Posted by: Dirk | September 19, 2011

The European financial crisis turns ugly

The WSJ is said to have reported this first:

Swiss drug giant Roche Holding AG has stopped delivering its drugs for cancer and other diseases to some state-funded hospitals in Greece that haven’t paid their bills, and may take similar steps elsewhere, a stark example of how the European debt crisis that has jolted global financial markets is having a direct effect on consumers.

There are hospitals “who haven’t paid their bills in three or four years,” [CEO of Roche] Mr. Schwan said. “There comes a point where the business is not sustainable anymore.”

The implications of this will be clear to everyone, I guess: the crisis has to be solved now, now, now. Well, perhaps not really. Roche has announced that they will deliver more medicine to Greek pharmacies. Nevertheless, the situation seems to get more desperate as austerity measure fail to deliver any significant improvements on the fiscal side.

For those still not in the know, here is a quick sketch of what happened:

1) The euro was introduced in 1999 when exchange rates were fixed. The currency was then introduced in 2002 for use of the public. The idea was that growth should increase in the euro zone, by the following reasoning. Countries not reforming as fast as Germany lost competitiveness. They reacted by devaluing their currencies, or currencies were depreciating, depending on which monetary regime was in place at the time. This was deemed to be unfair, since after each devaluation German unemployment went up and Germany therefore had to pay the costs of adjustment. A good welfare state cushioned the fall of the ‘losers’. On the public sector side, it was understood that public debt in some countries were to high as countries reacted to weak growth by increasing public spending. This would not be allowed in the future, in which the stability and growth pact was supposed to rule supreme.

2) These ideas worked in theory, while in practice they failed. Countries that lost competitiveness reacted either by increasing their foreign debt or did not even have to react as German banks diverted capital flows exactly towards those countries. Huge real estate bubbles were financed in Ireland and Spain, while Greece with its problem of public debt is somewhat of an outlier. When bubbles burst, the financial sector was bankrupt, if assets had to be marked to market. Huge bail-out increased government debt in almost all countries. The recession led to a fall in taxes via increased unemployment, and the fiscal stimuli increased government debts further. The burden of adjustment is now borne by those unemployed in the periphery. Institutions in Spain, Greece and Portugal are not well designed to deal with persistent mass unemployment.

3) Adjustment via prices did not come about and could not. In order to be able to repay foreign debt, a rise in exports and a fall in imports would help. That could be helped by lower nominal wages. However, given nominal debts, the real debt burden would increase. Also, countries could not print their own monies, which meant that they would have to rely on growth via more exports and less imports. Since a devaluation is not in the cards anymore, spreads went up and up and up. Differences in productivity growth effectively destroyed the euro. It did not help that the ECB set one interest rate for the euro zone as a whole, by the way. Also, inflation-targeting turned out to be faulty as well, as the experience in the US shows even in the case of a currency area with ‘economic government’.

What to do now? Throwing money at the problem by bailing out banks and governments was kicking the can down the road, but not changing anything substantial. While politicians hoped for the confidence fairy to come to the rescue, it was clear to many that this would not be the case. Now there are two options on the table:

  1. more European integration and
  2. back to national currencies

Discussing both options would take too long. Let me just mention a few things concerning each solution.

  • 1a) European institutions are not democratic by any meaningful definition. Can the parliament sack the ‘government’ by a vote of no-confidence with simple majority? No. Is there ‘one man, one vote’ in European elections? No. Perhaps at least the European Parliament selects the President of the Commission and other members? No. We would need to fix the EU before we fix the euro or … forgo democracy.
  • 1b) The introduction of euro bonds would lead to calmness in the market for sovereign bonds. However, the austerity programmes in place have generated a negative growth/increase in public debt spiral which would not be solved by euro bonds. Countries must return to positive growth rates.
  • 1c) The EU does not have the money to introduce an investment scheme for those countries under IMF/EU/ECB administration. Acquiring that money would mean to use the existing European institutions: see 1a) Getting the private sector to underwrite such an investment programme would create more of the private gains, social losses institutions which have led us into this crisis. As it stands, the private sector does not invest in the periphery, so the market does not fix the problem. Governments won’t fix it because they cannot use expansionary fiscal policy. Printing money is ruled out and international financial markets are frozen (never mind the stability and growth pact, this would clearly qualify as an emergency).
  • 1d) Higher inflation in Germany would mitigate some problems and generally lead into the right direction. However, the ECB is an inflation hawk and sets the interest rate for the whole euro zone anyways. Another institutional road block. Oh, and while a fall in the euro might increase total economic activity in the euro zone (mostly in Germany), it would worsen the situation elsewhere. Neither the US nor China seem willing to let their imports increase and exports decline right now, I would say. They will do anything to counter a fall of the euro, like buying European sovereign bonds (I think this is what China wanted to say when they recently offered ‘help’).
  • 2) we have seen in the past that national currencies worked relatively well, without causing depressions.

As it stands, the euro as a common European currency is a failure. Two ways lead out of the crisis and back to stability. Either move back towards national currencies or towards more integration. I think the first one is a plan B which should work in case of emergency, and the second one is more ambitious and potentially can turn this mess into something beneficial. However, more European integration is a project that will take years. Before significant shifts of (economic) power to Brussels can happen, the institutions have to be overhauled. For the reasons given above, we need democracy at the European level. Only after this is established, more power can be transferred to Brussels, where it makes sense. Note that not all power should be centralized in Brussels, and that harmonizing everything is not the solution. Also, the policy makers must understand what the crisis is about. The recent departure of Jürgen Stark from the ECB is a step in the right direction, if one aligns him with the inflation-targeting/stability&growth-pact policy regime that has failed in the euro zone (as well as in the US, in the case of inflation-targeting).

In order to create a new European reform project, more time needs to be bought. Parties must work out proposals of reform, and the European elections in 2014 might be turned into one big referendum on what direction the coming change should take. In the meanwhile, constant fear-mongering from rating agencies should be stopped, either by the ECB through continuation of sovereign bond purchases – thereby turning itself into a bad bank – or the introduction of euro bonds in a ECB/EU framework, accountable to the public either now or in the near future.

Allocating the losses from the sovereign bond losses of the recent past (and future) is a political problem that can and should be pushed some more into the future. Only then it is possible, I believe, to reform the European institutions. If losses would be allocated now, the European climate would not be favorable for more integration – or downright hostile. Therefore, given that European reforms are agreed upon, the show must go on.



  1. […] 4 weeks ago I have published my thoughts on the euro mess we are in. Let me quote myself: As it stands, the euro as a common European currency is a […]

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