying that the situation would not be so bad if they’d not been tied to a fixed Euro. I’m not so sure. Would the population of Greece tolerated the wage levels, price inflation and on going austerity of the years that would have been imposed by a flexible currency? Ot would they have done the same thing as they have done and hidden the economic weakness under a mountain of borrowing from the mega money world, thus maintaining a high value on the currency?
            Australia is a great example of this process. Have we allowed our currency to fall in response to a chronic CAD resulting in a drop in living standards in terms of our ability to consume? Or have we imposed the interest rates necessary to contain the CAD? No siree Bob!!! Not us mate! It’s fortunate that all our economists in Treasury, Parko, Henry,the RBA, McKibbin et al et al are soooo much smarter than all the other economists of the world…or so they keep telling us. We’ve also been helped by having the three greatest Treasurers of all time Keating, Costello and Swan…God help us! (Well Keating had some idea!)

            The truth is we have been willing to sell out the futures of following generations to maintain our lifestyle…even, or especially, with a ‘flexible’ exchange rate.
            In modern economic thinking would any other nation have done any different?

            The solutions don’t lie within any current economic framework. Unfortunately I don’t even think it lies within our belief systems or cultures. The Chinese, the Germans, the Poles and a few others have some idea. The rest of us seem clueless.

            What worries me more than anything else is that we, the whole Western world, are willing to engage in demonising those peoples who have worked and saved while we have been on our spending spree. It’s their fault not ours! It’s all the fault of the Germans. For the US it is all the fault of the Chinese! etc

            For Aus we are not even willing to start thinking we might have a problem!

            Thank you everyone for your thoughtful comments and for reading my often times meandering prose!

  5. Greece’s banks are already insolvent, their combined TARGET2 debt to the ECB (and thus indirectly to other European banks) is close to EUR 700 billion. Imagine an Australian bank with a RBA exchange setllement account with a similar balance 🙂

    IMHO the Greek are unlikely to accept continuous austerity for the next 15 years to have a balanced budget and pay back Gov debt.

    The can however save a lot of money by leaving the Euro and just defaulting on their external debts. Problem ‘solved’ ….

    They would have to leave the European Union in the process by the way (a Euro exit by treaty enforces a EU exit). Cheaper dolmades on the way!

    • exactly a63, anyone who hasn’t recognised this economic script already just isnt observant enough, they wont actually fix any of the underlying economic problems but they will delay them.

      Buy equities

  6. Francois Hollande wants ‘growth and less austerity’. What’s his first action? He cuts his salary and that of his ministers by 30%. So that’s’ 30% less of their wages to go into purchasing power, or whatever triggers growth, straight away!

    • Alex Heyworth

      Hollande appears to be one of those who hasn’t realized that growth is an outcome, not a policy prescription.

  7. George Locust

    Default and exit is not going to be some magic bullet for the Greeks. Far from it. Expect hyperinflation and wide spread business collapse due to lack of credit access.

  8. Alex Heyworth

    I must admit to being frankly amazed that there is still anyone who buys the theory that the cure for what ails Europe is more of the Koolaid (debt) that got them in this mess in the first place. There are only ever two possible cures for debt: pay it off or go bankrupt. That is as true for Greece, Spain etc as it is for you or me.

    The idea that more debt will lead to more growth, which can then be used to pay off the debt, is all very well, but faces a few problems. First, European nations are so buried in inefficiencies that the multiplier for additional government spending is almost certainly less than one. Second, European voters are so greedy at the moment that they will resist to the end any hint that extra growth as a result of government spending won’t end up in their pockets, but rather be used to pay off the bankers.

  9. While I agree that austerity will make it impossible for those countries to balance their budgets and it will be impossible for them to reduce the size of their outstanding loans and reduce their loan to GDP ratio. There is the matter of never letting a good crisis go to waste.

    They have their debt problems because their governments are incompetent (living beyond their means and introducing laws that handicap the economy while favouring a few) and their economies are uncompetitive. Unless there is significant pressure, those government will not make any steps to address their uncompetitiveness.

    For example, even if all debts to Greece were forgiven they would still be uncompetitive and living beyond their means. The debt problem would only be a matter of years away. Spain has run a two tier economy based on an unsustainable housing boom (sounds like Australia). Italy likewise has laws and regulations that impede the economy and enrich a few.

    Unless these matters are addressed then it is useless to talk about debt restructuring. Talking about the debt is discussing the symptoms not the underlying issues.

    Greece is so uncompetitive that they will have to leave the Euro and face a minimum of a forty percent drop in living standards. I consider a Greece a side show (only 70b cost to France and 80b cost to Germany)

  10. I have just reviewed the latest Target 2 imbalances. It appears that Germany could be owed around $700 billion with Spain and Italy leading the pack. So it is hard to say that Germany is not doing something.

    Moreover, the slow-motion bank run could force matters to a head far sooner that we think. Depositors already are making up their mind about who will leave the Euro and protecting themselves from the exchange rate risk.

    Finally, there are rumours about a liquidity squeeze on US dollars as the flight to safety reduces the number floating. That squeeze could well explain some of what is happening in CHina?

  11. Hilary Barnes

    Love Song of Chancellor A Merkel: We could not love thee Greeks so much Loved we not “rigeur” more.