Posted by: Dirk | September 11, 2012

The new politics of austerity

It seems that the reality is starting to sink in that austerity is guaranteed to a) make things worse economically for your country and b) make re-election of the government imposing austerity all but impossible. Mariano Rajoy, who gave his first extensive interview since he became president, has nevertheless stated that the budget deficit is his priority number one (source: EL PAIS).

Meanwhile, Europe’s so-called periphery is getting more and more desperate as society turns into something dysfunctional, at least from the perspective of enlightened self-interest. Recent news include the looting of super markets in Spain by normal people out of a job (source: Guardian), the return of beggars to Cyprus (source: philenews) and following quotes from Wolfgang Schäuble as of this morning at the Bundestag:

The causes lie in the mistakes of the financial and economic policies which member states have pursued and (the crisis) can only be solved via these.

There is no comfortable way out of that, neither through pooling debt nor by casually using the bank’s printing presses.

Schäuble, of course, is wrong on both the ethical and the technical side. The euro zone problems have originated in the banking system, which built up a portfolio of non-performing loans in the years following the introduction of the euro. The design of the ECB has been faulty, letting the loan portfolio of some countries balloon to obscene size even though real estate bubbles (Ireland, Spain) were clearly in the making. Since member state policies are not the cause of the crisis they cannot be counted on to remedy the situation. (What does “solving” the crisis mean here in Germany? I have the feeling that to politicians it means that all creditors get repaid regardless of how badly they have invested the money.)

George Soros in his recent article The Tragedy of the European Union and How to Resolve It has it basically right (source):

In my judgment the best course of action is to persuade Germany to choose between becoming a more benevolent hegemon or leaving the euro. In other words, Germany must lead or leave.

Since all the accumulated debt is denominated in euros it makes all the difference who remains in charge of the euro.If Germany left, the euro would depreciate. The debt burden would remain the same in nominal terms but diminish in real terms. The debtor countries would regain their competitiveness because their exports would become cheaper and their imports more expensive. The value of their real estate would also appreciate in nominal terms, i.e. it would be worth more in depreciated euros. The creditor countries, by contrast, would incur losses on their investments in the euro area and also on their accumulated claims within the euro clearing system. The extent of these losses would depend on the extent of the depreciation; therefore creditor countries would have an interest in keeping the depreciation within bounds.

The eventual outcome would fulfill John Maynard Keynes’ dream of an international currency system in which both creditors and debtors share responsibility for maintaining stability. And Europe would escape from the looming depression.  The same result could be achieved, with less cost to Germany, if Germany chose to behave as a benevolent hegemon.

The continuation along the path that Europe is on right now will lead to a return of problems that (Western) Europeans haven’t seen in a long time. Technically, the solution to the crisis is easy. Cut down the debts of governments and households to acceptable levels, which is what Iceland did, and then rebuild the euro area institutions along either a roll back of the euro with Germany exiting first or build a better monetary system that avoids the problems that led to this crisis. However, this solution would cause a big political problem to whatever government would agree on it since the debts of some is the wealth of others.

Apart from this financial problem there is still the slight problem of external adjustment. Germany should turn into a net importer and the periphery into a net exporter the sooner the better. With austerity not helping much to achieve this, other routes must be thought about.

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