From Michael Belkin via Barry Ritholtz:
Almost a year ago — on July 11, 2011 — I put up a post titled “Is Another 1931 in the Offing?“ The probability of the answer to this question being “yes” is unfortunately higher — much higher — now than it was then. Martin Wolf’s column in today’s Financial Times is a sign of the times. The first part of his column – “Panic has become all too rational” — deals with the present; the second with the past.
Part 1 — Today’s crisis
Suppose that in June 2007 you had been told that the UK 10-year bond would be yielding 1.54 per cent, the US Treasury 10-year 1.47 per cent and the German 10-year 1.17 per cent on June 1 2012. Suppose, too, you had been told that official short rates varied from zero in the US and Japan to 1 per cent in the eurozone. What would you think? You would think the world economy was in a depression. You would have been wrong if you had meant something like the 1930s. But you would have been right about the forces at work: the west is in a contained depression; worse, forces for another downswing are building, above all in the eurozone. Meanwhile, policy makers are making huge errors.
The most powerful indicator – and proximate cause – of economic weakness is the shift in the private sector financial balance (the difference between income and spending by households and businesses) towards surplus. Retrenchment by indebted and frightened people has caused the weakness of western economies. Even countries that are not directly affected, such as Germany, are indirectly affected by the massive retrenchment in their partners.
According to the International Monetary Fund, between 2007 and 2012 the financial balance of the US private sector will shift towards surplus by 7.1 per cent of gross domestic product. The shift will be 6.0 per cent in the UK, 5.2 per cent in Japan and just 2.9 per cent in the eurozone. But the latter contains countries with persistent private surpluses, notably Germany, ones with private sectors in rough balance (such as France and Italy) and ones that had huge swings towards surplus: in Spain, the forecast shift is 15.8 per cent of GDP. Meanwhile, emerging countries will also have a surplus of $450bn this year, according to the IMF.
One would expect feeble demand in such a world. The willingness to implement expansionary monetary policies and tolerate huge fiscal deficits has contained depression and even induced weak recoveries. Yet the fact that unprecedented monetary policies and huge fiscal deficits have not induced strong recoveries shows how powerful the forces depressing economies have been. This is the legacy of a huge financial crisis preceded by large asset price bubbles and huge expansions in debt.
Finance plays a central role in crises, generating euphoria, over-spending and excessive leverage on the way up and panic, retrenchment and deleveraging on the way down. Doubts about the stability of finance depend on the perceived solvency of debtors. Such doubts reached a peak in late 2008, when loans secured against housing were the focus of concern. What is happening inside the eurozone is now the big worry, with the twist that sovereigns, the actors upon whom investors depend for rescue during systemic crises, are among the troubled debtors. Such doubts are generating a flight to safety towards Germany and, outside the eurozone, towards countries that retain monetary sovereignty, such as the US and even the UK.
Part 2. Yesterday’s crisis
It is often forgotten that the failure of Austria’s Kreditanstalt in 1931 led to a wave of bank failures across the continent. That turned out to be the beginning of the end of the gold standard and caused a second downward leg of the Great Depression itself. The fear must now be that a wave of banking and sovereign failures might cause a similar meltdown inside the eurozone, the closest thing the world now has to the old gold standard. The failure of the eurozone would, in turn, generate further massive disruption in the European and even global financial systems, possibly even knocking over the walls now containing the depression.
How realistic is this fear? Quite realistic. One reason for this is that so many fear it. In a panic, fear has its own power. To assuage it one needs a lender of last resort willing and able to act on an unlimited scale. It is unclear whether the eurozone has such a lender. The agreed funds that might support countries in difficulty are limited in a number of ways. The European Central Bank, though able to act on an unlimited scale in theory, might be unable to do so in practice, if the runs it had to deal with were large enough. What, people must wonder, is the limit on the credit that the Bundesbank would be willing (or allowed) to offer other central banks in a massive run? In a severe crisis, could even the ECB, let alone the governments, act effectively?
Furthermore, people know that both banks and sovereigns are under severe stress in important countries that seem to lack any prospect of an early return to growth and so suffer the costs of high and rising unemployment. No better indication of this can be imagined than Spain’s final cry for help with its banks. Political systems are under stress: in Greece, a fragile democracy has imploded. Meanwhile, the German government seems to have reiterated opposition to more support.
How much pain can the countries under stress endure? Nobody knows. What would happen if a country left the eurozone? Nobody knows. Might even Germany consider exit? Nobody knows. What is the long-run strategy for exit from the crises? Nobody knows. Given such uncertainty, panic is, alas, rational. A fiat currency backed by heterogeneous sovereigns is irremediably fragile.
Before now, I had never really understood how the 1930s could happen. Now I do. All one needs are fragile economies, a rigid monetary regime, intense debate over what must be done, widespread belief that suffering is good, myopic politicians, an inability to co-operate and failure to stay ahead of events. Perhaps the panic will vanish. But investors who are buying bonds at current rates are indicating a deep aversion to the downside risks. Policy makers must eliminate this panic, not stoke it.
In the eurozone, they are failing to do so. If those with good credit refuse to support those under pressure, when the latter cannot save themselves, the system will surely perish. Nobody knows what damage this would do to the world economy. But who wants to find out?
As a long-time student of the Great Depression, I’ve often asked myself the same question that Wolf raises in his penultimate paragraph. Like him, I know now the answer.
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Being human, I take some pride in being occasionally prescient — even if, as in this instance, I wish I had not been. That’s my excuse for subjecting you to the entirety of my July 11, 2011 post:
As financial contagion spreads across Europe to include Italy, it brings to my mind 1931, when the mother of all such contagions took place. It began in Austria with the failure of the Kreditanstalt Bank. In only four months, the contagion spread to Germany, followed by England and, finally, the United States.
History need not repeat itself. However, as I argued in an earlier post, I’m concerned that the forthcoming budget deal will derail the anemic American economic recovery. Should this occur, it could have unforeseen — or, at least, unmentioned consequences — not the least of which could be an erosion of the values of the assets held by our major financial institutions. With the growing uncertainty regarding the creditworthiness of the sovereign debt of several European countries — and, hence, of the financial intermediaries holding that debt — the possibility of a financial perfect storm can’t be ruled out. Adding to that risk, in my view, is the position of the Bank for International Settlements (BIS), which in its recently-issued annual report, concluded that
Many of the challenges facing us today are a direct consequence of a third consecutive year of extremely accommodative financial conditions. Near zero interest rates in the core advanced economies increasingly risk a reprise of the distortions they were originally designed to combat. Surging growth made emerging market economies the initial focus of concern as inflation began rising nearly two years ago. But now, with the arrival of sharper price increases for food, energy and other commodities, inflation has become a global concern. The logical conclusion is that, at the global level, current monetary policy settings are inconsistent with price stability.
Even more worrisome to me is the position of the European Central Bank (ECB). While the BIS is an advisory institution, the ECB controls the monetary policy of the euro-zone, which includes all major European countries (and many minor ones, including Greece) with the exception of the United Kingdom. On July 7, the ECB raised interest rates for the second time this year.
While the U.S. Federal Reserve has a dual mandate — to keep the lids on both inflation and unemployment, the ECB’s sole objective is to contain inflation. Like the ECB, the BIS’ concern is solely with inflation; judged by the contents of its annual report, unemployment is beyond its ken. Unfortunately, in my view, the BIS’ and the ECB’s policy prescriptions — that interest rates should rise — mirror those of the many central bankers in the early 1930s who, in the midst of falling output and deflation, believed that monetary stringency was the cure for the ailing world economy. If the current slowdown in the world economy should worsen, as may happen in the aftermath of ECB’s rate hikes and the U.S. budget cuts, will these powerful institutions reverse course, or will they stay the course? I have no way of knowing. All I can say is that, if they don’t implement policy changes under such a circumstance, the possibility of something resembling the financial crisis of 1931 unfolding within the next year or two will increase.
At the beginning of each year in the 1920s and 1930s, the New York Times published a chronological record of the financial events of the past year. Below the fold are excerpts pertaining to the five months — from May to September of 1931 — of financial contagion that broadened, deepened and lengthened the Great Depression. For those who aren’t familiar with what transpired during those historic months, which witnessed the collapse of an international monetary system based on the gold standard, the investment of a few minutes of your time may be worthwhile.
MAY
Heavy Decline in Stocks; Bank Rates At Very Low Level
The principal event abroad, whose importance was not realized in America at the time, was the virtual failure of the great Kreditanstalt Bank in Austria, a Rothschild enterprise. Although the institution was saved by the Austrian Government, its collapse, under what proved to be discreditable circumstances, turned out later to have had an immense effect in producing the chain of circumstances which subsequently demoralized German and English finance.
JUNE
Run on Foreign Creditors on Reichsbank; Home Trade Unfavorable
The outstanding event of June was the sudden beginning of a run of foreign creditors on Germany’s gold reserve. In a very short time the recall of foreign balances and short loans from Berlin became panicky and reached almost unprecedented volume . . . The existence of a grave crisis was openly recognized by the German Government; it resulted in a precipitous fall of Germans foreign securities and in the efforts at foreign assistance to the country’s finances. The crisis was met in the middle of the month by President Hoover’s proposal of a one-year moratorium on both intergovernmental debts and German reparations [both stemming from World War I].
JULY
Critical German Situation; Run on Bank of England’s Gold
Very great uneasiness over the German situation continued during July, and in the latter part of the month financial attention was suddenly and unexpectedly converged on a run of foreign depositors on the London market and the Bank of England, similar to the “raid” on Germany and resulting in the swift development of crisis, with two advances of the Bank of England rate . . . Conferences of governments and bankers regarding the German situation were held during July at London and Paris . . .
Advances were made to the Reichsbank by foreign central banks, and emergency measures taken by the German Government regarding the situation, limiting the withdrawal of deposits and requiring that gold proceeds of foreign sales should be turned into the treasury. Early in the month the German bank and government authorities visited all important European centres in search of relief expedients . . .
In the middle of the month the strain shifted to England, in a run on the Bank of England’s gold by foreign depositors and lenders who were calling home their capital. Along with this, panic spread through European high finance . . .
Great demoralization occurred in foreign bonds on the New York market, as a result of the European troubles. At the same time domestic bonds, especially the second grade, fell to extremely low levels under forced selling of their holdings by banks which believed themselves to be in danger . . .
AUGUST
London Crisis Acute, Labor Ministry Resigns; Markets Here Uncertain
Although the German crisis was partly mitigated in August by the emergency measures taken by the government, by the assistance of other central banks, and by foreign bankers’ pledges to leave their German credits “frozen” at Berlin for six months, the strain on London increased. At the beginning of the month the Bank of England obtained a $250,000,000 foreign credit from the central banks of France and America for the support of sterling; this was virtually exhausted in three weeks . . . Pressure on the Bank of England relaxed at the end of the month, when the British government obtained a second emergency credit of $400,000,000 from French and American banks.
SEPTEMBER
England Suspends Gold Payments; Run on Our Reserves
In September the crisis in Europe’s credit situation reached a climax, and with it came outright panic in European high finance and a sudden and large-scale raid by European institutions on the American gold reserve. Simultaneously, the talk in American banking circles of impending bankruptcies of the economic world and of “breakdown of the capitalistic system” pervaded even experienced Wall Street circles.
The event which brought this mental unsettlement to a head was the suspension of gold payments by Great Britain, announced on the morning Of Sept. 21. It was followed first by similar suspension of gold payments by Norway, Sweden, Denmark, Finland and Egypt. It immediately occasioned renewed outpour of the American market of investment bonds both from home and foreign holders, along with large-scale hoarding of money on the European Continent and greatly accentuated American hoarding of cash.
If you’re going to read just one analysis of the origins and consequences of the Eurozone crisis, this speech delivered by Soros on June 2 should be it. The first three pages are a statement of his long-standing theory of “reflexivity” — a subject matter that may or may not be of interest to you. I became acquainted with his theory about 25 years ago; it has had a profound impact on my thinking about financial markets ever since.
The meat on the speech begins with the second paragraph on page 4. It’s certainly among the most insightful analyses of the disaster we see playing out in the Eurozone that I’ve seen. It may even be the most insightful analysis.
Don’t miss it.
The OECD says that it’s becoming increasingly difficult for Small and Medium Enterprises (SMEs) to get bank loans. Click here for the full report (read-only).
The FT reports that
. . . entrepreneurs and small business owners across much of the developed world but especially in Europe, where bank lending is going into reverse. Bigger companies may be enjoying low borrowing costs thanks to low central bank rates but for smaller ones the outlook is decidedly murkier. Although the extent varies significantly from country to country, Europe is the worst- affected region, and a looming credit crunch for small and medium-sized enterprises (SME) could impact economic growth significantly, bankers warn. “The decline of SME lending is a challenge that is just getting bigger and bigger,” says Christopher Drennen, a senior banker at BNP Paribas. “It could lead to real problems, especially in Europe.”
This IMF chart included in the FT report shows what’s happening in the Eurozone:
. . . on the fiscal cliff:
According to CBO’s estimates, the tax and spending policies that will be in effect under current law will reduce the federal budget deficit by 5.1 percent of GDP between calendar years 2012 and 2013 (with the resulting economic feedback included, the reduction will be smaller). Under those fiscal conditions, which will occur under current law, growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5 percent, CBO expects—with the economy projected to contract at an annual rate of 1.3 percent in the first half of the year and expand at an annual rate of 2.3 percent in the second half. Given the pattern of past recessions as identified by the National Bureau of Economic Research, such a contraction in output in the first half of 2013 would probably be judged to be a recession.
“It is frightening”
In my most recent post, The journey towards becoming Japan, I noted the similarities between what has been happening to the US and UK and what happened earlier to Japan. But the question obviously arises: why has eurozone experience been different?
Let us start by looking at what has happened. For this purpose, I compare countries of roughly similar economic size: Germany, France, Italy and Spain, which are, of course, members of the eurozone, and the UK.
The time since the signing of the Maastricht Treaty in 1992 can be divided into three periods: 1992-98, which was when interest rate convergence was achieved among the eurozone members; 1998-2008, when all eurozone bonds were treated as being essentially identical, while UK yields diverged a little, from time to time; and, finally, 2008 to today, which has been a period of growing divergence in the eurozone, with Germany acting as safe haven and revulsion from Italian, Spanish and, more recently, even French debt.
It is not that hard to see why Germany’s debt is treated as the safest inside the eurozone. But the fact that UK bonds now offer significantly lower interest rates than those of France, Italy or Spain is really puzzling, since its deficits and debts are actually fairly high and its prospects quite poor.
In the case of fiscal deficits, the UK is clearly worse than France, let alone Italy and Germany. It is in much the same position as Spain.
In the case of net public debt, the UK is, again, in a worse situation than France, Germany and Spain, though in a better one than Italy. But Italy has smaller fiscal deficits, which means its net debt is growing more slowly, relative to GDP, than the UK’s.
We can conclude, quite simply, that the UK’s relatively low bond yields are not caused by a superior fiscal position, in any way. On the contrary, the UK’s deficits are extremely large, its public debt position is poor and its deterioration has been relatively rapid.
So what might explain this?
I am going to look at that question in detail, in my next post, because it goes to the heart of what makes the eurozone financially and fiscally fragile.
I have noted in the first part of this blog that the debts of countries in the eurozone have suffered a very different fate from those outside the eurozone during the crisis. This is evident when one compares the yields on sovereign bonds of the UK with those of France, Italy and Spain, countries that on the face of it, have governments at least as solvent, if not more so.
So why has the experience of the eurozone members been so different and so painful and what can be done to remedy the problem?
There are two possible explanations, which are not mutually exclusive.
The first explanation is that a country with its own currency enjoys access to the captive savings of its private sector. The reason why people keep most of their financial assets in the domestic currency is that this is also the currency of most of their spending and of course, of the taxes they pay. Currency mismatches are also very dangerous in a world in which the currency might shift a large amount in a short time.
After a crisis, the private sector will also often (though not always) have a large financial surplus – that is, an excess of income over spending. This must be spent either on the liabilities of the government or on foreign assets. The former purchases fund the government directly. The latter drive down the external value of the currency, which will result in improved prospects for the economy and strengthening the public finances.
The position of eurozone members is very different. A Spanish resident may buy German bunds, instead of Spanish bonds, with no currency risk or to the extent such risk exists, it is only on the upside. The same is true for any other euro-based person. Thus, the debt of the government of Germany – both the largest country and one with a strong creditor position – has emerged as the safest asset in the system. Its price has risen as its yields tumbled. It should be grateful, but does not seem to be. Meanwhile, the debt of sovereigns deemed less secure than that of Germany risks being turned into junk.
Suppose that the interest rates on the bonds of the weaker sovereigns soar. Suppose, too, that there is limited official support for those bonds from the central bank (that is, the European Central Bank) or other governments. Then the government of the weaker sovereign will be forced into fiscal austerity. Quickly, the nominal rate of interest will become far higher than the prospective growth of nominal gross domestic product.
The government will find itself in a debt trap. It will need a large primary surplus (before interest payments) to constrain the growth of its stock of debt relative to GDP. But the weakness of the economy will limit its ability to achieve such a surplus. Awareness among investors of the trap will automatically make it deeper. This is why deflating a government back into solvency is so hard once interest rates become high.
The point is made below. The picture is particularly striking for Spain. Between 1995 and 2007, Spain’s nominal GDP grew on average 7.4 per cent a year. Between 2010 and 2014, this average is forecast by the International Monetary Fund to be just 1.2 per cent a year. For Italy, the corresponding average growth of nominal GDP was 4.5 per cent between 1995 and 2007, but again, the forecast average rate is 1.2 per cent a year between 2010 and 2014. Nominal interest rates on government bonds of 5-6 per cent will not work with such depressed growth of nominal GDP.
The second explanation for the high bond yields of governments in the eurozone is that a member of a currency union does not have a central bank of its own. This then creates liquidity and default risk in the market for government bonds.
Investors in government bonds should know that they have no collateral. So expectations of repayment depend on the ability of the government to refinance debt, since the latter can never pay it off: the market for government debt is lifted by its own bootstraps. Without a central bank, a time may arrive when the government is unable to refinance its debt. That creates tail risk – the likelihood of being trapped in debts whose maturity will be forcibly extended or on which the government will default. These risks will come to investors’ minds during a crisis. Liquidity will then dry up and investors flee. Only the central bank can halt such a “run” or market panic. But, by assumption, the latter will refuse to take the needed action.
Paul de Grauwe, who now teaches at the London School of Economics has put the point forcefully.
In a nutshell the difference in the nature of sovereign debt between members and non-members of a monetary union boils down to the following. Members of a monetary union issue debt in a currency over which they have no control. It follows that financial markets acquire the power to force default on these countries. This is not the case in countries that are no part of a monetary union, and have kept control over the currency in which they issue debt. These countries cannot easily be forced into default by financial markets.
Another way of looking at the absence of a central bank is as follows. The yield on a bond with no default risk should be the weighted average of expected short rates of interest. Thus for an economy in deep recession, with no serious risk of inflation over the relevant horizon, expected short-term interest rates will be low and so, as a result, will be the yields on bonds. This then explains the UK’s very low bond yields, since it has (next to) no default risk.
Yet bonds of eurozone member states do have default risk, since in effect, they borrow in a foreign currency, as have many emerging economies in the past. Investors now know of this risk not just from theory, but from what has happened in Greece. The expectation of ultra-low official short-term rates will not, in these cases, determine the yield on bonds, because the possibility of default will also enter the calculation. Worse, the probability of default is a function of the interest rate on the bonds: the higher is the rate, the greater is the probability of default. So yet again, governments may enter a trap in which the higher the interest rates they have to pay the smaller is their perceived likelihood of avoiding default.
What then could be done to reduce this dangerous fragility inside the eurozone? That will be the subject of my next post.
The previous two posts Part 2 and Part 1 tried to explain why the sovereign debt of eurozone countries seem to be far more fragile than that of countries with their own central banks.
This issue is a relatively new one, so far as I know. But it is extremely important.
One of the questions raised in the subsequent discussions is why the possibility of illiquidity-induced default (as in the Spanish sovereign debt market) should be any different in impact from the possibility of a devaluation and inflation (as in the gilt market).
I have three suggested answers.
The first is that the chance of illiquidity in the government bond markets is an additional risk. A freeze on liquidity may drive a solvent sovereign into default: we are then in the world of multiple equilibria. Thus a sovereign that could perfectly well avoid default if it had market confidence is, in the absence of a central bank, vulnerable to a run. The bonds of governments that lack their own central banks are exposed to an extra risk, in exactly the same way that the liabilities of banks without lenders of last resort are also exposed to risks that banks with lenders of last resort do not face.
The second answer is that investors believe they will be able to get out in time if a particular bond becomes vulnerable to inflation. Inflation is, initially at least, a slow-motion form of default for conventional bonds. Alert investors may well feel confident in their ability to escape in time. Defaults are a different matter. These may be sudden and so difficult to anticipate. Moreover, the loss of value in the case of a default is inherently unpredictable, being vulnerable to legal and other risks, while inflation is relatively predictable and also has no legal implications.
The third answer is that the risk of inflation or devaluation is, for an investor with domestic currency assets and liabilities, neutral for the balance-sheet. That is, it should not affect the relationship between the two sides of the balance sheet. This being so, neither inflation nor devaluation should expose the investor to increased risk of bankruptcy, which is always highly disruptive. But suppose a Spanish investor owes euro liabilities and holds Spanish government bonds subject to default risk (unlike, say, sterling bonds, which are exposed to inflation and devaluation risk). Such an investor is exposed to significant balance sheet risk associated with the chances of illiquidity-induced default.
For these reasons and those in the previous posts, as well as the evidence, it seems clear that eurozone sovereigns are exposed to risks that sovereigns with floating exchange rates and central banks are not.
It is of course possible that the main reason for the sovereign debt fragility is simply that investors believe so-called “internal devaluations” are infeasible and so assume that Spain will not return to growth, while the UK can. If so, nothing can be done, other than push for higher inflation in the core of the eurozone.
Leaving this last possibility aside, how might one fix this fragility of public debt markets (and so banks) in the eurozone?
There are essentially two strategies: more federalism or greater nationalism.
Under more federalism, one can envisage three possibilities:
- The first and most radical possibility would be to create a federal government, following the US model in the 1790s, as discussed briefly in a recent column (“A fragile eurozone must change fast”). The federal government would have its own revenue and have responsibility for providing certain fundamental services throughout the eurozone. In that way, it would matter far less for citizens if their own government did default.
- A second and less radical possibility would be to create a class of debt that is liquid in all circumstances. This would be some form of eurobonds or eurobills. These would cover a substantial portion of all the outstanding government debts (maybe, up to 60 per cent of each country’s GDP, this being limit set in the Maastricht treaty). All members would issue joint and several guarantees of such eurobonds and the European Central Bank would use such bonds (and bills) in all its market interventions. Being collectively issued and guaranteed and senior to all other public debt, these bonds would be safe. Moreover, the ECB would promise to keep this market liquid if necessary.
- A third and least radical possibility would be that the ECB simply agreed to be buyer of last resort in sovereign debt markets, making its own judgement of when the market was oversold, so seeking to be a stabilising speculator and eliminating pure illiquidity risk. While politically difficult and making it necessary to reach difficult judgements of credit quality, the job is certainly possible, in theory.
These are radical proposals, of course, and agreement on any might be impossible.
Under more nationalistic approaches comes an intriguing suggestion from Richard Koo of the Nomura Research Institute, whose work on balance-sheet deflation I have mentioned before (The journey towards becoming Japan). In a paper entitled “Revitalizing the Eurozone without Fiscal Union”, delivered at the conference organised by the Institute for New Economic Thinking in Berlin, in April 2012, Mr Koo suggests that eurozone governments should limit sale of their bonds to citizens. That, he argues, would exclude foreigners from their markets and so limit these countries’ ability to run deficits. It would also prevent people from buying foreign bonds, thereby underpinning the domestic market.
I can see objections to this proposal, not least that it would remove an important aspect of financial integration. But the most obvious objections are practical: how would one prevent evasion? Spanish citizens might, for example, invest in German private funds that buy German bunds, and vice versa. Spanish savers might also find it more attractive to invest in the private liabilities of German entities than in their own government’s bonds, in the absence of exchange risk, so starving their government of funds. Finally, while it is clear who a Spanish citizen is, the citizenship of a European company may be far less clear. Thus, Spanish savers might put money into Spanish financial institutions that use a subsidiary to invest in German bunds, and vice versa.
I do not know what the best or most likely way forward can be. But one must be found. The fragility of sovereign debt in the eurozone is potentially lethal, since it can push governments into unmanageable crises. Governments that would have been solvent if they had remained outside the eurozone are so no longer. Countries risk defaults of their governments and banks, together. This is likely to prove intolerable.
Yet solutions may require a degree of political and economic radicalism beyond the member countries.
It is frightening.
“Those who don’t know history are destined to repeat it.”
– Edmund Burke (1729-1797)
“Those who cannot remember the past are condemned to repeat it.”
–George Santayana (1863-1952)
In addition to illustrating the financial version of the Golden Rule — that those with the gold make the rules — the German government’s insistence that austerity is the only way that the health of the Eurozone’s economically-troubled members can be restored shows that knowledge of the past doesn’t prevent it from being repeated.
When World War I ended, the victorious Allies imposed a Carthaginian peace on Germany. The Versailles Treaty milked Germany dry. Unable to make its reparation payments, the government of the Weimar Republic resorted to the printing press. The hyperinflation of 1923 destroyed the savings of the middle class. Loans from American banks — a stop-gap measure analogous to credits now being issued through the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) — restored economic and political stability for five years. In 1928, the Germany economy started to contract. Soon after the 1929 Wall Street crash, risk-averse American bankers stopped bankrolling Germany. The German economy crumbled, accelerating the worldwide economic crisis. And setting the stage for Hitler.
The lesson from this admittedly sketchy depiction of a tragic episode in world history is that victors (militarily or economically) that impose harsh austerity on losers ultimately pay a heavy price. Unfortunately, this isn’t the lesson that the Merkel Government and the majority of the German people have taken to heart. Instead, fear of inflation has been embedded in the German DNA. They know their history, but they’ve drawn the wrong lesson from it.
The export-heavy German economy is outperforming other mature economies, but for how long? If the German belief in and enforcement of austerity persists, the economies of its Eurozone trading partners — led by Greece — will fall deeper and deeper into an economic quagmire. As this happens — and whether or not the currency union survives — exports will plunge, resulting in a German economic contraction. Carthaginian austerity will undermine its author.
Statement by G-8 Leaders on the Global Economy
Our imperative is to promote growth and jobs.
The global economic recovery shows signs of promise, but significant headwinds persist. [On the one hand, on the other . . . ]
Against this background, we commit to take all necessary steps to strengthen and reinvigorate our economies and combat financial stresses, recognizing that the right measures are not the same for each of us. [No measures are "right" for all concerned]
We welcome the ongoing discussion in Europe on how to generate growth, while maintaining a firm commitment to implement fiscal consolidation to be assessed on a structural basis. [There's no trade-off between austerity and growth] We agree on the importance of a strong and cohesive Eurozone for global stability and recovery, and we affirm our interest in Greece remaining in the Eurozone while respecting its commitments. [Even though sticking to its commitments means an economic death spiral] We all have an interest in the success of specific measures to strengthen the resilience of the Eurozone and growth in Europe. We support Euro Area Leaders’ resolve to address the strains in the Eurozone in a credible and timely manner and in a manner that fosters confidence, stability and growth.
We agree that all of our governments need to take actions to boost confidence and nurture recovery including reforms to raise productivity, growth and demand within a sustainable, credible and non-inflationary macroeconomic framework. We commit to fiscal responsibility and, in this context, we support sound and sustainable fiscal consolidation policies that take into account countries’ evolving economic conditions and underpin confidence and economic recovery.
To raise productivity and growth potential in our economies, we support structural reforms, and investments in education and in modern infrastructure, as appropriate. Investment initiatives can be financed using a range of mechanisms, including leveraging the private sector. Sound financial measures, to which we are committed, should build stronger systems over time while not choking off near-term credit growth. [How can this be accomplished?] We commit to promote investment to underpin demand, including support for small businesses and public-private partnerships.
Robust international trade, investment and market integration are key drivers of strong sustainable and balanced growth. We underscore the importance of open markets and a fair, strong, rules-based trading system. We will honor our commitment to refrain from protectionist measures, protect investments and pursue bilateral, plurilateral, and multilateral efforts, consistent with and supportive of the WTO framework, to reduce barriers to trade and investment and maintain open markets. We call on the broader international community to do likewise. Recognizing that unnecessary differences and overly burdensome regulatory standards serve as significant barriers to trade, we support efforts towards regulatory coherence and better alignment of standards to further promote trade and growth.
Given the importance of intellectual property rights (IPR) to stimulating job and economic growth, we affirm the significance of high standards for IPR protection and enforcement, including through international legal instruments and mutual assistance agreements, as well as through government procurement processes, private-sector voluntary codes of best practices, and enhanced customs cooperation, while promoting the free flow of information. To protect public health and consumer safety, we also commit to exchange information on rogue internet pharmacy sites in accordance with national law and share best practices on combating counterfeit medical products.