Tuesday, September 20, 2011

Bad Days Ahead for Europe and its NATO Partner in North America

The Wall Street Journal has a good column by Bret Stephens which fits in nicely with my current reading of Tony Judt's magnificent POSTWAR, a book that should be required reading for Euroweenies everywhere.

As a personal aside, Nikos Papandreaou, the brother of the current Prime Minister, had a one-on-one dinner with me a couple of decades ago and explained the essential corruption of the Greek economy, which is based on no civic accountability and massive tax evasion, plus a giant dose of sheer graft and peculation. Essentially, in Greece everyone lies to everyone else and a wink and a nod are what make the country muddle through from day to day. At the time, his father was the Prime Minister, and his description of an essentially fraudulent state puzzled me. He described it as a third-world country, long before it was foolishly admitted into the Maastricht Accords and the Eurozone. Greece was even back then guilty of massive fraud of a Madoff-size Ponzi numbers scam just to get into the Eurozone and get all that free money. And Nikos laughingly described his countrymen as self-described political experts, who sat around coffee shops all day while the women did the housework and their state-sector jobs did themselves by means of a coat hanging on a chair in their government "office."

Here's Bret Stephens:
When the history of the rise and fall of postwar Western Europe is someday written, it will come in three volumes. Title them "Hard Facts," "Convenient Fictions" and—the volume still being written—"Fraud."

The hardest fact on which postwar Europe was founded was military necessity, crisply summed up by Lord Ismay's famous line that NATO's mission was "to keep the Russians out, the Americans in, and the Germans down." The next hard fact was hard money, the gift of Ludwig Erhard, author of the economic reforms that created the Deutsche mark, abolished price controls, and put inflation in check for generations. The third hard fact was the creation of Jean Monnet's common market that gave Europe a shared economic—not political—identity.

The result was the Wirtschaftswunder in Germany, Les Trente Glorieuses in France and il miracolo economico in Italy. It could have lasted into the present day. It didn't.

In 1965, government spending as a percentage of GDP averaged 28% in Western Europe. Today it hovers just under 50%. In 1965, the fertility rate in Germany was a healthy 2.5 children per mother. Today it is a catastrophic 1.35. During the postwar years, annual GDP growth in Europe averaged 5.5%. After 1973, it rarely exceeded 2.3%. In 1973, Europeans worked 102 hours for every 100 worked by an American. By 2004 they worked just 82 hours for every 100 American ones.


Former FDIC official Vern McKinley gives a brief history of moral hazard.

It was during this general slowdown that Europe entered the convenient fiction phase.

There was, for starters, the convenient fiction that if you just added up the GDP of the European Union's expanding list of member states, you had an economy whose size exceeded that of the United States. Didn't this make "Europe" an economic superpower? There was the convenient fiction that Europe didn't need robust military capabilities when it could exert global influence through diplomacy and soft power. There was the convenient fiction that Europeans shared identical values and could thus be subject to uniform regulations governing crime and punishment. There was the convenient fiction that Continentals weren't lagging in productivity but were simply making an enlightened choice of leisure over labor.

And there was, finally, the whopping fiction that Europe had its own "model," distinct and superior to the American one, that immunized it from broader international currents: globalization, Islamism, demography. Europeans love their holidays and thought they were entitled to a long holiday from history as well.

All this did wonders, for a while, to mask European failures and puff up European pride. But there is always a danger in substituting grandiosity for achievement, mistaking pronouncements for facts, or, more generally, believing in your own nonsense.

Here is where Europe slipped from convenient fiction to outright fraud.

There was the fraud of Greece's entry into the euro, a double-edged affair since Athens lied about its budgetary figures and Brussels chose to accept the lie. There was the fraud of the so-called Maastricht criteria—the fiscal rules that were supposed to govern the euro only to be quickly flouted by France and Germany and then junked altogether in the current crisis. There was the fraud of the European Constitution, overwhelmingly rejected wherever a vote on it was permitted, only to be revised and imposed by parliamentary fiat.

What is now happening in Europe isn't so much a crisis as it is an exposure: a Madoff-type event rather than a Lehman one. The shock is that it's a shock. Greece was never going to be bailed out and will, sooner or later, default. The banks holding Greek debt will, sooner or later, be recapitalized. The recapitalization will be borne by German taxpayers, and it will bring them—sooner rather than later—to the outer limit of their forbearance. The Chinese will not ride to the rescue: They know not to throw good money after bad.

And then Italy will go Greek. Europe's crisis will lap on U.S. shores, and America's economic woes will lap on Europe's—a two-way tsunami.

America will survive this because America is a state. But as Bismarck once remarked, "Whoever speaks of Europe is wrong. Europe is a geographical expression." The "fiscal union" that's being mooted will never come to pass: German voters won't stand for it, and neither will any other country that wants to retain fiscal independence—which is to say, the core attribute of democratic sovereignty.

What comes next is the explosion of the European project. Given what European leaders have made of that project over the past 30-odd years, it's not an altogether bad thing. But it will come at a massive cost. The riots of Athens will become those of Milan, Madrid and Marseilles. Parties of the fringe will gain greater sway. Border checkpoints will return. Currencies will be resurrected, then devalued. Countries will choose decay over reform. It's a long, likely parade of horribles.

Where is the Europe of Ismay, Erhard and Monnet? It's there in memory, if anyone cares to recover it. Give it another 50 years, and maybe someone will.

Nouriel Roubini, the only major economist to predict the 2007-8 crash, expatiates:
Greece is stuck in a vicious cycle of insolvency, low competitiveness and ever-deepening depression. Exacerbated by a draconian fiscal austerity, its public debt is heading towards 200 per cent of gross domestic product. To escape, Greece must now begin an orderly default, voluntarily exit the eurozone and return to the drachma.

The recent debt exchange deal Europe offered Greece was a rip-off, providing much less debt relief than the country needed. If you pick apart the figures, and take into account the large sweeteners the plan gave to creditors, the true debt relief is actually close to zero. The country’s best current option would be to reject this agreement and, under threat of default, renegotiate a better one.

Yet even if Greece were soon to be given real and significant relief on its public debt, it cannot return to growth unless competitiveness is rapidly restored. And without a return to growth, its debts will stay unsustainable. Problematically, however, all of the options that might restore competitiveness require real currency depreciation.

The first of these options, a sharp weakening of the euro, is unlikely while the US is economically weak and Germany ├╝ber-competitive. A rapid reduction in unit labour costs, through structural reforms that increased productivity growth in excess of wages, is just as unlikely. Germany took 10 years to restore its competitiveness this way; Greece cannot wait in depression for a decade.

The third option is a rapid deflation in prices and wages, known as an “internal devaluation”. But this would lead to five years of ever-deepening depression, while making public debts more unsustainable.

Logically, therefore, if those three options are not possible, the only path left is to leave the eurozone. A return to a national currency and a sharp depreciation would quickly restore competitiveness and growth, as it did in Argentina and many other emerging markets that abandoned their currency pegs.

Of course, this process will be traumatic. The most significant problem would be capital losses for core eurozone financial institutions. Overnight, the foreign euro liabilities of Greece’s government, banks and companies would surge. Yet these problems can be overcome. Argentina did so in 2001, when it “pesified” its dollar debts. America actually did something similar too, in 1933 when it depreciated the dollar by 69 per cent and repealed the gold clause. A similar unilateral “drachmatisation” of euro debts would be necessary and unavoidable.

Major eurozone banks and investors would also suffer large losses in this process, but they would be manageable too – if these institutions are properly and aggressively recapitalised. Avoiding a post-exit implosion of the Greek banking system, however, may unfortunately require the imposition of Argentine-style measures – such as bank holidays and capital controls – to prevent a disorderly fallout.

Realistically, collateral damage will occur, but this could be limited if the exit process is orderly, and if international support was provided to recapitalise Greek banks and finance the difficult fiscal and external balance transition. Some argue that Greece’s real GDP will be much lower in an exit scenario than in the hard slog of deflation. But this is logically flawed: even with deflation the real purchasing power of the Greek economy and of its wealth will fall as the real depreciation occurs. Via nominal and real depreciation, the exit path will restore growth right away, avoiding a decade-long depressionary deflation.

Those who claim contagion will drag others into the crisis are also in denial too. Other peripheral countries have Greek-style debt sustainability and competitiveness problems too; Portugal, for example, may eventually have to restructure its debt and exit the euro too.

Illiquid but potentially solvent economies, such as Italy and Spain, will need support from Europe regardless of whether Greece exits; indeed, a self-fulfilling run on Italy and Spain’s public debt at this point is almost certain, if this liquidity support is not provided. The substantial official resources currently being wasted bailing out Greece’s private creditors could also then be used to ringfence these countries, and banks elsewhere in the periphery.

A Greek exit may have secondary benefits. Other crisis-stricken eurozone economies will then have a chance to decide for themselves whether they want to follow suit, or remain in the euro, with all the costs that come with that choice. Regardless of what Greece does, eurozone banks now need to be rapidly recapitalised. For this a new European Union-wide programme is needed, and one not reliant on fudged estimates and phoney stress tests. A Greek exit could be the catalyst for this approach.

The recent experiences of Iceland, along with many emerging markets in the past 20 years, show that the orderly restructuring and reduction of foreign debts can restore debt sustainability, competitiveness and growth. Just as in these cases, the collateral damage to Greece of a euro exit will be significant, but it can be contained.

Like a broken marriage that requires a break-up, it is better to have rules that make separation less costly to both sides. Breaking up and divorcing is painful and costly, even when such rules exist. Make no mistake: an orderly euro exit will be hard. But watching the slow disorderly implosion of the Greek economy and society will be much worse.

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