Economy

Eurozone Catastrophe: How Saving the Euro Could Mean Blood on the Streets

The whole future shape of Europe must be resolved in a week or so. It’s a high-stakes game of poker that the Germans are determined to win--at the expense of misery for many.

The eurozone story is changing by the hour. Here's what you need to know to understand developments that will impact the entire global economy and potentially cause major social upheaval.

The eurozone is facing two distinct, but related, problems: Problem #1 is a national solvency issue, which only the European Central Bank (ECB) can solve. Problem #2 is deficient "aggregate demand" (a fancy term for the spending power of consumers), which calls for a stronger fiscal policy response to offset declining investment and purchases in the private sector.

As it stands, the ECB is the only show in town to save the eurozone from a very drawn out and damaging recession. Why is that? Well, because the individual member states in the European Economic and Monetary Union (EMU) cannot spend without taxation revenue or debt-issuance, because they are usersof their currency, rather than issuers. This is a key distinction, and one often missed in media coverage. Their position is in sharp contrast to, say, the US, the UK, Canada, and Australia, all of which are issuers of their own currency and therefore not subject to the same kind of solvency risk because they are in control of their own money supply. The only institution in the EMU that can spend without recourse to prior funding is the ECB. That is the consequence of the flawed design of the monetary system that the neo-liberal conservatives in Europe forced upon the member states at the inception of the common currency.

As the issuer of the euro, only the European Central Bank is in the position of backstopping the eurozone nation’s bond markets, which allows these countries to fund themselves without paying the usurious rates of interest now being demanded for countries such as Greece. The problem is that the ECB is only willing to do so for countries willing to submit themselves to harsh austerity measures as a quid pro quo. This strategy might well save the euro, as it will diminish the markets’ concerns about national solvency. But the cost is likely to be yet even more depressed economic activity, higher unemployment, lower tax revenues, higher social welfare expenditures and, consequently, even higher public deficits. And isn’t that precisely what the Germans in particular most fear?

That gives you problem #2. If you have a continent full of consumers who have no money to spend and lack of competitiveness in the “PIIGS” countries (Portugal, Italy, Ireland, Greece, and Spain), then you'll consequently have years of sub-par economic growth. And unless the EMU's architecture moves in a much more pro-growth direction, then the continent will be afflicted with years of high unemployment and mounting social strains. Unfortunately, the EMU is captive to the same kind of thinking as the Germans, who continue to view this crisis as one which has been caused by fiscal profligacy in the periphery countries, rather than seeing it for what it is: a crisis of the euro’s institutional design itself.

For those nations unwilling or unable to subject themselves to the rigors of so-called Teutonic discipline, there might well be an exit from this newly-reconfigured eurozone – in effect creating a two-tier or multi-tier Europe, with a smaller eurozone and a host of competing national currencies for the “outs.” On the one hand, there would be a “hard currency” bloc led by Germany and the so-called “Benelux” countries (Belgium, the Netherlands, Luxembourg), all of which have largely converged with Germany’s economy. Then you'd have a “soft currency bloc," which could devalue its way back to prosperity through exporting cheap goods.

The problems here are that there are no real mechanisms in place to do this in an orderly way, so there would be a risk of a complete breakdown in the existing payments system. Additionally, countries such as France would likely get hurt if they were to join the hard currency bloc. Even though France likes to think of itself as a disciplined Teutonic style country, the reality is that its industrial/manufacturing/social profile is much more like a Mediterranean country such as Italy. Were France to join arms with Germany in a smaller currency bloc, it could face huge competitive threats from Italian industry (which would presumably not be part of this new German economic bloc). It is also questionable whether the French populace as a whole would withstand the kinds of restraints to living standards which the Germans themselves accepted in the wake of their country’s reunification in the 1990s.

Would Germany itself benefit from the introduction of a two-tier Europe? That's highly questionable. Germany could well suffer from a huge trade shock, as a result of the likely appreciation of the new currency, let's call it the “neuro.” A new system might also affect the living standards of the average Germans as well, as German multinationals might simply move manufacturing facilities to the new, low cost regions of Europe to preserve market share and cost advantage or, at the very least, use the threat of moving to extort cuts in wages and benefits to German works as a quid pro quo for remaining at home. If you go for the two-speed Europe, ultimately countries like Italy can devalue their way back to prosperity as their goods become vastly more competitive against German exports. Clearly, if a newly reconfigured Italian lira (or the introduction of some other soft currency) were substantially lower in value against a much stronger "neuro," this provides Italian manufacturers with a chance to sell their goods at substantially lower prices than their German competitors.

But wait! Germany’s large manufacturers originally bought into the currency union because they felt it would prevent the likes of chronic currency devaluers to use this expedient to grab a higher share of world trade at Germany’s expense. In fact, it is doubly ironic that Germany chastises its neighbors for their “profligacy” but relies on their “living beyond their means” to produce a trade surplus that allow its government to run smaller budget deficits. The truth is that Germany is structurally reliant on indebtedness and borrowing in other parts of the eurozone in order to grow at all. Over-spending of southern states is the only thing that has allowed Germany’s economy to prosper. It is mindless for Germans to be advocating harsh austerity for the southern states and hacking into their spending potential and not think that it won’t reverberate back onto Germany.

In the end, a "United States of Germany" under the guise of a United States of Europe, actually better suits German aspirations to dominate Europe politically and economically.

Now, of course, German Chancellor Angela Merkel may not consciously know all of these things. But it's clear to me that the political quid pro quo for greater ECB involvement in dealing with Europe's national solvency crisis is German control over the overall fiscal conduct of countries like Greece, Italy, etc. ECB head Mario Draghi is Italian, but he is playing a German game of chicken: he is embracing exactly the strategy that Angela Merkel's political director, Klaus Schuler, laid out to me two weeks ago: holding out for fiscal union commitments from the weaker "Med" countries, in return for turning the ECB into a lender of last resort. It's high stakes poker, and questions that affect the whole future shape of Europe need to be resolved in a week or so. Obviously this is one reason the Germans felt so comfortable in naming an Italian to the ECB. Trojan horses apparently don’t just come in Greek form these days. A Europe where countries such as Italy and Greece become client states provides a very effective outcome for Germany.

My base view remains that Europe is headed to a blood in the streets outcome. There is no plan B. The game is to just keep raising taxes and cutting spending even as those actions work to cause deficits to go higher rather than lower. So while the solvency and funding issue is likely to be resolved, the relief rally won't last long as the funding will continue to be conditional to ongoing austerity and negative growth. And the austerity looks likely to not only continue but also to intensify, even as the eurozone has already slipped into recession.

From what I can see, there's no chance that the ECB would fund and at the same time mandate the higher deficts needed for a recovery, because the Germans will never allow it. In which case the only thing that will end the austerity is blood on the streets in sufficient quantity to trigger chaos and a change in governance.

 

 

 

 


 

Marshall Auerback is a market analyst and commentator.