IEA Blog

The so-called Keynesian consensus that seemed to emerge following Obama’s stimulus package, was a short-lived one. Governments, mainly in the eurozone shatter belt, are dropping the same public policies they had put forth a year ago. It is not that unemployment has decreased – on the contrary. Nonetheless, “special social measures” and “job creating” public investment is being curtailed.

This should be sufficient evidence that the Keynesian answer to the crisis has failed. The Keynesian stimulus plans ignored the very low saving rates. In particular, Greece and Portugal had the lowest internal liquid savings rates (when public and private savings are added, and replacement investment deducted) of the last decade. Indeed, both countries had negative saving rates in 2008, with Portugal hitting a low of -5.8% of GDP against an EU average of 6%! It is no surprise that such highly indebted countries are now paying heavily for such leveraging.

Added to this, the Portuguese socialist government failed to understand that it should cut spending drastically. Instead, it has decided to increase taxes to respond to market worries about government borrowing. Taking into account the deep level of leveraging, both in the public and the private sector, the tax rise simply added to the risk of a banking failure, as it passed on debt from the government to households and firms, leaving the size of government untouched.

As such default probabilities on credit derivatives based on Portuguese sovereign debt remain very high; interest rates spreads are increasing; and bank refinancing is more expensive, leading to added costs for indebted firms and households, as well as to another increase in the budget deficit.

The question is: how is the government going to avoid default? Raising taxes again will be suicidal, and reducing the public sector wage bubble is anathema. Public sector wages have never been frozen in Portugal, and they are still growing. If the government does not lower them, there is no way Portugal will get out of its debt trap. I would bet on Portugal being the first eurozone country to default.

The EU, national governments, academics and media are discussing how to rebuild the shattered EMU stability framework, after the Stability and Growth Pact failed to prevent the current crisis. In particular, its weak enforcement mechanism is said to be responsible for the failure.

One proposal for a new stability framework by the European Commission demands more centralisation of fiscal policy. National budget plans would be submitted to and approved by the EU in advance of national legislation. However, this would undermine national sovereignty and would be a further step towards political union.

An alternative framework would see the adoption of very tight fiscal rules (which will become law in Germany from 2011 onwards) for the whole EU. This so called “debt brake” allows structural net borrowing of just 0.35% of GDP. However, the failure of the Maastricht criteria suggests that such rules could be undermined by political pressure. There is also a problem with enforcement.

One recommendation to improve enforcement is to cut EU money for countries that do not stick to the rules. This proposal seems plausible, but it will fail if it is applied to a net paying country. Such a country might offset the cuts with lower contributions to the EU. Further proposals, such as excluding countries from voting in EU legislation or the threat to expel a country from the euro, also have significant drawbacks. Both options conflict with the “European Idea” and might promote nationalism and resistance against the EU, making a break up of the eurozone even more likely.  

A better way to avoid a repeat of the current crisis may be to rely on market mechanisms. This implies that a eurozone country can default, either with no restrictions or regulated by an insolvency procedure. However, for market-based restraints on government profligacy to be effective, the EU must make a clear and credible commitment to a no-bailout rule. Regaining credibility may prove difficult in the context of the current multi-billion-euro bailout package.

See also Philip Booth’s article,  ”Europe should have allowed Greece to default“, in City AM.

The new Chancellor of the Exchequer’s proposal to set up an independent Office for Budget Responsibility sounds like a good idea. But how sad that government ministers cannot be trusted to tell the truth. Who thinks that Sir Alan Budd and his team will come to the conclusion that Alastair Darling’s estimates of likely national economic growth rates over the next few years were too low?

The Greek government, it now appears, told lies in order to pretend that they had “qualified” for entry into the euro. But as the government of almost every other current member-state in the eurozone did the same thing, the only sensible rejoinder is: “Join the club!” After seeing what France did to the Stability and Growth Pact, it hardly seems the eurozone is yet ready for budget responsibility.

Perhaps other British government departments could follow the Treasury’s example. What about an independent Office of School Honesty, to get away from the pretence that standards in state schools have been rising? Or why not an independent Office of Military Straightforwardness, which could reveal genuine statistics about the quality and quantity of the armed forces’ equipment?

The possibilities are endless, though we must be realistic and not let our hopes rise too much. Obviously one couldn’t have accuracy in election results, given electoral fraud in this country that (as one magistrate pointed out recently) would disgrace a banana republic. And it would hardly be England if one could trust the statistics on crime or immigration.

Somehow I doubt if it will catch on.

After years of continuous growth in public spending and public debt, the Portuguese economy finds itself in a bleak situation in the context of the ongoing international crisis. Internal and external imbalances have been steadily accumulating and recent events in Greece have placed increased pressure on the country’s debt. The combination of a stagnant economy with the pressure of large budget and current account deficits leaves little room for optimism. The EU bailout package addresses some of the more immediate liquidity concerns but will prove unsustainable if structural adjustments do not follow.

Portugal’s situation is not as severe as that of Greece – the predicted budget deficit is around 8% – but it does have a number of disturbing similarities, particularly in the lack of competitiveness. The pervading lack of competitiveness is associated with an economy marked by high levels of direct and indirect government intervention and leaves little room for solutions. Several structural factors contributed to make the 2000-2010 period essentially a lost decade for Portugal in terms of economic growth: an extremely rigid labour market, an inefficient and often unreliable justice system, a pervading culture of nepotism and corruption in numerous institutions, and growing government intervention in key economic sectors are among the main factors and all seem unlikely to experience major improvements in the short run.

Apart from the far-left parties (which have an electoral weight of close to 20% and hold radical anti-capitalistic views) there is a large social-democratic consensus in Portuguese society favouring Keynesian views that is shaken only by the prospect of imminent financial collapse. The Keynesian consensus pervades most political, media and academic contexts and leads to a dangerous state of denial and to blaming external agents (greedy faceless speculators, the US, the ECB or even Germany) for the crisis.

In the face of collapse, there seem nevertheless to be some encouraging signs. The opposition parties to the right of the current socialist government have been publicly insisting on the need to suspend major public works projects and cut public spending and it was recently announced that the construction of a major new airport in Lisbon as well as that of third major bridge across the River Tagus would be reconsidered. Amazingly, however, the socialist government has apparently decided to proceed with the construction of a high speed train project linking Lisbon to Madrid.

In the past, the fiscal irresponsibility of Portuguese governments was often resolved via monetary and exchange policy. The euro provided international credibility and lower interest rates but also removed the possibility of devaluing the currency at a national level. In this context, the only sustainable remaining options seem to be an austerity programme involving major cuts in public spending and wages (which might lead, as in Greece, to grave political and social unrest) or leaving the euro.

Either way, there are very difficult times ahead.

This weekend the EU finance ministers, the EU and the IMF agreed a huge bailout package for the troubled eurozone countries and the single currency. The emergency package comes after international bond and equity markets became nervous about the Greek crisis spreading to other PIIGS countries.

The deal is worth about 500 billion euros; the IMF adds further 250 billion euros. It includes loans and state guarantees. Additionally, the European Central Bank announced today it would buy government bonds in the market, a further step to flood jittery markets with liquidity. Both measures will certainly calm down the markets; that is clearly a benefit of last night’s agreement.

Nevertheless, European leaders have only bought time – the crisis is not over yet. Of course, the governments of PIIGS countries no longer need to borrow money at steadily rising interest rates and the threat of default is off the agenda. However, the problems of high and unsustainable deficits and deteriorated competitiveness in some euro area countries have not diminished.

All countries of the eurozone, especially the PIIGS, still need to cut their huge structural deficits and to reduce their debts. Greece must stick to her austerity measures. The differences in competitiveness and the resulting current account imbalances within the euro area have to be adjusted through greater labour market flexibility. Moreover, the credibility of the ECB to curb inflation needs to be restored after today’s announcement that it will monetise government debts. Unless urgent action is taken to deal with these problems, the crisis could re-emerge in even more dramatic form. It might not be possible to rescue the euro again.

The Austrian Business Cycle Theory (ABCT), developed largely by Ludwig von Mises and F. A. Hayek, predicted the present crisis and explained its causes in advance. Many commentators aware of this theory warned that after the real estate bubble went bust, a new one would form in the sovereign debt markets. Expanding fiscal budgets in a recessionary environment would ultimately lead to a situation in which highly indebted governments needed a bailout. For Greece and the other PIIGS  (Portugal, Ireland, Italy, Greece and Spain), that burden now largely falls on their friends and allies within the European Union.

Chancellor Angela Merkel has tried to calm things down. Recently portrayed by the media as la Madame Non, she hesitated to confirm German aid, but eventually gave in. And this is despite the fact that such financial aid appears to constitute a breach of European Law (§125 of the Treaty on the functioning of the European Union clearly states that the Union shall not be liable for or assume the commitments of central governments of any member state). A group of respected economists and lawyers are therefore questioning the legitimacy of bailouts in the highest German court, the Bundesverfassungsgericht. The same individuals fought but lost their case against the introduction of the euro in 1998. This time, however, they insist on their position, for otherwise the bailout might turn the “European Union into an inflationary union.”

Indeed, giving financial aid to Greece and the other PIIGS means not only breaking the very principles on which the eurozone was once founded; it also means opening a Pandora’s Box. German President Horst Köhler (who now seems to be supporting the bailout) warned about this in the 1990s, when he was still a government secretary in the German ministry of finance. His words back then were rather clear: in order to assuage the fears of German taxpayers he told Der Spiegel that each member state will deal with its own deficits and that there will be no aid obligations for the European Community. He went on to assert that “it won’t happen that the South cashes in on the so-called rich countries, as then Europe would fall apart.”

After months of agonising discussions, European leaders have agreed on a “solution” for the Greek crisis. Unfortunately, the joint efforts of the EU and the International Monetary Fund to keep Greece financially afloat are not addressing the more pressing issue of Greece’s competitiveness.

The mistake most politicians make about the Greek situation is simple. They believe that Greece’s principal problem is its budget deficit of around 13 per cent of GDP (if the figures are to be trusted). If that were the case, plugging the hole in Greece’s public finances with international help could work. To be sure, it would still require huge amounts of money from the IMF and eurozone members. But it would buy the Greeks time to get their budget troubles under control.

This calculation will not work, though. It ignores the fact that apart from its fiscal crisis, Greece has more serious economic problems. The most pressing issue is Greece’s lack of cost competitiveness. To put it simply, as long as a cappuccino costs €4.50 in Athens, the country has no chance of economic recovery.

Given the Greeks’ poor productivity, Greek wages (and prices) are at least a quarter higher than they should be. This means that Greece will not be able to compete with Germany. It will also struggle to compete with its neighbours in the important tourism market. It will not be able to recover.

If Greece still had its old currency, there would be an easy way out of its current quagmire, namely to devalue. In fact, that’s precisely how countries like Greece had previously dealt with similar challenges. This would have made imports more expensive, thus correcting the trade imbalances that are currently troubling Europe.

The euro has made this course of action impossible. Greece is trapped in a monetary union that now forces it to slash its budget and cut its wages in the country’s most severe recession for decades. You don’t need to be a Keynesian to understand that this will cause enormous economic pain and risks political destabilisation.

So Greece’s problems are not solved by the billions of euros now flowing into the country for the next three years. At best, this will only postpone Greece’s eventual collapse. Greece would be much better served if it were allowed to default, leave the euro and devalue. It would be following the example of Argentina’s default from which the country bounced back at a remarkable speed.

European politicians are scared of such a scenario, of course. Having bailed out their banks in the financial crisis, they would have to do the same once again for all banks holding Greek bonds. However, why shouldn’t they bail out the banks directly instead of taking the detour via Athens?

Besides, it is not clear why Greek bondholders should not suffer some loss (i.e. a haircut). If interest rates on different types of government bonds reflect the risk of default, then default as an option should not be taken off the table. We are creating moral hazard if even the most risky government bonds would always be backed by an implicit EU/IMF guarantee.

On closer inspection, the EU/IMF rescue package does not provide the help the Greece really needs. But this non-solution will still cost taxpayers, not least in Germany, billions of euros. Years from now, the Germans will ask why they had to pay about €40bn to Greece when this substantial amount of money did not manage to cure the Greek patient. The answer is that it was the wrong medicine in the first place, but politicians were gullible enough to believe that there was no alternative.

We can only speculate how long the German taxpayers’ patience with the euro will last under these circumstances. If they are not going to wake up now, will they wake up when Portugal asks them for money? Or Spain? Or Italy? Or Belgium?

As long as countries such as Greece are joined with Germany in a monetary union, this monetary union will not work. Both of them cannot be members of workable monetary union at the same time. It is high time for one of them to leave.

Will the Germans finally realise that it’s not too late for them to bring back the Deutschmark?

Dr Oliver Marc Hartwich is a Research Fellow at the Centre for Independent Studies.

While Greece’s financial issues, both domestic and international, are making any bailout package more difficult in deed than word, the social issues at stake are no less troubling.

Domestically, the situation has bred a population unwilling to recognise the problem for what it is – a clear case of a culture of entitlement created by the kindness of strangers. As Anita Acavalos has explained, in Greek culture using the wealth of others is not considered fundamentally immoral. Furthermore, seeking recourse against the productive elements of the country is popular as “the rich … are commonly perceived to be everything that is wrong with Greek society.”

A recent poll suggests that a majority of Greek citizens are against their government’s decision to accept a bailout from eurozone partners and the IMF. While the domestic government resists political unrest by only gently suggesting that spending restraint and wage reductions should occur, the foreigners who will foot the eventual bill are chastised for suggesting that the behaviour that got the nation into this mess should be curtailed.

Were Greek opposition to the bailout package based on a desire for independence and prudence, we could rest easy. Instead, international calls for austerity measures aimed at combating a bloated public sector rife with unfunded government obligations, drive fear into the eyes of many Greek public employees. These same employees have already been bailed out for years by other European nations, allowing an unsustainable situation to persist and, indeed, worsen.

One particularly troubling incident occurred recently when striking dock workers prohibited tourists from boarding their ship. For an economy dependent on tourism for a good part of its GDP and employment, discomforting tourists willing to bring their foreign money into the nation risks reducing future revenues. Without these revenues Greece will be even more reliant on foreign bailouts – with all the restrictions and concessions demanded.

Biting the hand that feeds you is never in one’s best interest. A failure to recognise the means available to bring prosperity to the Hellenic nation will prolong the spending imbalances central to today’s crisis.

Talks over what should happen about the Greek debt situation were recently delayed by the impromptu eruption of the Icelandic volcano Eyjafjallajökull. In the meantime, analysts and commentators continued missing the essential problem engulfing the country. Its problem lies in the past, not the future. The seeds have been sown, and there is no way now to escape all the hardships that must be endured. While short-term relief may come, this will quickly be exhausted and leave an imbalanced situation.

Greece’s accession into the Eurozone caused an immediate reduction in the implicit risk on its government issued debt. Secured by a robust European community committed to supporting weaker members befalling hard-times, interest rates on Greek bonds were commensurately reduced.

Interest rate reductions are generally promoted endogenously through high saving rates. The exogenous support of friendly European neighbours created an atmosphere of proliferate credit expansion in the face of reliably low interest charges – charges which were not complemented by any form of spending restraint. This problem has come to the fore now as a burgeoning public sector is unable to be supported at higher interest rates, and any increase in taxes to sustain the situation will place undue pressure on an already strained (and shrinking) private sector.

The situation may well prove fatal to Greece’s economic prospects.

International hesitation at providing a bailout has created further uncertainty as to what the future holds for the country. Lacking both private and public savings to address its financial woes, any short-term relief must come from an international consortium – fellow European Union members, or the IMF.

Yet it is important to remember, as Philipp Bagus has outlined, that Greece has already been bailed out by the EU for many years. The European Central Bank (ECB) has accepted as collateral most government bonds – including Greece’s. Consequently, European banks have been purchasing Greek government bonds to pledge as collateral against loaned ECB funds at historically low interest rates. This already highly profitable deal has been magnified as the crisis continues as Greek bond yields have crept higher, making the spread relatively more profitable. This increased demand for Greek government bonds has already provided the Greeks with a bailout through artificially low interest rates.

The ECB monetizes Greek debt by printing new Euros against the collateral of the pledged Greek government bonds. This allows the government to spend beyond its means, comforted in knowing that spending shortfalls can be papered over by issuing more bonds for the ECB to monetize. Inflationary pressures originate in Greece as the new liquidity is spent, but quickly spread to other European nations. As the domestic purchasing power for Euro-using citizens decreases, there is a latent transfer of wealth to the Greek government.

The moral hazard signalled to other EU member states by a further Greek bailout would have massive ramifications. While details are still being ironed out, the Eurozone will tentatively fund the Greek government with a €30bn loan, with the IMF contributing an additional €15bn. While this package has provided some immediate calm to the markets, the long-term effects look much less positive. The reasoning can be seen in the support given to the bailout.

While Spanish and acting-EU president José Luis Rodríguez Zapatero welcomed the bailout, Germans remained much more sceptical. Spain will fund about 10 per cent of the EU’s bailout – a noble contribution. However, the precedent set will almost certainly be repaid to the Spanish government in the future. By pushing for a bailout, Spain has almost assured that European support will be forthcoming for itself when the time arises. As the 2nd largest economy of the PIIGS (Portugal, Ireland, Italy, Greece and Spain), and with an unemployment rate hovering around 20 per cent, Spain is sufficiently large, interconnected and troubled to raise the expectation that it could be the next Greece. By supporting its troubled ally today, Spain increases the odds that it will be aided in the future.

Any bailout to Greece now will do little to remove its previous excesses, and may well exacerbate the problem elsewhere in the EU.

One analyst jokingly tweeted: “It was the dying wish of Iceland’s economy to have its ashes spread across Europe.” Luckily, Greece’s own Mount Olympus is not volcanic. If continued assurances of a bailout continue, the adjustments necessary to save the Hellenic nation – less spending, lower wages and more saving – will fail to materialize. Europe may well have to contend with the financial fallout anyway.

“Borrow as much as you like – the ECB will bail you out” – that was arguably the implicit message of European Central Bank president Jean-Claude Trichet last week as he announced that the ECB would continue to accept Greek sovereign bonds. The statement came after fears that Greek government bonds would be further downgraded and would therefore lose their status as collateral for ECB open market operations. In addition, a current relaxation of collateral quality requirements to BBB- is supposed to be extended.

Certainly, the ECB acted in the belief that their actions would safeguard the eurozone and the euro. If Greek government bonds were excluded from ECB monetary policy operations, Greece would find it even harder to sell their government bonds at “acceptable costs”. However, Mr Trichet’s rash promise to help Greece imposes a long-term threat for the eurozone.

Firstly, credibility is an important “tool” in today’s monetary policy. Markets must believe in monetary policy to make it effective. However, changing the rules to help Greece is highly discretionary. Accordingly, markets will anticipate discretionary policy in the future and they will treat monetary policy statements with scepticism. The resulting uncertainty in monetary policy (or even higher inflation), will not, however, help the eurozone economies recover from the crisis. Special aid to Greece will therefore have a negative impact on other members of the zone.

Secondly, the guarantee by Mr Trichet is virtual a “no-default-guarantee” and implicitly accelerates central bank financing of Greek government debt. Irrespective of rating or fiscal stance, commercial banks are likely to buy Greek government debt. They receive high yields and can use the junk bonds as collateral for low interest central bank loans. At the end of this process, Greek government bonds end up on the ECB balance sheet. This could have a “crowding out” effect on high quality collaterals. Yields of high rated countries could increase.

Thirdly, the ECB statement encourages moral hazard. Why should another country in a similar situation to Greece today (maybe Portugal) be willing to undergo painful austerity measures? Why should Greece stick to its announcements on public spending cuts? The ECB (together with the EU bailout plan) has created an environment where government debt can be rolled over repeatedly and increased. Market forces are switched off and the requirement to cut deficits and public debt is substantially reduced.

Although the ECB has acted to safeguard the eurozone, its guarantee to help Greece may prove to be counterproductive in the long term.