It took financial markets more than a year to realize the implications of Chancellor Merkel’s declaration, demonstrating that they operate with far-from-perfect knowledge. Late in 2009, when the newly elected Greek government announced that the previous government had cheated and the deficit exceeded 12 percent of GDP, the financial markets began to realize that government bonds, which had been considered riskless, carried significant risks and could actually default. When they finally discovered it, risk premiums in the form of higher yields that governments had to offer so as to sell their bonds rose dramatically. This rendered commercial banks whose balance sheets were loaded with those bonds potentially insolvent. That created both a sovereign debt problem and a banking problem, which are linked together in a reflexive feedback loop. These are the two main components of the crisis confronting Europe today.
There is a close parallel between the euro crisis and the international banking crisis of 1982. Then the IMF and the international banking authorities saved the international banking system by lending just enough money to the heavily indebted countries to enable them to avoid default but at the cost of pushing them into a lasting depression. Latin America suffered a lost decade.
Today Germany is playing the same role as the IMF did then. The details differ, but the effect is the same. The creditors are in effect shifting the whole burden of adjustment onto the debtor countries and avoiding their own responsibility for the imbalances. Interestingly, the terms “center,” or “core,” and “periphery” have crept into usage almost unnoticed, although it is obviously inappropriate to describe Italy and Spain as periphery countries. In effect, however, the introduction of the euro relegated some member states to the status of less developed countries without either the European authorities or the member countries realizing it. In retrospect, that is the root cause of the euro crisis.
Just as in the 1980s, all the blame and burden is falling on the “periphery” and the responsibility of the “center” has never been properly acknowledged. In this context the German word Schuld is revealing: it means both debt and guilt. German public opinion blames the heavily indebted countries for their misfortune. Yet Germany cannot escape its share of the responsibility. As I shall try to show, the Schuld or responsibility of the “center” is even greater today than it was in the banking crisis of 1982. In creating the euro, the “center” was guided by the same false economic doctrines that were responsible for the financial crisis of 2007–2008.
The Maastricht Treaty took it for granted that only the public sector can produce chronic deficits. It assumed that financial markets would always correct their own excesses. Although these market fundamentalist assumptions have been refuted by the 2007–2008 financial crisis, European authorities continue to abide by them. For instance, they treated the euro crisis as if it were a purely fiscal, i.e., budgetary, problem. But only Greece qualified as a genuine fiscal crisis. The rest of Europe suffered largely from banking problems and a divergence in competitiveness, which gave rise to balance of payments problems. The authorities did not understand the complexity of the crisis, let alone see a solution. So they tried to buy time.
Usually that works. Financial panics subside and the authorities realize a profit on their intervention. But not this time, because the financial problems were combined with a process of political disintegration. When the European Union was being created, political leaders kept taking the initiative for further steps forward; but after the outbreak of the financial crisis they became wedded to the status quo. They realized that the public had become skeptical about further integration. Under duress, every country was preoccupied with protecting its own narrow national interests. Any change in the rules would transfer power away from the European authorities based in Brussels back to the national authorities.
Consequently, the words of the Maastricht and Lisbon treaties were treated as if they were cast in stone, including for example Article 123, which forbids the European Central Bank to lend money to governments. This has pushed a great many of those who consider the status quo unsustainable or intolerable to adopt anti-European attitudes. Such is the political dynamic that has made the disintegration of the European Union just as self-reinforcing as the process of its creation had been.
Angela Merkel read German public opinion correctly when she insisted that each country should look after its own banking system. In fact, Germany has reversed itself since reunification. Just as it had been willing to make considerable sacrifices for the sake of reunification, now that it had to pay the costs of reunification it was focused on keeping its budget balanced. Far from always contributing a little bit more than others, Germany did not want to become the deep pocket for the rest of Europe. Instead of proclaiming that Germany has no policy other than a European one, the German media started vilifying the European Union as a “transfer union” that would drain Germany.
To make matters worse the Bundesbank remains committed to an outmoded monetary doctrine that is deeply rooted in German history. Following World War I, Germany had a traumatic experience with inflation; consequently it recognizes only inflation as a threat to stability and ignores deflation, which is the real threat today.
After reunification caused Germany’s debt burden to balloon, it introduced far-reaching labor market and other structural reforms and adopted a constitutional amendment requiring the federal budget to be balanced by 2016. This worked like a charm. Germany enjoyed an export-led recovery, helped by housing and consumption booms in the rest of Europe. Germany now advocates fiscal austerity and structural reforms as the cure-all for the euro crisis.
Why shouldn’t it work for Europe now, if it worked for Germany then? For a very good reason: economic conditions are very different. The global financial system is reducing its excessive leverage and exports are slowing down worldwide. Fiscal austerity in Europe is exacerbating a global trend and pushing Europe into a deflationary debt trap. That is, when too many heavily indebted governments are reducing their budget deficits at the same time, their economies shrink so that the debt burden as a percentage of GDP actually increases. Monetary authorities worldwide recognize the danger. Federal Reserve Chairman Ben Bernanke, Bank of England Governor Mervyn King, and even Bank of Japan Governor Masaaki Shirakawa have all engaged in unconventional monetary measures to avoid a deflationary debt trap.
The German public finds it extremely difficult to understand that Germany is foisting the wrong policy on Europe. The German economy is not in crisis. Indeed, until now Germany has actually benefited from the euro crisis, which has kept down the exchange rate and helped exports. More recently, Germany enjoyed extremely low interest rates, and capital flight from the debtor countries has flooded Germany with capital, at the same time as the “periphery” has had to pay hefty risk premiums for access to funds.
This is not the result of some evil plot but an unintended consequence of an unplanned course of events. German politicians, however, have started to figure out the advantages it has conferred on Germany and this has begun to influence their policy decisions. Germany has been thrust into a position where its attitude determines European policy. So the primary responsibility for a policy of austerity pushing Europe into depression lies with Germany. As time passes, there are increasing grounds for blaming Germany for the policies it is imposing on Europe, while the German public is feeling unjustly blamed. This is truly a tragedy of historic significance. As in ancient Greek tragedies, misconceptions and the sheer lack of understanding have unintended but fateful consequences.
If Germany had been willing at the outset of the Greek crisis to extend the credit that was offered at a later stage, Greece could have been rescued. But Europe did only the minimum necessary to avoid a collapse of the financial system and that was not enough to turn the situation around. The same happened when the crisis spread to the other countries. At every stage the crisis could have been arrested and reversed if Germany had been able to look ahead of the curve and been willing to do more than the minimum.
At the onset of the crisis a breakup of the euro was inconceivable. The assets and liabilities denominated in the common currency were so intermingled that a breakup would have led to an uncontrollable meltdown. But as the crisis progressed the financial system has been progressively reoriented along national lines. Regulators have tended to favor domestic lending, banks have been shedding assets outside their national borders; and risk managers have been trying to match assets and liabilities within national borders, rather than within the eurozone as a whole. If this continues, a breakup of the euro would become possible without a meltdown, but it would leave the central banks of the creditor countries with large, difficult-to-collect claims against the central banks of the debtor countries.
This is due to an arcane problem in the euro clearing system called TARGET2. In contrast to the clearing system of the Federal Reserve, which is settled annually, TARGET2 accumulates the imbalances between the banks in the eurozone. This did not create a problem as long as the interbank system was functioning because the banks settled the imbalances among themselves through the interbank market. But the interbank market has not functioned properly since 2007 and since the summer of 2011 there has been increasing capital flight from the weaker countries. When a Greek or Spanish customer makes a transfer from his account at a Greek or Spanish central bank to a Dutch one, the Dutch central bank ends up with a TARGET2 credit, offset by a TARGET2 claim against the Greek or Spanish bank. These claims have been growing exponentially. By the end of July this year the Bundesbank had claims of some €727 billion against the central banks of the periphery countries.
The Bundesbank has become aware of the potential danger and the German public has been alerted by the passionate if misguided advocacy of the economist Hans-Werner Sinn. The Bundesbank is increasingly determined to limit the losses it would sustain in case of a breakup. This is acting as a self-fulfilling prophecy. Once a central bank starts guarding against a breakup everybody has to do the same.
So the crisis is getting ever deeper. Tensions in financial markets have risen to new highs as evidenced by the historic low yield on German government bonds. Even more telling is the fact that the yield on the British ten-year bond has never been lower in its three-hundred-year history, while yields on Spanish bonds have set new highs.
The real economy of the eurozone is in decline while Germany is doing relatively well. This means that the divergence is getting wider. The political and social dynamics are also working toward disintegration. Public opinion, as expressed in recent election results, is increasingly opposed to austerity and this trend is likely to grow until the policy is reversed. So something has to give.