The Minotaur’s Global Legacy, Part D – A brief history of a very European debacle

07/03/2011 by

The  region by region assessment of the impact of the Global Minotaur’s demise post-2008 today proceeds to an analysis of the eurozone crisis. Having just looked at the story of Germany’s European engagement (see here), and after having scrutinised the triangular relationship between Japan, East Asia and the USA), we are (I hope) ready for a re-consideration of the current European conundrum.

First as history then as farce: Europe’s bank bail outs

Despite European gloating that the Crash of 2008 was an Anglo-Celtic crisis, and that its own banks had not been taken over by financialisation’s equivalent to a gold fever, the truth soon came out. German banks were caught with an average leverage ratio of €52 borrowed to every €1 of own funds; a ratio worse even than that raked up by Wall Street or London’s City. Even the most conservative and stolid state banks, the Landesbanken, proved bottomless pits for the German taxpayer. Similarly in France whose banks had to admit that they had at least €33 billion invested in CDOs. To this sad sum, we must add the European banks exposure to the indebted eurozone states[1] (€849 billion), to Eastern Europe (more than €150 billion), to Latin America (more than €300 billion), and to around €70 billion of bad Icelandic debts.

The European Central Bank (ECB), the European Commission (the EU’s effective ‘government’) and the member states rushed in to do for the European banks that which the United States administration had done for Wall Street. Only there were two profound differences. The first difference is that the euro is nothing like the dollar. While the dollar remains the world’s reserve currency, the Fed and the US Treasury can write blank cheques knowing that it will make very little difference on the value of the dollar, at least in the medium term. Indeed, IMF data shows that the dollar’s share of global reserves was 62% at the end of 2009 and has, since then, been rising in response to Europe’s post-2010 debt crisis.

The second difference relates to the eurozone’s problematic architecture, especially the way that its member states are bound by a common currency but their public debts are strictly separate, their banks are the responsibility of member states alone, and there is no Surplus Recycling Mechanism to avert structural faultlines from developing. To put it simply, imagine what would have happened in 2008 if in the ‘dollar-zone’ each state (e.g. California or Nevada) had to bail out the banks registered on their soil and there was no way of financing public deficits from Washington!

Within this institutionally problematic framework, the ECB and the European Commission struggled to contain the banking crisis. Between 2008 and 2009, they ‘socialised’ the banks’ losses and turned them into public debt. Meanwhile, the economy of Europe went into recession, as expected. In one year (2008-9) Germany’s GDP fell by 5%, France’s by 2.6%, Holland’s by 4%, Sweden’s by 5.2%, Ireland’s by 7.1%, Finland’s by 7.8%, Denmark’s by 4.9%, Spain’s by 3.5%…

Suddenly, hedge funds and banks alike had an epiphany: Why not use some of the public money they were given to bet that, sooner or later, the strain on public finances (caused by the recession on the one hand, which depressed the governments’ tax take, and the huge increase in public debt on the other, for which they were themselves responsible) would cause one or more of the Eurozone’s states to default?

The more they thought that thought, the gladder they became. The fact that euro-membership prevented the most heavily indebted countries (Greece et al) from devaluing their currencies, thus feeling more the brunt of the combination of debt and recession, focused their sights upon these countries. So, they decided to start betting, small amounts initially, that the weakest link in that chain, Greece, would default. As London’s famous bookmakers could not handle multi-billion bets, they turned to the trusted CDSs;[2] insurance policies that pay out pre-specified amounts of money if someone else defaults.

Of course, as the volume of trade in this newest form of private money increased the crisis worsened. There were two reasons for that: First, the rise in the price of CDSs taken out against Greece or Ireland pushed up the interest rates that Athens and Dublin had to pay to borrow, thus pushing them further into the red (and effective bankruptcy). Secondly, the more money was spent on these CDSs the more capital was siphoned off both from corporations seeking loans to invest in productive activities and from states trying to refinance their burgeoning debt.

In short, the European variant of the banks’ bail out gave the financial sector the opportunity to mint private money all over again. Once more, just like the private money created by Wall Street before 2008 was unsustainable and bound to turn into thin ash, the onward march of the new private money was to lead, with mathematical precision, to another meltdown. This time it was the public (also known as sovereign) debt crisis whose first stirrings occurred at the beginning of 2010 in Athens, Greece.

Greeks bearing debts

In October 2009 the freshly elected socialist government announced that Greece’s true deficit was in excess of 12% (rather that the projected 6.5%, already more than double the Maastricht limit). Almost immediately the CDSs predicated upon a Greek default exploded, as did the interest rate the Greek state had to pay to borrow in order to refinance its €300 billion debt. By January 2010 it had become clear that, without institutional help, the Greek government would have to default.

Informally, the Greek government sought the assistance of the eurozone. German Chancellor Angela Merkel who issued her famous nein-cubed: Nein to a bail out for Greece; nein for interest rate relief; nein to a Greek default. That triple nein was unique in the history of public or even private finance. Imagine if on 15th September 2008 Secretary Paulson had said to Lehman Brothers: “No, I am not going to bail you out” (which he did say); “No, I shall not organise for you very low interest rate loans” (which he also probably said); and “No, you cannot file for bankruptcy” (which he would never have said).” The last no is unthinkable. And yet this is precisely what the Greek government was told. The German government could fathom neither the idea of assisting Greece nor the idea that Greece would default on so much debt held by the French and German banks (about €75 billion and €53 billion respectively).

For five tortuous months, the Greek state was borrowing at usury rates, getting deeper and deeper into insolvency, pretending that it could weather the storm. Mrs Merkel seemed prepared to let Greece twist in the wind until the very last moment. That moment came in early May of 2010 when the world’s bonds markets went into something close to the Credit Crunch of 2008. The Greek debt criis had panicked investors and caused them not to buy anyone’s bonds, fearing a cascading default similar to that of 2008. So, on 2nd May 2010, the Eurozone, the ECB and the IMF agreed to extend a €110 billion loan to Greece at an interest rate high enough to make it highly unlikely that the Greek public purse would be able to repay this new loan as well as the existing ones.

Naturally unconvinced that throwing new, expensive loans on an insolvent government, which was presiding over an economy in deep recession, would magically render it solvent, investors continued to bet in a default by Greece and also by other vulnerable eurozone states. So, a few days later, the EU announced the creation of the European Financial Stability Facility (the EFSF, whose toxic structure was discussed in Chapter 7), supposedly a war chest of €750 billion that would be on standby, just in case another eurozone member needed assistance with its public debt repayments.

The markets, after a few days of calmness, took a good look at the EFSF and decided it was merely a stop-gap measure. Thus the euro crisis continued with a vengeance. The reason is, of course, that expensive new loans do not address the deficit states’ descent into bankruptcy and they certainly do nothing for the faulty architecture, the noxious Simulacrum, whose destructive potential was realised the moment the Global Minotaur was wiped out by the Crash of 2008.

If I am right, and the euro crisis is a systemic failure that began as a banking crisis, Europe’s medicine is worse than the disease. It is like sending a weak swimmer out to sea to save a drowning bather. All you can expect is the sad sight of the two weak swimmers hanging onto one another for dear life, both sinking fast toward the bottom of the sea.

The two swimmers are, of course, the eurozone’s deficit states and Europe’s banking system: Over-laden with paper debts issued by states like Greece and Ireland, which are worth little, they constitute black holes in which the ECB keeps pumping oceans of liquidity that, naturally, only occasion a tiny trickle of extra loans to business. Meanwhile, the ECB, the surplus countries and the IMF steadfastly refuse to discuss the banking crisis, concentrating their energies solely on imposing massive austerity on the deficit states. In a never ending circle, the imposed austerity worsens the recession afflicting these deficit states and, thus, inflames the bankers’ already grave doubts about whether they will ever be paid back by Greece, Ireland etc. And so the crisis is reproducing itself.

Tumbling mountaineers and the euro crisis

The domino effect, with one deficit-stricken country falling upon the next, until none is left standing, is the common metaphor by which the eurozone’s crisis is narrated. I think there is a better one: It is that of 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’.

This is precisely why the euro crisis has not been dealt with. The EFSF structure was compared in Chapter 7 to the structure of Wall Street’s toxic CDOs. 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, austerity causes more banking anxiety by clearly boosting the shrinking of the deficit economies and, in a vicious feedback effect, that parallel drama dislodges the next ‘marginal’ country from the cliff-face.

Most puzzlingly, this is a crisis that Europe could resolve in a few weeks. How could it be resolved? And, if am I right, why is Europe dithering?

Why is Europe dithering when the crisis can be resolved simply and quickly?

I shall start by explaining how the twin crisis facing the eurozone, the one involving the indebted states and the other afflicting the banking sector, could be resolved without delay. Europe’s approach has failed because it has both ignored the way the debt crisis and the banking crisis are reinforcing one another and, additionally, because it has turned a blind eye to the deeper cause of the crisis: the lack of a Surplus Recycling Mechanism at the heart of the eurozone. Here are three simple steps in which effective remedies can be put in place:

The first step would be for the ECB to make the continuation of its generous assistance to the banks conditional on the banks writing off a significant portion of the debts of the deficit countries to them.[3] (The ECB has ample bargaining power to effect this as it is constantly keeping Europe’s effectively bankrupt banks liquid.)

The second step would have the ECB take on its books, with immediate effect, a portion of the public debt of all member states equal in face value to the debt that the Maastricht Treaty allows them to have (i.e. up to 60% of GDP). The transfer is financed by ECB-issued bonds that are the ECB’s own liability, rather than being guaranteed by member-states. 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.

Finally, the third step brings into play another venerable EU institution, the European Investment Bank (EIB). The EIB has the capacity to invest in profitable projects twice the capital of the World Bank. Unfortunately, it is under-utilised because member-states must advance, under existing rules, a proportion of the investment. In the awful state they find themselves in, the eurozone’s deficit states cannot afford to do this. But by granting member-states the right to finance their contribution to the EIB-financed investment projects by means of bonds issued for this purpose by the ECB (see the second step above) the EIB can become the Surplus Recycling Mechanism which the eurozone is now missing: Its role will be to borrow, with the ECB’s assistance, surpluses from European and non-European surplus countries and invest them in the Europe’s deficit regions.

Summing up, the first two steps would make the debt crisis go away and the third would underpin the eurozone by providing its missing link; the mechanism that it never had and whose lack caused the euro crisis in response to the Crash of 2008. But if I am right about all this, why is Europe not taking up this suggestion, or something along these lines? The answer lies in the preceding pages. Time to spell it out: It is because, if the euro crisis is resolved quickly and painlessly, the surplus eurozone countries (Germany in particular) will forfeit the immense bargaining power which the simmering crisis hands the German government vis-à-vis France and the deficit countries.

To put the same point differently, the surplus countries now have one foot inside the eurozone while retaining the other foot outside of it. On the one hand, they have bound the rest of the eurozone to them by means of a common currency, thus securing large intra-eurozone surpluses. On the other hand, they know that the ongoing crisis affects the deficit countries disproportionately and, as long as the surplus countries retain the option of getting out of the eurozone, their bargaining power in Europe’s fora is immense. For instance, whenever the German Chancellor wants to take some item off the agenda, she does so unopposed. But were the crisis to end tomorrow in a manner that prevents the surplus countries from ever leaving the eurozone, then Germany’s Chancellor is just another one of almost two dozen heads of government around a large decision table.

Now notice how the second step of my proposed euro crisis solution would stop Germany from ever leaving the eurozone: Once the ECB, a common institution, acquires large debts (by issuing its own bonds) it becomes impossible to allocate this common debt among different member-states. Thus, it is impossible for anyone to leave. Furthermore, if the third step is adopted, and Europe is fitted with the missing Surplus Recycling Mechanism, Germany’s Simulacrum will be well and truly debased.

So, it seems that the euro crisis is wholly unnecessary from an economic viewpoint but that it serves the interests of maintaining within Europe the role that Germany developed for itself during the reign of the Global Minotaur. And now that the Minotaur is kaput, Europe is in crisis and Germany in… denial.

[1] Greece, Ireland, Portugal, Spain, Italy and Belgium.

[2] See the relevant box in Chapter 6 for a description of CDSs.

[3] Technically this could be done by swapping the existing bonds of deficit states that Europe’s banks hold for new ones with a much lower face value.

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