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The Eurozone's Vicious Circle

EconomicsPosted by john sloboda Thu, April 12, 2012 11:39:15

(This article posted on the web site of the New Economics Foundation puts Europe's financial problems, and the needed solution, in a nutshell. Why won't politicians do the right thing?)

Austerity measures won't save the continent.

James Meadway, Senior Economist

The eurocrisis is back, as expected. Greece is contained – at least for the moment – and attention has shifted to Spain. Twenty per cent unemployment, a shrinking economy, rising government deficits, and public and private debts totalling more than four times its national income have conspired to panic the financial markets. Spain has failed to hit the stringent borrowing targets set by the EU. Costs of borrowing for the Spanish government have shot up in the few days since Easter.

With weary predictability, the solution offered by the European powers is more austerity: sharp spending cuts now to reduce Spain’s deficit, and bring its public debt under control. Equally predictably, this is grossly misguided. Spain, up to 2008, ran consistent budget surpluses – unlike Germany. It was the financial crash of that year and the subsequent, very sharp, recession that provoked the deficits. As unemployment rose, and tax revenues fell, the gap between what the government spent and what it earned opened wider. The deficit exploded and the national debt rose.

Spain already had heavy debts. But they were not, in the main, owed by its government. They were owed by its citizens. By 2008, Spanish public debt was just 30 per cent of GDP. It has risen now to 79 per cent and continues to increase. But just as in Greece before it, by choking off economic activity, austerity actually increases the burden of the debt. In Greece’s case, its debt to GDP ratio was 130 per cent at the start of this round of crisis, in late 2009. By late 2011, after nearly two years of severe austerity, it stood at over 160 per cent. Spain, Ireland and Portugal have all suffered the same way.

Austerity is not just the wrong medicine for the wrong diagnosis. It is actively harmful. By insisting on austerity, the EU and major European powers are – in effect – placing the immediate needs of finance above any other consideration. It is hopelessly short-term at best and it is driving the whole continent into stagnation.

The imbalances behind the crisis

This is not a Greek crisis. It is not a Spanish crisis. This is a crisis of the European system. It is the direct product of deregulated finance and a dysfunctional single currency. During the boom years, easy credit masked real underlying weaknesses. Greater and greater injections of debt kept the European system moving. In particular, with different economies locked inside the single currency, effectively operating fixed exchange rates against each other, chronic balance of payments imbalances built up. In the north, countries began to run huge surpluses on their current accounts. In the south, these were matched by huge trade deficits, funded by debt. With currency adjustments ruled out, the imbalances became permanent. Spain ran annual current account deficits that reached 10 per cent of GDP or more, year on year.

When boom turned to bust, these deep weaknesses were exposed: and, worse yet, the debt overhang is immense. Spain is an acute example: a property boom, which at one point saw 12 per cent of the workforce employed in construction, was funded by cheap credit sloshing through the euro-backed financial system. Rising property prices helped drive greater borrowing. By 2007, average household debt had risen to 130 per cent of average household earnings, up from just 68 per cent in 2000. So government borrowing remained low, but private borrowing exploded. As the financial crisis broke, ending the property boom, those private debts turned bad. Spain, like the rest of Europe, now suffers from an immense debt overhang.

The problem of debt

Until that overhang is removed, the crisis will not end. The mechanism works like this. European banks, stuffed full of loans threatening to default, know they are weak. And they know all the other banks are weak. They fear collapse. This fear makes them reign in on further lending. As lending dries up, the risk of default and subsequent collapse increases. It makes perfect sense for each bank to tighten up its lending – they don’t want any more exposure to risk. But it undermines the whole system. This is the irrationality of private finance at work.

By the second half of 2011, this fear had begun to turn into a serious financial freeze. Spain and Portugal in particular were suffering enormously as capital retreated. Inflows of private funds, necessary to keep their economies moving, were drying up. In response to this, the new – unelected, note – head of the European Central Bank, Mario Draghi, authorised the flooding of financial markets with liquidity – hard cash. Tearing up the ECB’s own rulebook, over €1tr of new cash has been released electronically into European banks since December, through the so-called “Long-Term Refinancing Operation”

There’s nothing greatly “long-term” about this. The bulk of the new cash went straight back into the ECB’s own deposit accounts, European banks preferring the safety of the official institution to anything else out there. Very little went to businesses – the credit crunch did not end. But some went into buying up European government bonds, which, in the case of Italy and Spain helped reduce their costs of borrowing for a while.

These purchases, in turn, increased the banks’ exposure to those countries. With no recovery in sight, that debt threatens to default. That threat is now worse than it was before Draghi’s “rescue operation”. And the debt doesn’t need to actually default to allow fear and panic to spread disastrously throughout the financial system. The increased possibility of default is enough. Like an epidemic diseases, financial contagion can spread rapidly through the system, dragging country after country behind it. Spain is a big economy with substantial debts. But bigger still is Italy, with its €1.3tr public debt burden. It is also now back in the bond markets’ firing line.

Ending the crisis – the first steps

To break the crisis, two things need to happen. First, austerity must end. It is counterproductive, but it is followed because finance holds the upper hand. That means ending the swingeing spending cuts and looking to public investment to create sustainable jobs. Second, debts will need to be written off. They are the product of a bloated, crippled financial system and the rest of European society should not be expected to bear their burden. Nor can they: for as long as the debts demand repayment, prospects for any recovery are grim. For Greece, this will mean cancelling all of its outstanding public debt. For Spain, where private debt is the concern, this will require writing off household debts: a general amnesty being declared, perhaps along the lines recently implemented by Iceland. Of course, this will damage the banks; they will need nationalising and – unlike our own dear RBS, where public servants ape private greed – run democratically in the public interest. Capital and exchange controls, to prevent financial markets spreading contagion, will also be required. Countries like Spain and Greece will need to exit the euro to be in with a chance of achieving any recovery.

Until a serious break is made with the errors of the past, the continent will remain trapped. As things stand, there are no realistic prospects for recovery – although those who believe in magic free-market fairies may want to offer unrealistic ones. The pattern is familiar: each attempt to stave off the last crisis prepares the way for the next, worse, round of panic. That vicious circle must be broken, and broken in the interests of the people of Europe. The protests against austerity, from the occupations of the squares to the strikes, show the way forward.

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