Thursday, May 13, 2010

The tarping of Euroland

By Hossein Askari and Noureddine Krichene

Euroland has adopted a gigantic bailout scheme of about US$1 trillion and the European Central Bank (ECB) has also announced, "of course" under no political pressure, that it will buy the bonds of Euroland governments.

Euroland is "tarping" itself. There is no point beating about the bush and blaming credit default swaps for Euroland’s public debt crisis. The dramatic moves by Euroland finance ministers and the ECB were aimed at averting an imminent contagion of the Greek debt crisis to other Euroland economies that have already reached about the same financial disequilibria as Greece: namely a public
debt in excess of 110% of gross domestic product (GDP), fiscal deficits at 13-14% of GDP, unsustainable external deficits, an external debt in excess of 200% of GDP, negative economic growth at minus 4.1% in 2009, and soaring unemployment ranging between 10% and 20%.

All indicators were flashing red warnings to banks to be more vigilant in lending to governments on the verge of default. Many Euroland countries have seen yields on their bonds increase significantly and have difficulty borrowing from international capital markets. Euroland external debt, as enormous as it is now, was not incurred to finance capital accumulation and economic growth. If it had, full employment would have been secured, economic growth would have been strong, and debt would have been easily serviced.

Debt has instead financed fiscal profligacy and consumption. A default by even one Euroland country would send their respective domestic banks crumbling as well as the foreign banks that have large exposure to Euroland debt. Besides imminent banking chaos similar to that triggered by the subprime debt meltdown, if European governments default on their debt, there will be political and social unrest similar to the upheaval in Greece.

The Greek austerity program has demonstrated that fiscal adjustment without outside financial support might prove to be too painful, putting the brunt of the burden on the civil service and taxpayers, and possibly intensifying political and social instability. It would push unemployment to even higher levels. Although Greeks are notorious for not paying their taxes, levying higher taxes at this time to finance unproductive government expenditures would only obstruct economic growth.

In fact, governments rarely adopt austerity programs when they have control of their monetary policy. They simply resort to re-inflation, levy seignorage by printing
money, and devalue their currency. Examples of re-inflationary experiences are numerous; the German hyperinflation in 1922-23 is a typical example of money printing to solve the problems of a bankrupt government; before this there was the French assignats hyperinflation during 1789-1796 that showed how printing money could solve the debt problems of a bankrupt government; the Latin American inflation during 1950-1990 became a textbook example of monetization of fiscal deficits. More recently, Russian inflation at 222% per year during 1993-1999 afforded Russia an avenue to solve its debt problem; and the Russian currency fell from one rouble to the US dollar in 1993 to 31.7 roubles per dollar in 2009.

But Euroland countries no longer have their own individual currencies. They lost them when they jettisoned their own currencies and embraced the euro. A Euroland country cannot on its own deploy monetary policy and inflate its way out of debt. However, collectively, Euroland countries can use monetary policy, inflate, and earn seignorage to pay for government debt and rising fiscal deficits.

Euroland leaders must have realized that it is not the time and these are not conditions when they can play the honest broker and think religiously of monetary discipline of a common currency when other leading countries are indulging in monetary and fiscal sins. If others are sinning, why should Euroland be righteous?

Many countries will now regret seeing themselves bound by one currency. Euroland leaders must have looked around and realized that the United States, the United Kingdom, Japan and a number of other countries have even worse fiscal deficits, larger public external debt and large external deficits. Yet these countries could not care less about what others think of their monetary extravagance and have no shame in bailing out their banks and financing extravagant deficits exceeding 13% of GDP.

If the Fed bought $1.5 trillion in toxic mortgage-backed assets and is monetizing US fiscal deficits, does it make sense for the ECB to adhere to monetary honesty? The Fed is a dependent independent central
bank - dependent on both the US Treasury and Wall Street - so why doesn’t the ECB pretend it is as independent as the Fed and play the same game as other central banks?

The roots of the current debt crisis in the US and Europe can be traced to the era of low interest rates during 2001-2005 by the Fed, the ECB, and Bank of Japan and the out of control liquidity created by these central banks. Floating over an ocean of liquidity, banks had no choice except to push cheap money to subprime markets and to sovereign borrowers that previously had good credit ratings.

Banks were spontaneous in lending to Greece and Spain but not to Burundi and Sudan. Before the collapse of the Bretton Woods agreement, French economist Jacques Rueff argued that US external deficits created multiple equivalent amounts of liquidities; the same applies for other reserve currencies such as the euro, the British pound and the Japanese yen. Namely, dollars, euros and other reserve currencies resulting from external deficits are repatriated to reserve currency central banks and serve as a new basis for credit multiplication.

The multiplication of liquidity that is created has to be placed somewhere in interest-earning debt instruments. This exponentially growing liquidity inflates public-private debt in borrowing industrial and emerging market economies and in turn inflates asset and commodity prices.

The ECB decision to buy government bonds is a monetization of fiscal deficits and in many ways resembles Fed bailouts. The Fed has decided to buy close to $1.5 trillion of mortgage-backed assets, which were toxic assets that were plaguing the US banking system. At the same time, the Fed decided to force interest rates to near zero bound, monetize fiscal deficits, and to depreciate the US dollar.

An unorthodox policy to debase money allows the transfer of the debt burden and the burden of fiscal adjustment from borrowers and from the budget to creditors, consumers and the holders of dollar
cash balances. Creditors of the US will bear a larger burden through a fast real depreciation of their dollar assets. The same applies to holders of euros.

Most of the Euroland countries could face the same debt prospects as Greece and suffer, or have suffered, declining real growth and unemployment rates ranging between 10-20%. These countries could be called on to adopt austerity programs that are similar to the ones just announced by Greece with a view to bringing fiscal deficits from 13-14% in 2010 to 3% of GDP (as required under the agreement establishing the euro) by 2013.

The burden of adjustment will be borne by the budget and by borrowers. Public service salaries will have to be cut drastically, current government expenditures will have to be curtailed, and taxes will rise drastically. These measures will cause an economic contraction and deflation. Often, governments completely circumvent this process and resort to re-inflation and devaluation of the currency. A devaluation will drastically shift the burden of their debt to the private sector and to those who hold cash balances and liquid capital. It will obviate fiscal adjustment. The specter of devaluation caused a peso problem and a flight of liquid capital outside of the country or to safe assets such as gold, commodities and stocks.

A bailout on such a huge scale will obviate the need for fiscal adjustment and will dramatically re-inflate Euroland economies. The decision of the ECB to buy government bonds will enable them to intensify the re-inflationary process undertaken by the ECB since September 2008 and keep the euro in a depreciating mode. The euro has fallen from $1.6/euro in the late spring of 2008 to $1.26/euro in May 2010 and is now under intense downward pressures and in danger of loosing its attraction as a serious challenger to the US dollar as a reserve asset.

The burden of the Euroland debt will fall on the private sector, workers and on foreigners who hold euros as a reserve currency. The holders of euros and workers will have to pay an inflation tax, ie, seignorage that will alleviate substantially the real debt and fiscal adjustment.

A sustainable debt would require a devaluation of the euro by over 50% vis-a-vis major currencies, as illustrated by the depreciation of the currencies of over-indebted countries, bringing the euro possibly to as low as $0.75/euro. A substantial devaluation of the euro will push inflation rates to high levels and will enable countries to relieve government debt constraints and bring deficits to less than 3% of GDP by inflating the revenue base and reducing real costs of the budget.

Imports will become dramatically more expensive and exports very attractive. The ECB would have to inject monumental amounts of money through buying government debt to achieve this scenario. This scenario will be certainly met by retaliating measures from trading partners. The Fed has already decided to put in place swap facilities to prevent a dramatic appreciation of the dollar.

The fiscal deficits and mushrooming debt of the US, UK, and Japan are no healthier than those of Greece or other highly indebted countries. The only difference is that some countries walk with three legs, that is, fiscal, money, and exchange rate policies, while others walk with one leg - fiscal policy. In the first case, the brunt of the burden is deflected to foreign holders of dollar assets and to the private sector; in the second case, the brunt of the burden is confined to the budget. Relying on fiscal adjustment alone spells considerable trouble and upheaval. That is why the ECB may have decided to renounce its founding principle, namely, monetary stability, and instead to follow a powerful inflationary course.

The inflationary drive in the US, Euroland, UK, and other reserve currency centers has raised the prospects of currency depreciations and high inflation in industrial countries and in the rest of the world. There is a noticeable flight to gold as paper monies could become increasingly worthless. The price of gold has reached $1,236 per ounce and could remain under considerable pressure as long as money unorthodoxy prevails. Gold could once again play an increasing role as a reserve asset as reserve central banks are forcefully debasing their currencies.

The inflationary course would alleviate to a large extent fiscal strain and transfer a large part to the poor in Africa in the form of an inflation tax to subsidize the debt of advanced countries; however, it has a dramatic impact on economic growth and social equity. It curtails real spending and social welfare and spreads unemployment; a combination of stagnation and unemployment, or stagflation.

The monumental Euroland bailout has cheered markets as the risk of public debt meltdown has been eradicated. Stock indices have recorded big increases as the specter of bank failures has been removed; nonetheless, as with the Troubled Asset Relief Program (TARP) in the United States and other bailouts, bankruptcies have been deflected for banks, but free lunches have to be paid by someone else, since there is no such thing as a free lunch.

Gains remain private and losses have to be socialized. The cost of bailouts will be high inflation, declining real
, low growth, and rising unemployment not only in affected countries but also in low-income countries. The quest for monetary stability remains elusive and more financial instability and exchange rate volatilities loom ahead.

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