bailouts, currencies, current accounts, ECB, economics, economy, EFSF, Euope, eurozone, germany, government bonds, housing, keynes, keynesian economics, mitlon friedman, monetarism, PIIGS, sovereign debt, trade, trade balances, US
As the eurozone continues to slug along, there’s still a radical misconception about the nature of the problems amongst politicians, the general public, and even many economists. The latest maneuver in the Great Eurozone Crisis is an attempt to recapitalize the banks. Admittedly, I could not describe the precise mechanisms to achieve this, as my knowledge in that sphere is not great enough to decipher the tangled web of financial transactions involved. But I don’t need to be able to understand that “tangled web” in explicit detail to know that the eurozone is still missing the point.
As Cullen Roche of Pragmatic Capitalism recently points out, the big eurozone banks are certainly overly leveraged. That’s only part of the problem, however. The bigger problem is that the euro’s structure creates trade distortions within the eurozone. The chart below shows the major eurozone economies by current account as a percentage of GDP.
As you can see, Greece, Italy, Portugal, Spain, and Ireland all have been running significant current account deficits. And the problem is that they cannot correct these deficits. They are essentially stuck as trade deficit nations.
Of course, one might counter that the United States and the United Kingdom are also perpetual trade deficit nations. I’d argue that while this is true, the circumstances significantly differ.
The US and UK both have sovereign currencies, whereas Spain and Greece no longer do. The US and UK likewise benefit from lower prices and interest rates as a result of these trade distortions. While the US and UK’s trade distortions are undesirable, they are not unsustainable.
I’d further argue that these trade imbalances are largely the result of currency distortions across the world, with China and the East Asian nations being the biggest culprits. Ultimately, even if harmful, the US and UK’s sovereign currencies allow them to continue to slog along. It’s the nations on the other end of this distortion that should be worried; namely China.
Spain, Portugal, and Greece cannot claim the same set of benefits as the US and UK. In fact, the situation is just the reverse there. Instead of having their trade deficits offset by lower prices, they actually face higher prices and interest rates!
Below is a chart of 10-year government bond yields in the same set of eurozone nations as above:
First off, let me say for the record, that these are estimates. In order to capture the data quickly, I used charts from the website Trading Economics; so I might be 5-10 bps off in some cases. I also added the US and UK bond yields for comparative purposes.
The second thing to point out is that I used two columns: one for the current yield and one for the near-term high (2010-2011). The reason I did this is so that you can see that the eurozone governments have had moderate success at knocking down the funding costs for some of the troubled eurozone states.
However, there’s still a very clear pattern: the eurozone nations that are doing well (i.e. those running current account surpluses) are the states with the lowest funding costs. The eurozone nations that are doing poorly are the states with the highest funding costs. In essence, there’s an economic distortion going on here.
Germany, by virtue of having a hot economy, should theoretically have higher inflation and would need to “cool off” its export bubble by increasing funding costs. Spain, by virtually of being in a major balance sheet depression (technical definitions aside), should have extraordinarily low interest rates in order to lower prices and help increase export growth. Instead, we have the exact reverse situation.
In this sense, the euro is a wealth redistribution system that takes money out of the economically weaker Southern states (and Ireland) — and gives it to the “Northern Block” nations like Germany, the Netherlands, and Finland. While this relationship does temporarily benefit the “Northern Block” of states, it does so while bankrupting their Southern neighbors; which then implicitly requires them to “bail out” those states. So it isn’t “beneficial” in the long-run to the Northern Block either, since it essentially puts them in the uncomfortable position of permanently supporting “zombie states.”
The Disease and the Cure
All this suggests that all the bank and state bailouts in the world won’t necessarily fix the underlying issues inherent with the Euro. The banking and sovereign debt crises are offshoots of the trade distortions created by the Euro. This is not to say that banks and governments aren’t to blame, as well; clearly Greece has mismanaged its finances and clearly many of the European banks have taken on absurd amounts of leverage. Ultimately, though, these problems are merely like adding kindling to an already-burning fire.
It’s the trade imbalances that are creating the eurozone crisis! That’s the disease! The bubbles, sovereign debt issues, and banking crises are merely the “symptoms” of that disease. The eurozone politicians are treating the symptoms, and not the disease.
They’ve attacked the banking crisis by creating a bailout fund for the banks. They’ve attacked the sovereign debt crisis by implementing austerity programs on the PIIGS. In fact, within the past two weeks, Portugal implemented an even tougher austerity program that’s likely to only exacerbate the problem further.
This is not to say that one should never treat “the symptoms” rather than the disease. After all, when we catch the flu, we can’t “cure it”, but we can alleviate the short-term pain. We can do this precisely because we know the disease will cure (i.e. self-correct) with time.
Business cycles are a theme throughout history and we’ve seen that normally the markets can self-correct the problems given time, just as a viral disease will normally get better with time. The simple fact of the matter is that people learn thier lessons if they are forced to take the pain.
If we have an infection, rather than a self-curing virus, however, things are a bit different. We need more than a bottle of Nyquil; we need an antidote! And the Euro’s structure is a disease that creates trade imbalances throughout Europe.
The US and the Eurozone
The United States caught the flu in 2007. The Federal Reserve pumped too much money into the system in the late ‘90s and early ‘00s, which helped ignite a housing bubble. The President and Congress spent like drunken sailors, thereby adding a fiscal stimulus on top of the Fed’s monetary stimulus. Then, banks and consumers decided to lever up and assume housing prices could rise forever. It all collapsed and now we’re sitting in the bed with a 101 degree fever.
There are, of course, problems to address in the US. We still have the issue of the TBTF banks. We still have dimwitted policymakers. But truth be told, our system has fought off this virus much better than most people realize. Even with all the carnage, we still only have 9.1% unemployment and most of the job losses are concentrated in construction and distribution related industries. At this points, US banks are very well capitalized and in correction mode. Once the housing market bottoms out, job growth will start to come back.
The Eurozone, on the other hand, has an infection. They can drink a bottle of Nyquil for three weeks straight and the problem will still be there. Until the trade imbalances that are created by the Euro’s dysfunctional structure are corrected, the disease will continue to manifest itself.
In the end, the Eurozone policymakers are going to have to decide between abandoning the Euro, on one hand, and fiscally integrating, on the other. As is, European poilcymakers refuse to go to the doctor to get an antibiotic. Instead, they’ve decided to continue chugging that bottle of NyQuil every night. Good luck with that.
I’ll continue buying American securities during this downturn, while staying away from the eurozone, until I see some evidence that they have finally convinced themselves to see the doctor and take this disease seriously.