The Europe of Broken Dreams, Part 5: Default20th February 2013

I’ve taken an extra couple of days to prepare this blog, for the issues it raises and the potential threats it portends should not be taken lightly. You have been warned.

We finished our previous blog, part 4, on Europe by suggesting that the struggling Eurozone states, who are in a mess as currency users rather than issuers, may have just three choices:

1) To meet the austerity criteria required by the ECB, which can’t work because even in the unlikely event that they eventually sort out public sector debt, private sector debt is still far too high, and in democratic systems voters generally lack the inclination and patience to support such policies.

2) They attempt austerity through a technocrat who faces the same hurdles, who also ultimately fails.

3) Default, which is the focus of today’s blog.

From previous articles in this Eurozone series we have covered the manner in which money is created (blog 1), that Eurozone bank leverage at 26:1 is far too high (blog 2), that insolvent states entwined with their insolvent banks have stuffed them full of their worthless debt (blog 3) and that the unspoken response of states is consistent financial repression (blog 4).

All efforts to overcome a problem require an accurate identification and communication of the underlying problem. But instead we have policy responses with no attempt to accurately convey the issues to the voting public. This continuing act of denial is a decent definition of madness, and burns up time that could be put to use to create a reasonably orderly solution.

Default …

Lets be clear. When I talk about default, that isn’t something that can occur in the UK or US, because currency issuers can conveniently print enough money to repay what they have previously borrowed. Even if inflation has eroded real spending power, a £ is still repaid with a £, a $ with a $. If you protest that inflation is a form of default I absolutely agree with you, but that will be the subject of a later blog.

Real noticeable default is something that can happen to individuals, businesses and states as currency users. They all face a fundamental solvency constraint; if they spend more than their income they need to borrow, and if they cannot borrow they simply run out of money. In the Eurozone the ECB is independent of the individual sovereign states and won’t simply step in to save them with no questions asked.

In the absence of this ability for states to create their own money we have witnessed all manner of juggling to keep the balls in the air, but when Greece was refinanced we saw some real haircuts. First we saw the market re-pricing Greek government debt to very low levels. Then the first haircut round saw private sector holders of Greek government bonds being told they wouldn’t get all their money back, i.e. a permanent haircut and default, as suddenly a promise to repay a € with a € was not to be. And then the same happened to state and similar institutional holders. But it seems that use of the word “default” was officially discouraged!

And now things are building up again …

When Eurozone Prime Ministers and Finance Ministers announce that the crisis is over, or the worst is over, thinking people know that there is a reason for such statements, and its not because things are getting better. But when Eurozone Prime Ministers announce, as Mr. Rajoy of Spain has just done, that “it is not enough, there are no green shoots, there is no Spring …” you can sense panic in the air. He has promised a second wave of reforms, but has already used up most of the country’s social security fund to buy-up Spanish government debt! That’ll come back to haunt him and the Spanish people.

Yes the efforts to achieve Eurozone fiscal and banking union, if they really get there, may help the solvency problem, but that is far removed from returning so many different cultures to a widely prosperous economy.

States are starting to discover, but failing to admit, that successful economics isn’t about them being able to fix things with financial engineering and mathematical modeling, or about central bankers achieving “escape velocity”. Real economics is about the individual decisions of millions of individuals, or “human action” as the great but sadly overlooked Austrian economist Ludwig von Mises stated back in 1949. Without confident and motivated people the economy won’t create a healthy balance between capital investment and employment, and state macro and micro management just gets in the way. So where does this state planning take us?

The next default …

Over the past few weeks Cyprus has been deeply troubled. Not just a holiday island, Cyprus has a huge financial sector, and the scale of the bailout apparently required is close to 100% of Cypriot GDP.

The Financial Times broke a story by Peter Spiegel and Quentin Peel on 10^th February: “A radical new option for the financial rescue of Cyprus would force losses on uninsured depositors in Cypriot banks, as well as investors in the country’s sovereign bonds…” The leaked Eurozone memorandum talked of a “bail-in”, as one of three alternatives to a “bailout”.

The unique nature of a bail-in is that bank bondholders and depositors carry the can for keeping their money in a dud institution. Alongside government bondholders losing 50% of their capital in a huge haircut, this option would cut debt dramatically, but you can already see the queues forming outside the doors of the affected institutions as depositors rush for the return of their cash before Default-Day. No doubt about it, default creates panic.

I stress this is only an option, but the fact that these issues are being talked about demonstrates, finally, that the depth of the crisis is starting to be properly considered in official circles. Talk of default is never welcome, but like personal or corporate insolvency, it does clear out un-fundable legacy problems and can help the survivors return to a productive lifestyle. The truth will out, and maybe this will lead to states living within their means.

The Eurozone response …

Recent efforts on austerity or growth when there is already so much unemployment and so much state and private debt in the system cannot have more than a marginal impact on the Eurozone’s debt problems. Economist Richard Koo is well regarded for his comments on the “Balance Sheet Recession,” a type of long-term economic nightmare for which short-term fixes achieve nothing. Individuals, businesses and banks need to re-trench, steadily reducing their reliance upon debt, before regaining the confidence to invest. But we have lived in an era of economies driven by “consumption”, whether by our own spending or by the public sector. In what is known as “the paradox of thrift” consumption won’t grow whilst everyone is trying to pay down debt, and in conventional economic understanding you need growth to pay down debt. Perhaps there is no real solution to this other than time?

Austerity only works if competitiveness is eventually enhanced. In the Eurozone what we have seen is a massive collapse in demand, but with no complementary improvement in competitiveness to help the Eurozone strugglers climb out of the hole they find themselves in. This achieves nothing. If they had individually floating currencies (i.e. pesetas, lira, drachma or francs rather than Euros), then imports could have reduced (as they became more expensive relative to domestic goods and services) whilst demand for internally produced goods and services might have been sustained. Weak currencies cause many other problems, but this action could have avoided much of the strife we have witnessed, and with Eurozone states tied to the Euro this has not been possible.

To boost competitiveness also requires significant and permanent cuts in regulatory costs and restraint, unfettering individuals and businesses so they can get on with employment and trade. This gives a troubled economy a chance of making its way in a competitive world. Sadly, it seems that states find this the hardest thing to do, but at least some Eurozone members are trying, just a little bit.

In the short-term governments can ease the pain by continuing to keep the pot boiling by providing liquidity to the banking system and sustaining excessive state spending. In a time when money supply is otherwise collapsing this can help enormously, without triggering an inflationary surge, but it causes other long-term misallocations that, unchecked, steadily destroy an economy from within. One could argue that this is what got us into trouble to start with, as politicians never like to let constraint of spending or credit creation get in the way of a good vote. We have certainly seen plenty of this.

So the Eurozone response has been to try austerity, with some very modest rolling back of state restraints on enterprise, with huge monetary lubricant. Deficits have even been coming down in relation to GDP. But that means borrowing is still going up, and GDP is generally declining. Bad situations just keep getting worse.

As currency users, the Eurozone’s sickly states remain stuck in this silo of demand-side economics, misallocated credit and poor competitiveness, with inadequate decision-making prolonging the real agony.

Which brings us back to default …

With none of the actions taken so far being workable or permanent solutions, we are back to default. Some say that this is morally hazardous, as those who have borrowed should pay their dues, Shylock style, and in a normal environment I would agree that one should strive to do just that.

But others would say that we have gone far too far already. Consistently saving bankrupt institutions (whether states or banks, when a free market would have seen them fail long ago) is where the moral hazard lies, as it only encourages continued unsustainable behaviour and false promises, places obligations on future generations, prevents any form of recovery, denudes remaining capital even further, and only prolongs the pain before the ultimate and inevitable bust.

Just imagine being a bank in France, right now, with a shrinking economy and foreign investors shirking from the idea of running production plants in that country because of taxation, employment laws and union practices. As the US CEO of Titan Tyres recently wrote to Les Echos, a French newspaper, “You think we’re so stupid!”

And now we have imminent Italian elections, where Berlusconi is promoting a policy of “arrivederci”, to leave the Euro. What then happens to all the government debt denominated in Euros that can never be repaid in a much weaker new Lira? Despite legal obligations, it would seem that default would be inevitable, and even attractive to the voting populace. So what happens to the Italian banks and European institutions that have bought reams of Italian government debt that can no longer be fully repaid?

The deflationary fall-out doesn’t bear thinking about, but maybe it was inevitable all along. Whether the Eurozone imposes default (as it has contemplated with Cyprus), or the individual states vote for default, it is hard to see any other meaningful outcome.

We need to end on a positive note …

In contrast to the demand-side, which seems to require ever more money and growth to sustain itself, the supply-side school of economics argues that in order for there to be consumption, the goods need to exist in the first place. No-one knew they wanted to buy an iPhone or iPad before they were invented, but supply of a great product generated huge demand. Human ingenuity is the supply-side, creating new things that are better or cheaper than their alternatives, or opening up new opportunities for improved lifestyles for the producer and consumer, for investors and the workforce. This is what we need to encourage, and the best way of encouraging it is for the state to get out of the way. If it takes a deflationary bust to get there, well maybe we’ll all be grateful in the long run.

It was only 5 weeks ago that our first Eurozone blog reported how quiet Europe had become … too quiet. Those words are proving seriously prophetic.

If you have any thoughts, comments or counterpoints arising from this series of Eurozone blogs then I’d be very interested in hearing from you. Please do get it touch, and I’ll happily post the most thought-provoking.

Back to lighter, shorter, but no less important issues next week.