The Eurozone Crisis

May 2010

Earlier I wrote an article on the Greek Crisis, now that sense of crisis is infecting the Eurozone at large, and this article analyses the situation.

In my last article I explained: Monetary union without political union is not impossible, it just requires exceptional economic discipline (in all areas of economic policy including government borrowing, labour market regulation, physical infrastructure, balancing social security and individual incentive, intelligent cost effective government bureaucracy, fair efficient taxtion, educational excellence in maths and science, etc etc). Asked to list the key benefits of monetary union most people begin by talking about the absence of foreign exchange transaction fees, exchange rate stability and low interest rates (which come, for example, out of capital market economy of scale benefits). These several factors act to increase economic efficiency. Yet there is more to the Eurozone story. The absence of devaluation and the intensification of free trade turns the Eurozone into a vicious economic pressure cooker, an ultra competitive environment which raises game play, a Darwinian economic war zone. This de-homogenization of economic activity also creates second order economy of scale benefits that further enhance economic growth across the system as a whole. For example, each country ideally tends towards its own special expertise, and together they create a more powerful whole than they would under a less integrated alliance, so intensifying competition creates a smart collective instead of a chaotic herd.

If the somewhat socialist French and Italians had focused on the Darwinian aspect of the Eurozone, they might have avoided creating it. However, economic growth in these countries was deteriorating, there was no political will for the sort of tough Anglo-Saxon labour market reforms Thatcher & Regan had made, consequently they clutched at the Euro straw, they hoped it would restore their competitiveness relative to the USA.

The UK is an instinctively liberal country, therefore a generally laissez-faire country, and so one would have expected it to be a natural Euro supporter. However, the UK rejected the Euro primarily because of fears that it would lead to a loss of national sovereignty. Just as the UK tabloids often rail against the evils of compelling citizens toward the metric standard, the emotive issue of compulsion took precedent over intellectual arguments about the economic advantages of a more efficient currency (We see the same dynamic in the even more freedom obsessed USA, not only is the metric standard resisted, they still have an all green one dollar bill, no mater how inefficient, because people hate to be made to change).

Ireland, on the other hand, another instinctively laissez-faire country, rushed to join the euro. Of course Ireland was also an example of a quasi emerging market economy, for her, for Greece, for Portugal, for Spain, membership of the Eurozone offered almost everything - stability, funding and billions of euros in structural funds.

The least laissez-faire countries in Europe were the Scandinavian countries. With their generous social security models, which reduce the pain of unemployment, these countries consciously sacrificed a degree of economic growth for the sake of happiness, so they mostly avoided joining the competitive Eurozone. Unlike France, these countries were generally stable and contended, they didn't need to gamble on the Euro. Norway, like Canada and Australia, also had extensive natural resources and a low population density, so she had no fear of American competition. Only Finland, a big exporter and home of world leading Nokia, was initially tempted to join.

Germany is an interesting case whose position to some extend transcends both the socialism of France and the laissez-faire of England. Germany, for example, has always been more disciplined that the French, more prepared to subject her people to economic hardship in the name of progress, a sort of conservative looking tendency. Yet the Germans have also tolerated a far greater degree of authoritarianism that the freedom loving English. However, this tendency toward 'statism' has not held Germany back economically. It is true that the effectiveness of English laissez-faire put it at the forefront of several revolutions, including sea power, the industrial revolution and the acquisition of colonies. Nevertheless, what England innovated, Germany often perfected. Indeed Germany has been arguably the most economically successful European power since the 1800s. So, for a superstar like Germany, Darwinian competition holds no dangers, the Euro made complete sense from that point of view. German's single worry was that by marrying irresponsible partners in monetary union, she would end up either permanently enslaved by their reckless spending and feckless lifestyle, or utterly impoverished by a disastrously expensive divorce (today this nightmare, of course, is gradually coming true).

Now that we have described the various dynamics associated with the creation of the Euro, let us analyze what has happened since its creation.

With entry into the Eurozone Greece was able to borrow cheaply and literally went on a growth inducing spending spree. Between 2000 and 2007 Greece ran at, on average, a budget deficit of 5% and an official growth rate of 4%. But economic statistics in Greece are disputed, both because of government corruption and widespread tax evasion. The Greek black economy isn't just about businesses & self employed people, it touches almost everybody through real estate transactions. According to government statistics tax revenue accounted for about 30% of GDP, about the same level as Ireland and 10% less than in Germany. However, in reality it is likely that if one could go back and measure the black economy accurately, tax revenue was significantly less than 30% and GDP was significantly higher. According to government statistics the Greeks today have a per capita GDP about 15% lower than the Germans, but if one includes the black economy the Greeks probably became wealthier than the Germans within a few years of joining the single currency, and by 2007 they had probably become almost as wealthy as the Austrians. No wonder so many of us were amazed by the Greek transformation, the rebuilding of Athens and the Islands, the rising educational standards, the emergence of sophisticated wealthily Greeks. What we didn't comprehend was the level of irresponsible spending behind it. Greece got away with its excessive level of borrowing to a large extent by lying, but also because once Germany herself exceeded the 3% limit, everyone began ignoring it.

What happened to the money the government spent? A lot of it was used to rebuild the country, a lot went into public sector wage increases and exceedingly generous pensions (Greece is the only country in Europe which allowed, for example, hairdressers to retire on a full pension at age 50). Property prices across Greece rose, the development of the Greek Island of Mykonos in particular exemplifies the astronomical creation of asset value. Some economists believe Greek private individuals today have approximately 600 billion euros deposited in foreign bank accounts, a number significantly larger that their national debt, and a number that, if true, testifies to Greece's wealth. Yet little of this money found its way into government coffers, so the government is saddled with an enormous debt that it will struggle to service. On top of that, wages and rents in Greece climbed, and now need to drop around 20% to restore competitiveness with Germany.

Spain is in another boat, the Spanish Government did not go on a Greek style spending spree. Whilst Greece was racking up public sector debts Spain put in several budget surpluses. Then suddenly, in 2007, the train came off the tracks. The wreckage is now so vast that people are seriously worrying about the long term future of the country. What happened? The combination of low eurozone interest rates and excessive optimism created a massive bubble in the Spanish property market.

The problem is that this property bubble coloured the entire Spanish economy. The bubble caused wage and asset prices to rise across the economy, which squeezed out other jobs, for example in exporting. Instead of manufacturing and selling goods to foreigners, Spain sold houses. Spain's Mykonos is of course called Ibiza, today it is one of the best, and most expensive, places to live in the world. When this vast flow of foreign money in search of holiday homes stopped, it left an economy with no means of supporting itself.

So the problem in Spain did not come out of excessive government spending, what happened is that the Government took it's eye off the ball, it relied on laissez-faire, it failed to appreciate the importance of maintaining a well rounded economy with long term potential, its economy was turned over to building holiday homes in the sun. Laissez-faire is motivated by short term profits, it can pump up an economy one minute and abandon it the next. The Government should have tried to contain the property boom, it should have tried to prevent resources being diverted from exports to construction. Such is the brave new world of interventionist economics exemplified by the State Capitalist Chinese.

What is happening to Spain now? Once the property bubble burst people connect to it started loosing their jobs. Spain now has the highest Eurozone unemployment (20%). In theory, these people will eventually take lower paid jobs doing other work and resources will return to manufacturing etc, but this transformation could take many years.

Of course the UK is not a member of the Eurozone, but economists are also pointing to imbalances in the UK between banking and the rest of economy. If the banking industry dies, the UK's economic model derails.

In Ireland and Portugal property booms also developed. However, in these countries, there was more domestic as opposed to foreign buying. So in these countries domestic private sector counterparties have racked up substantial mortgage debts with domestic banks, and as the property market goes into reverse the loans default and the banking system could collapse. Government in these countries failed either to stem the real estate gains, or tighten loan conditions by regulation.

Germany, however, is another kettle of fish altogether. When the Germans joined the Eurozone the Deutschemark was too high and their manufacturing industry was declining. However, the disciplined Germans then began cutting wages in real terms. Gradually they restored competitiveness, and today they have regained their historical pre-eminent position in Europe. In fact, when it comes to exports, Germany is undoubtedly one of the world leaders. Recent figures, for example, show Germany, which has an economy less than one-fourth as large as the U.S., exported two-thirds as much as the U.S. to China last year.

Another reason for Germany's success is that Germany doesn't have a very "liberal" housing market, and consequently avoided the property bubble that has done such terrible damage to so many other European states. Germany doesn't have Singapore style state owned enterprise housing, or even lots of old fashioned socialist style council estates for the poor, but rather a sort of benign crony capitalist system. A large proportion of the real estate stock is owned by pension funds who rent it out for low returns, home ownership is low, so the property market has very little froth.

So the Darwinian Eurozone process has now re-established the supremacy of Germany, now that the champagne has ran out of bubbles, the rest of the Eurozone has started declining. From here, the strong get stronger, the weak get weaker.

Eurozone politicians are searching for excuses, blaming the crisis on hedge funds and weak fiscal rules, making up policy on the fly, announcing huge rescue packages and short selling bans, but the only real solution is much better economic policy. Convergence is not an effortless process, if individual Eurozone governments fail to raise their economic game they will slowly die out. This is, after all, the principle of evolution which underlies our world.

Theoretically Spanish citizens could move to Germany to take up jobs, but the language barrier is an enormous obstacle compared to the USA. A person who speaks English can visit any European state, but he can't work or read the ingredients on his packet of cornflakes etc. The sad reality is that learning a new language is extremely hard and time consuming, and this language problem tends to condemn economic migrants to menial jobs, social isolation, and a poor quality of life.

The eurozone's one size fits all monetary policy actually works in reverse, because countries that deflate to regain competitiveness suffer higher real rates. Increased German aid, eg more structural funds, could smooth the inequalities, but there is a limit to how far this can be pushed. Besides, recall West-East German reunification or Africa, aid often works against long term adjustment. Some say that intensifying the competition in services will help, but it also risks further ratcheting up the competitive pressures.

So what will happen? Perhaps contained decline is as much as we can hope for. A combination of greater discipline and German aid might allow the decline of the weak to continue without provoking political rebellion or endangering the euro. Countries like Greece saw asset price booms, now the impoverished Greek Government needs to find ways to confiscate some of this wealth and give it to the Germans. We need to think about ways in which the Greek people can become poor again, how the Germans can inherit their wealth, expecting Greece to regain competitiveness any time soon looks unlikely. In summary, it is "Deutschland über alles" all over again.

The crisis is most of all about the failure of democracy to create good economic policy, and the Eurozone pressure cooker is only accelerating the impending crisis which is echoed across the world today. Just as most EU member states are now declining relative to Germany, America is declining relative to China. In the past the Germans would have invaded and imposed better policy on their new subjects, how will it work today? So far EU politicians have no solution.

The terrible, almost unmentionable, truth is that the intellectual-psychological gap between say the Germans and Greeks is vastly greater than the per capita wealth differential between these two countries today. European statesmen looking for a solution to the centuries old problem of German superiority imagined the European project restoring European harmony and preventing the wars and empire building that inevitably occur when resources are scarce and neighbours are vastly unequal. But the fact is that if you put a worthy and an unworthy man together under capitalism the unworthy man ends up the worthy man's economic slave. National identity and political power have not disappeared, nor is there any political will in Greece to give up their wealth, nor any political will to let others run their country more efficiently, nor any political will in Germany to pay for the Greeks to continue enjoying their current standard of living - so the problem of German superiority has not been solved, indeed it has just remerged.