The following article was commission by the European Financial Review which just published it online – a hard copy version of the periodical is also out soon. It is based largely on the ideas in my Global Minotaur. For the EFR’s site click here.
The Eurozone was designed for a global economy in which the United States played a crucial role in recycling global surpluses, thus generating the requisite demand for net exporters around the world. When the 2008 financial storm hit, and the United States economy lost its capacity to recycle the net surpluses of the Rest of the World (including Europe’s), a monetary union lacking essential stabilising devices was bound to be profoundly destabilised. Can Europe’s leaders agree to a redesign that will help Europe survive in the brave new world unleashed by the financial crisis? Will they?
The Eurozone’s reliance on a United States that could not be sustained after 2008
After the Bretton Woods system collapsed as a result of America slipping from a global surplus to a global deficit position, something quite remarkable happened: for the first time in history, the hegemonic nation increased its dominance by expanding massively its… deficits.
Indeed, from the 1970s onwards, the United States began absorbing an increasing portion of the Rest of the World’s surplus industrial products. America’s net imports were, naturally, the net exports of surplus countries like Germany, Japan and China; the main source of their aggregate demand. In turn, approximately 70% of the profits earned by the surplus nations’ entrepreneurs were channelled, daily, to Wall Street, in search of higher returns. Wall Street would then use this influx of foreign capital for three purposes: (a) to provide credit to American consumers, (b) as direct investment into US corporations and (c) to buy US Treasury Bills (i.e. to fund the American government deficits).
This recycling system broke down in 2008 because Wall Street took advantage of its central position to build colossal pyramids of private money on the back of the net profits flowing into the United States from the Rest of the World. While it lasted, the process of private money minting by Wall Street’s banks, also known as financialisation, added much energy to the recycling scheme, as it oozed oodles of new financial vitality, thus fuelling an ever-accelerating level of demand within the United States, in Europe (whose banks soon jumped onto the private money-minting bandwagon) and Asia. Alas, it also brought about its demise.
When, in the Fall of 2008, Wall Street’s pyramids of private money auto-combusted, and turned into ashes, Wall Street’s capacity to continue ‘closing’ the global recycling loop vanished. America’s banking sector could no longer harness the United States’ twin deficits (trade and budget deficits) for the purposes of financing enough demand within America to keep the net exports of the Rest of the World going (a financing process that, until the Fall of 2008, tapped the Rest of the World’s surplus profits which these net exports produced). From that dark moment onwards, the world economy would find it exceedingly hard to regain its poise – at least not without an alternative Global Surplus Recycling Mechanism (GSRM).
Turning now to the Eurozone’s creation, two remarks are in order. First, the Eurozone was set up in a manner that removed the natural shock absorbers of the participating members-states while guaranteeing that the shock, when it would come, would be massive. Not only was it no longer possible to absorb shocks through devaluation but, in addition, no substantial surplus recycling was designed into the Eurozone of the sort that would kick in if a credit crunch followed (as it surely did) some financial crisis. While the United States was actively and effectively recycling global surpluses, keeping Europe’s banking sector liquid either directly (through flows of financial instruments into Europe’s banks) or indirectly (through providing demand for the net exports of Europe’s surplus countries, e.g. Germany), the lack of an intra-European surplus recycling mechanism went unnoticed. It was only when America’s capacity to perform that surplus recycling role disappeared in 2008 that the effects of the Eurozone’s ill design were felt so brutally – especially in the European Periphery.
Secondly, after the mother of all shocks hit in 2008, Europe’s leaders refused to concur that their monetary union’s design demanded immediate reconfiguration. European leaders thus became embroiled in ridiculously piecemeal ‘rescue plans’ (with that of Greece presenting itself as a paragon of idiocy) and hopelessly unproductive debates on whether there should be more or less austerity, faster or slower moves towards central control of government budgets etc. Thus, the true cause of the Eurozone’s march toward fragmentation, i.e. the lack of effective surplus recycling in its midst, was well and true ignored.
In short, Europe’s elites failed to recognise, both before and after 2008, that their precious Eurozone was predicated upon the United States’ capacity to recycle global surpluses, including of course Europe’s surpluses. Lacking its own effective surplus recycling mechanism, Europe became unhinged shortly after the Fall of 2008, remains in denial to this day and, as a consequence, is wedded to policies that are either irrelevant to the nature of the Euro Crisis or impossible to implement in the new, post-2008 world.
“Europe’s elites failed to recognise, both before and after 2008, that their precious Eurozone was predicated upon the United States’ capacity to recycle global surpluses.”
Can Europe not rely again on a resurgent America?
America’s trade deficit, after a two-year subsidence, has returned almost to its pre-2008 levels. Nevertheless, America’s deficits, even though they have bounced back after the 2008 ‘setback’, no longer have the capacity to play the surplus recycling role that they once did. At least not so in a manner that will restore the conditions under which the Eurozone can return to its pre-2008 normality.
To see why America has lost its capacity to recycle other nations’ net exports at the pre-2008 pace, it suffices to note that in 2011 the United States was generating 23.7% less demand for the Rest of the World’s net exports than it would have been without the Crash of 2008. Secondly, and at the same time, America was failing to attract (through Wall Street) the level of capital flows which would be necessary to maintain the pre-2008 pace of investment into its private sector. To be precise, by 2011 the United States had lost 56.48% of the assets held by foreigners compared to the (trend) level that would have been held had the Crash of 2008 not happened. The main, and indeed crucial, reason for this precipitous decline was that foreign net capital flows ending up as loans to US corporations fell drastically from around $500 billion in 2006 to -$50 billion in 2011.
By 2013 these trends have crystallised into a devastatingly simple picture: On the one hand, the Crisis did not alter the deficit position of the United States. The federal budget deficit more or less doubled while America’s trade deficit, after an initial fall, stabilised at the same level as before. However, the US deficits are no longer capable of maintaining the mechanism that keeps the global flows of goods and profits balanced at a planetary level. Whereas until 2008 America was able to draw into the country mountains of net imports of goods, and a similar volume of capital flows (so that the two balanced out), this is no longer happening post-2008. American markets are sucking 24% fewer net imports (thus generating only 66% of the demand that the Rest of the World was used to before the Crash of 2008) and are attracting into the American private sector 57% less capital than they would have had Wall Street not collapsed in 2008.
In short, the only reminders that remain of the kind of global economy in which the Eurozone flourished prior to 2008 are the still accelerating flows of foreign capital into America’s public debt, evidence that the world is in disarray and, in this age of tumult, money is desperately seeking safe haven in the bosom of the reserve currency. But as long as the Rest of the World is reducing its injection of capital into America’s corporate sector and real estate, while America is reducing its imports of their net exports, we can be certain that the Eurozone cannot rely on the United States to provide, as it did before 2008, the level of aggregate demand that is necessary in order to maintain the mercantilist daydream of a Germanic Europe; i.e. of a Eurozone that behaves as a Greater Germany, reacting to drops in global demand by boosting its overall net exports while, internally, squeezing real wages.
Divided by a common currency
It really takes a penchant to misconstrue the Euro Crisis in order to believe that the insolvency of countries like Ireland, Spain and Italy had anything to do with fiscal profligacy (recall that Spain had a lower debt than Germany in 2008 and Italy has consistently smaller budget deficits). The true cause of the Eurozone’s predicament is the foundational over-reliance of its macro-economy on the United States economy’s capacity to generate sufficient demand of the Eurozone’s net exports. Once Wall Street imploded and liquidity vanished worldwide, two effects brought Europe to its knees:
One was the sequential death-embrace of bankrupt banks and insolvent states (beginning with Greece, moving to Ireland, to Portugal and continuing until Italy and Spain were torn asunder). The other was (a) Europe’s determination to hang on to what I call the principle of perfectly separable debts and (b) the reluctance of national politicians to challenge their nation’s bankers by instituting a proper Eurozone-wide bank resolution scheme, over which they (the national politicians) would have no say.
The telling question thus becomes: Why such resistance, particularly from Germany, to every single idea that would end the Euro Crisis? The standard answer is that Germany does not wish to pay for the debts of the Periphery and will resist all federal-like moves (e.g. a proper banking union) until it is convinced that its partners behave responsibly with their German-backed finances. While this captures well the mindset of many Northern Europeans, it is besides the point. In fact, there are many proposals for ending the banking crisis, hugely reducing the Eurozone’s long term public debt and, indeed, introducing the missing surplus recycling mechanism while reducing substantially the burdens on the German taxpayers.1
So, why is Northern Europe, i.e. the Eurozone’s surplus nations, so steadfast in its determination to maintain an architecture that was designed for a time when the United States played a role it can no longer fulfil? I fear that there are two powerful, intertwined, yet utterly irrational, reasons. The first one was conveyed to me by one of the German Chancellor’s close economic advisers. His simple point was that instituting a proper intra-European surplus recycling mechanism (like our Modest Proposal2) would mean that Germany would never be able to leave the Eurozone in the future. It would, effectively, be giving up the Get-Out-Of-Here card that only surplus nations truly possess currently (since deficit nations know that an exit from the common currency area would mean a massive capital outflow and a subsequent collapse of their banking sector). “It is not, of course, that the German Chancellor wants to use this card in order to exit the Eurozone”, my interlocutor continued. “No, she just loves having it because the fact that the French President is lacking one, as are the Italian and Spanish Prime Ministers, grants her an exorbitant degree of bargaining power within the European Council, the Eurogroup etc.”
In short, Europe’s tragedy is that those with the power to resolve the crisis, by replacing the broken American surplus recycling mechanism (at least internally, within the Eurozone), will lose much of their political power within Europe if they effectively use that power.
The second reason reinforces the first one: For three years now, the German public has become convinced that Germany has escaped the worst of the Crisis because of the German people’s virtuous embracement of thriftiness and hard work; in contrast to the spendthrift Southerners who, like the fickle grasshopper, made no provisions for when the winds of finance would turn cold and nasty. This mindset goes hand in hand with a moral righteousness that implants into good people’s hearts and minds a penchant for exacting punishment on the grasshoppers – even if punishing them also punishes themselves in the long run. They see the low interest rates of the German bunds as a reward for thrift rather than as evidence of the capital flight from the rest of the Eurozone caused by the latter’s disintegration in the Periphery.
“Europe’s tragedy is that those with the power to resolve the crisis, by replacing the broken American surplus recycling mechanism will lose much of their political power within Europe if they effectively use that power.”
The same mindset is strengthened by a radical misunderstanding of what kept the Eurozone healthy and Germany in surplus prior to 2008; i.e. America’s generation of demand for German, Dutch, Chinese and Japanese goods which allowed countries like Germany and the Netherlands to remain net exporters of capital and consumer goods within and without the Eurozone (while importing US-sourced demand for their goods from the Eurozone’s Periphery).
To recap, before 2008 the United States operated like a huge vacuum cleaner sucking into its territory a disproportionate volume of the net exports as well as the profits of the Rest of the World. This surplus recycling mechanism was essential to the maintenance of the Eurozone’s faulty edifice. Once it vanished from the scene, the European common currency area would either be re-designed or it would enter a long, painful period of disintegration. An unwillingness by the surplus countries to accept that, in the post-2008 world, some other form of surplus recycling is necessary (and that some of their own surpluses must also be subject to such recycling) is the reason why Europe is looking like a case of alchemy-in-reverse: for whereas the alchemist strove to turn lead into gold, Europe’s reverse alchemists began with gold (an integration project that was the pride of its elites), but will soon end up with the institutional equivalent of lead. Unless, of course, a modicum of rationality sips into the collective mind of Europe’s hapless leaders before the tectonic plates shift irreversibly against a common currency that is now dividing proud European nations.