Earlier this week, we got a reminder that the European Debt Crisis has not, in fact, been resolved. It amazes me that market participants can be so easily lulled by new rounds of easy money from central bankers that do nothing but buy time. The ECBs LTRO operations launched in December injected €1 trillion into the banking system, yet here we are less than 5 months later and we’re on the verge of plunging headfirst back into trouble. That should indicate the severity of the problem, and the futility of the ‘ECB must do more’ approach. Increased liquidity, lower rates, more QE and so on cannot fix a solvency crisis. It can only kick the can further down the road. At some stage, it must be picked up, and it would be better if it is done so without destroying the currency in the process.
The Strain in Spain
The problems Spain faces are well documented. Like most of the West, it was thrust headlong into a credit fueled boom in the better part of the last decade that ended abruptly in 2008. It had a massive housing boom that was proportionally larger than the one in the US and far more ingrained in the Spanish economy. It’s bursting led to a sharp decline in housing prices, but not sharp enough to return to pre-crisis price/wage ratios according to this research presentation. This, in turn put a massive strain on the banking sector in Spain, and the Spanish government upped its efforts to backstop the banking system.
The net result of this has been an increase in Spanish sovereign debt in order to support zombie banks in their endeavors to prevent the recognition of losses and their subsequent failures. It is no different to the situations in much of the Western world regarding its banking systems. Japan and the US both intervened in the 1990s and in 2008 respectively to keep institutions afloat that would have failed. The difference is that Spain is under pressure from the bond market, with its funding costs rising to levels that would prove impossible to sustain without external support.
So what should be done to resolve the issues facing Spain and the rest of the Eurozone? Matt O’Brien, in his latest column at The Atlantic, basically summarizes the mainstream view on what should be done – Germany should prop up the Southern states. But before that, he says that Germany has misdiagnosed the crisis in the first place.
The Germans have latched onto a misdiagnosis of the crisis. They think it’s a morality tale about profligate governments finally having to live within their means. It’s not. If it were, Spain wouldn’t be in trouble now. They actually ran budget surpluses during the boom years. (Germany was the one that broke the Maastricht Treaty’s deficit limits). What’s really going on is a balance-of-payments crisis. Capital gushed into Southern Europe during the bubble years. Then it stopped. Austerity won’t solve this.
The point about Spain running surpluses before the crisis is my focus here. Yes, Spain ran surpluses before the crisis. But once the crisis arose, they went into deficit to prop up their banking system. This fundamentally changed the quality of their sovereign debt. Paul Krugman made the same point in a column last month:
Spain had low government debt and a budget surplus on the eve of the crisis; it’s in trouble thanks to private-sector, not public-sector, excess.
The Spanish government wasn’t forced to backstop a banking system that got out of control. It could have allowed bad actors to acknowledge their losses, face bankruptcy and restructure debts. It could have allowed that creative destruction to create an environment in which capital could be allocated to profitable firms based on a sustainable price level, thus unconstrained by a housing situation that currently weighs down on the Spanish economy like an albatross. Instead, capital is diverted to the zombie firms the Spanish government now supports. A foundation for sustainable long term growth could have taken place in the end, albeit after a painful restructuring phase. That it chose to stand behind insolvent banks and their excesses, preventing the restructuring, rendered the obligations they took on to do so equally excessive. This absolutely is a case of a profligate government having to face the music. That it spent recklessly on backstopping its banking system instead of excessive social benefits like Greece did is of little consequence.
Returning to O’Brien’s solution; he states that Germany should:
…promise stimulus for southern Europe, conditional on those governments carrying out fiscal and structural reforms. That could mean Eurobonds to counteract local austerity. It could mean letting the ECB be much more aggressive — perhaps by putting a ceiling on borrowing costs for southern Europe. It doesn’t really matter how Germany does it. It just needs to do something. Eventually you need to stop kicking the can down the road, and actually pick it up.
In other words, the prescription is a heavy dose of inflation. Or, Germany taking on more debt to back Southern Europe, which ultimately is an international version of what was just discussed above. As Spain got itself into a debt crisis backing its insolvent banks, Germany will ultimately get itself into a debt crisis of its own by backing Southern Europe. It’s more likely that if anything is done, the inflation route will be the bulk of the response. Even if for some strange reason Germany goes all in and takes on debt, when it comes time for the Germans to deal with its debt, the likely suggestion will be to print it all away. Thus, printing is really the only ‘solution’ suggested by O’Brien, with the question being when it will happen.
Regardless, the implication that the Germans acting is them finally picking up the proverbial can is utterly ridiculous. The phrase ‘kicking the can’ refers to the continued efforts by sovereigns to postpone reducing unsustainable debt levels, across all sectors of the economy. Should the Germans and ECB ‘do something,’ they will continue to postpone the reduction these debt levels, and even increase them, thus continuing to kick the can down the road.
In reality, both the inflation method O’Brien and Krugman advocate, and the Austerity method they both rail against essentially achieve the same thing: the preservation of existing debt loads. Austerity seeks to maintain debt loads by saddling the burden of the debt upon the average individual in an explicit manner, via taxes and cutting deficit spending. The inflation method seeks to maintain debt loads by burdening the average individual implicitly, through devaluing the currency and robbing the average of their purchasing power. The end result is the same: the average individual ends up footing the bill for the excesses taken on in government. Both methods result in minimal to negative real growth, social unrest and high unemployment. The only real solution has been, and will continue to be through nominal defaults by troubled nations and a remaining in the Eurozone. Debts must be written down or forgiven, prices must be allowed to fall and the chips must be allowed to fall where they may. The consequences will be difficult, but they will be swift, and they will give the generation of youth plagued by high unemployment an opportunity to gain meaningful employment once the price level drops. The alternative, inflating the woes away will lead to the destruction of the currency. As I stated at the beginning of this piece €1 trillion of new funds only bought the market 4.5 months of calm. For the ECB to print enough to buy more temporary calm will require much, much more easing, and ultimately when prices rise and growth subsides, a severe problem will await.