Of Debts and Faultlines: Greece and the Euro Crisis in a Global Context

28/02/2011 by

On Thursday 24/2, a one day workshop was organised by the European Union Studies Centre and the National Seoul University (S. Korea) at the latter’s campus in Seoul. The title of the workshop was:  Crisis and the future of European Integration: Implications for Asia. I was honoured with an invitation to open the workshop. Here is the text of my talk. Regular visitors of this blog will recognise the main argument which leads to the Modest Proposal.

Of Debts and Faultlines: Greece and the Euro Crisis in a Global Context


One weekend Neils Bohr, the famous physicist, had a fellow physicist visiting him at his summer house. The visitor, noticing a horseshoe pinned above the entrance door, playfully told Bohr: “I did not know you believed that a horseshoe could protect you from bad luck.” Bohr, with his usual sharp wit, responded:

“No, of course I do not believe it protects me from bad luck but, then again, my housekeeper tells me that it works even if one does not believe in it.”

Bohr’s reply captures the essence of the EU’s posture during the unfolding eurozone crisis.

  • For a year now the eurozone is gripped in the most vicious, slow burning, accelerating crisis.
  • For a year now every EU summit, every meeting of the wise and the good, every new institutional fix, every announcement of some ‘final solution’ for the eurozone crisis results in some new policy initiative which leads with saddening precision to nothing but failure after failure.

What is most disturbing however is that none of our European leaders seriously believes that these initiatives are even close to working.

But, just like Bohr’s housekeeper, they keep living in hope that their policies, their very own horseshoes, may well work even if they do not believe in them. It is a sad, sad tale, ladies and gentlemen. And a perilous one to boot not only for Europe but for the world social economy as well.

An outline of the main argument

In the few minutes that I have before me, I shall be putting forward a string of five main arguments:

1st. – The eurozone crisis is not a crisis of public debt. Sovereign debt is just one of its many symptoms.

2nd – The policies adopted and the institutions created after May 2010 to address the eurozone crisis are an augmentation of the problem rather than part of the solution. Beginning with the so-called Greek ‘bail out’, which quickly gave shape and form to the European Financial Stability Facility, the EU has adopted a type of medicine that is worse than the disease.

3rd – The eurozone crisis was an accident waiting to happen. The inevitable result of the global Crash of 2008 on a faulty architecture that was never designed to withstand the shock of what began as a financial crisis in New York and ended up changing the global capitalist game.

4th – I shall be arguing that there is an alternative to the catastrophic policies currently pursued. Several alternatives in fact that could end the crisis in a few short weeks.

5th – These sensible, rational alternatives are unlikely to be adopted. Why not? For political reasons that have to do with preservation of vested interests, intra-European power plays and a deep rooted aversion to authentic democracy on the part of Europe’s governing elites.

These five arguments are too complex to defend in detail within my allotted time. All I can hope to do is to put them before you, speak to them in brief and use them as a catalyst for the discussion that will follow. So, let me take them one at a time so as to flesh them out sufficiently for the purposes of  stimulating debate.

Argument A: The nature of the eurozone crisis

If the eurozone crisis is not a sovereign debt crisis, what is it?

In 2008 the Credit Crunch initially seemed to European eyes as an Anglosaxon disease. Soon, Europeans discovered that our banks are  replete with the toxic money that turned into ashes after Lehman Brothers went to the wall. The effects were devastating. Europe’s banks turned into zombies instantly. Their balance sheets remain, to this day, textbook case studies of bankruptcy in action. For more than two years they are being kept alive by the  ECB.

While the ECB and European states have gone out of their way to replace the burnt out toxic money on which the European economy had become addicted, they could not forestall the flight of what financial capital was left to the safety of the dollar and the embrace of New York. As capital fled Europe, and its states were cranking up their public borrowing to keep our zombie banks alive, sovereign bond yields skyrocketed.

The banks and the hedge funds suddenly spotted a great opportunity in the midst of this crisis: They picked the weakest link in the eurozone and bet heavily that it would break first. And so it did, earning the issuers of CDSs great rewards in the process. And so the creation of new private, toxic money was on again! This time not as CDOs based on subprime mortgages but as CDSs based on the prospect of a Greek default. And as in all Greek tragedies worth their salt, the prophecy was self fulfilling. The rest, as they say, is history:

The result is the most abhorrent of twin crises: Insolvent member states on the one side owing trillions to banks that are practically insolvent as they do not expect to get all their money back from the states. Thus they do not lend to business, which makes the recession worse and pushes the states further into the clasps of insolvency. A textbook case of a vicious circle.

Argument B. Medicine worse than the disease

And what is the EU doing? Instead of attacking, at once, the member-states’ debt and the banks’ potential losses, the EU has gone into business with the IMF to pursue the following policy:

First, it forces new, expensive loans upon bankrupt states, like Greece, Ireland, Portugal etc.

Secondly, it makes these loans conditional first on paying off every last penny owed to the bankrupt banks and secondly on severe austerity which is guaranteed to reduce GDP and in their long term tax base. Moreover, the new IMF-EU loans have super-seniority status, meaning that they will be the ones to be repaid first in case of a sovereign default by the bankrupt states.

Naturally, Europe’s zombie banks panic when they hear this. They look at the austerity measures imposed on Greece and on Ireland and immediately understand that they are now less likely to get their money back from these states, since their GDP is falling and they must now give priority to repaying the EU-IMF loans.

So, what do the zombie banks do? Go on strike. Stop lending to business and households, choosing instead to hoard the massive liquidity given to them by  the ECB. The result is that the recessionary forces gather pace and the tragic prophecy is fulfilled.

So much for the bail outs. Let me now explain my claim that the new institutions founded to tackle the crisis are, essentially, toxic. Take the EFSF. I shall try to explain its workings in terms of a parable: Consider a group of disparate mountaineers, perched on some steep cliff-face, tied to one another by a single rope. Some are more agile, others less fit, all bound together in a forced state of solidarity.

Suddenly an earthquake hits (the Crash of 2008) and one of them (of a certain Hellenic… disposition) is dislodged, her fall arrested only by the common rope. Under the strain of the stricken member’s weight, dangling in mid-air, and with some extra loose rocks falling from above, the next weakest (or ‘marginal’) mountaineer struggles to hang on but, eventually, has to let go too. The strain on the remaining mountaineers greatly increases, and the new ‘marginal’ member is now teetering on the verge of another mini free-fall that will cause another hideous tug on the remaining circle of ‘saviours’.

With each country that leaves the bond markets, and seeks shelter in the EFSF, the next ‘marginal’ country faces higher interest rates while the average country’s burden also rises. This is a dynamic from hell. It is like watching a tragic accident happen in slow motion. Only the reality of the euro crisis is, in fact, much worse. For there is another aspect of it that the mountaineering example does not capture: The banking crisis which is intensifying with each ‘transition’ of a country into the ‘receiving’ end of the EFSF.

Indeed, as the tragedy on the cliff-face deepens, the drama in the banking arena intensifies too, the budget deficits grow (as states pump more money into the banks and the austerity measures reduce economic activity and, in turn, the governments’ tax take) and, in a never-ending circle, that parallel drama dislodges the next ‘marginal’ country from the cliff-face.

Come to think of it, the very structure of the EFSF is precisely that of the CDOs that led Lehmans’ to the dustbin of financial history. Madness in action. Irrationality at work. That is, I am afraid ladies and gentlemen, today’s European reality.

Argument C. Faultlines

I now turn to my argument that the eurozone crisis was an accident waiting to happen.

What was the main lesson that 1929 and the subsequent collapse of the Gold Standard ought to have taught us? What was the main fault in the postwar Bretton Woods design that led to its collapse in 1971? What was the fundamental flaw in the Argentinean dollar peg that led to the recent crisis on which we shall be hearing a great deal later? One thing. One lesson that we should have learnt ages ago:

No stable exchange rate mechanism can survive for long without a Surplus Recycling Mechanism. An SRM of the sort that keeps the dollar zone (also known as the USA), the sterling zone (Britain), the yen zone etc. going.

No SRM no sustainable fixed exchange rates. It is as simple as that.

Will California ever have a balanced trade sheet with Ohio? Never! So, how come California and Ohio sustain a fixed exchange rate, a common currency, between them in the presence of persistent trade imbalances? The answer is simple: There is a complex SRM in place. When Boeing secures a contract to build a new fighter plane, Washington adds the proviso that it will be built in a deficit state like Ohio. And when Ohio’s banks fail, it is not the State of Ohio that must bail it out but the Fed. Moreover none of these moves are conceived off as bail outs for Ohio!

The eurozone lacked an SRM and was founded on the basis of the incongruous No-No-No clause: No bail out for fiscally stricken states, no default, no fiscal transfers. Well, this is what you get when you build such an edifice on top of shifting, magnifying imbalances: A wreck waiting for the first earthquake to happen.

Argument D. A Modest Proposal

My fourth argument, if you recall, was that the eurozone crisis can be fixed in a few weeks, as long as the current policies are abandoned. Can I be serious?  Yes, I can and I am. In short, here is my proposal. I call it a Modest Proposal and it is the result of brainstorming with my good friend Stuart Holland, ex Member of the British Parliament, aid to Jacques Delors during the formation of the euro and formerly Professor at Oxford and Sussex Universities.

Our point is that to arrest this twin, escalating crisis, before the eurozone unravels completely, the two parallel solvency crises (of the banks and of the states) must be addressed centrally and at once. Our proposal involves three steps that do precisely that within the EU’s current institutional framework:

Step 1: Restructuring of the Sovereign Debt held by ECB-funded banks

The ECB makes the continuing provision of liquidity to private banks conditional on the latter accepting forthwith a swap of the existing bonds they hold (previously issued by all eurozone’s member states) for new ones (issued by the same state) with a much lower face value (up to 50% haircut) and longer maturity (up to 2 years extra). No other bonds are affected.

Step 2: ECB-issued eurobonds to cover all member-states’ Maastricht-compliant sovereign debt

The ECB takes on its books, with immediate effect, a tranche of the sovereign debt of all member states equal in face value to the Maastricht-compliant 60% of GDP of each. The transfer is financed by ECB-issued bonds that are the ECB’s own liability (rather than by eurozone members in proportion to their GDP). Member states thus continue to service their debts but, at least for the Maastricht-compliant part of the debt, they pay the lower interest rates secured by the ECB bond issue.

Step 3: Pan-European Investment Recovery Program led by the European Investment Bank (EIB)

Since only sustained growth will see the twin crises well and truly off, Europe must embrace a pan-European, large-scale, eco-social, investment-led, program by which to put in place a permanent counter-force to the forces of recession, especially in peripheries that keep dragging the rest of the currency union toward stagnation. To this end, the EU can summon the services of the EIB. The only one change in the EIB’s charter that is necessary is to grant member-states the right to finance their contribution to the EIB-financed investment projects by means of special bonds that the ECB issues on their behalf. With this simple move, the EIB can become the Surplus Recycling Mechanism without which no currency union can survive for long.

Concluding remark: The greatest threat of them all

I can hear some of you think: If your proposal is so smart, why is it not adopted? Surely Europe is brimming with people smarter than you.

It is indeed. The gross failure to move in the direction of a resolution of the crisis is not a failure of intelligence. It is a failure of political process. More so, it is a catastrophic failure and a mortal threat for European democracy.

To give you a flavour of my point, consider the following science fiction scenario. Some brilliant scientist develops a device featuring a red button and hands it to Mrs Merkel. By pressing the red button she can end the crisis here and now, with no loss to the German taxpayer. Would she press it?  It is not clear that she would. For if she did, in the next summit, the German Chancellor would be just one of 27 EU leaders. Now, while the crisis is spreading terror across Europe, and Germany retains its option of exiting the eurozone, Mrs Merkel sets the agenda fully and completely. Our Modest Proposal would end this. If I am right in saying that it would resolve the crisis, it would substantially reduce Germany’s relative power within the EU. No German leader can take this decision, and press the red button, lightheartedly. Especially when it involves ECB-issued eurobonds that effectively lock Germany into the euro forever and ever.

Ladies and gentlemen, let me cast a troubled gaze beyond Europe. I believe the Crash of 2008 changed the world. The post-2008 world can no longer be understood or managed on the basis of what we took for granted before 2008. In Asia and in Latin America, in India and in Australia, growth is strong and spirits are high. But if we scratch the surface, I believe we shall discover a great deal of anxiety, a dearth of sustainable aggregate demand, a global dynamism that threatens to run out of steam.

Europe may be old and wrinkled but it retains the capacity to damage the rest of the world in profound ways. If we Europeans fail to deal with our ongoing crisis, we may well prove the spanner in the works; especially in view of an ungovernable United States of America finding it extremely hard to regain its poise. We may, I fear, export our unnecessary stagnation, thus causing a new global recession.

Europe has taken the world down with it at least twice in the past century. For reasons that, once more, are connected to gross political failure it is, I believe, threatening to do so again. I hope it does not come to that. But I will not be surprised if it does. If I despair at our European leaders’ dithering it is because this is a crisis and a peril that could be  so easily defused.

But it has happened before and it may happen again. To quote something that John Maynard Keynes wrote in 1920: Perhaps it is historically true that no order of society ever perishes save by its own hand. Europe proved him right a few years later. I hope it proves me wrong  now.

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