November 28, 2011
Europe’s crisis has gone nuclear. For readers of this column, the endgame in Europe, which is likely to be a currency break-up, hardly comes as news. But the event itself will be traumatic for all of us. The most likely scenario is some sort of two-tier eurozone, where the euro breaks into a strong and weak euro. And yes, you guessed it: we will be in the weak camp.
The euro simply can’t go on as is. Even fiscal union (which would be a disaster for us, because our corporate tax rate would be the first thing to go) can’t help what is now a currency in its death throes.
The reason the euro is likely to be consigned to history is simple. As argued here for years, the currency is a profoundly destabilising influence because it amplifies credit booms and exacerbates normal recessions.
To examine this dilemma, let’s go back to first principles about how economic systems are supposed to work.
The most basic attribute of an economic system is that, when working properly, it smoothes the business cycle. The business cycle is a normal thing. When things are going well, human nature is such that we think that this will go on forever, so we become recklessly confident.
This causes us to do stupid things, like buying too much property at the top of the cycle and borrowing too much to finance this effervescence. This is a mistake.
In contrast, when things are going badly, human nature becomes too pessimistic and believes that the economy will never recover. We therefore sell too much in the downturn at whatever price we can get and, if we can’t find a buyer, we let prices fall further. We stop spending and save too much because we can’t see an end to the downturn. This, too, is a mistake.
The role of wise economic policy is to control these wild human emotions. When things are getting too hot, economic policy should cool things down and, when things are getting too cold, it should warm things up. Unfortunately, the euro does the opposite.
We all know what happened here in the boom. Too much credit fuelled too much optimism and more than a little bit of added local financial criminality, leading to disaster. But let’s not go over that again; let’s focus on what is happening right now.
In ‘normal’ economics – the economics you would learn in school or university – the rate of interest should fall when a country goes into recession. If a country has its own currency, there is no default risk premium. So lower activity leads to a lower demand for credit and a lower interest rate.
The fall in the rate of interest allows those in debt to pay their debts at a lower rate to reflect the lower income they have suffered as a result of the recession.
Conversely, there are those who didn’t take out debt and see the new economic paradigm as an opportunity. They can therefore borrow at lower interest rates. They take a new risk, borrow money, re-invest it in the economy and the economy begins to recover.
This is how things work in the US and Britain because they have their own currency. American and British long-term interest rates have never been lower because the system works and everyone knows that lower interest rates are necessary when the economies are in such a precarious position.
In contrast, within the euro, this ‘smoothing’ mechanism doesn’t work. This is because the euro is a ‘foreign’ currency for everyone. For Germans, the euro is too Italian, and for Italians the euro is too German.
Therefore, there are perceived risks everywhere. Money leaves Italy in a slum and gets sucked into Germany because the very foreignness of the currency makes investors feel safe only in Germany rather than Italy, which is actually using a foreign currency that it can’t print.
Therefore, ‘normal’ economics breaks down in the euro and is replaced with a perversion of traditional economics. Far from falling in a recession, the rate of interest actually and counter-intuitively rises in a recession, making things worse and eventually threatening a melt-down. Think about what happened here last year. As the economy slowed down, the rate of interest charged on Irish assets increased, rather than decreased. This is ludicrous.
Think of Italy in the past few weeks. As the Italian economy slowed down, the rate of interest at which the Italian government could borrow went up, not down.
This creates an enormous liquidity problem. As the rate of interest on Italian government bonds goes up, the price – and thus the value – of Italian government bonds goes down.
But who holds Italian government bonds? Why, Italian banks do. This means that the value of the Italian banks’ portfolio goes down as the price of the bonds fall.
Does this make them more likely to lend? Of course not, as they are now in a position where their balance sheet is weaker than before. What do banks with weaker balance sheets do? Do they lend? Of course not, they try to get money in rather than give money out. So they stop lending.
What does this do to the economy? If there is less lending, it makes the economy contract even more.
So the rate of interest in the euro – outside Germany – behaves in precisely the wrong way. This economic perversion, is made all the more problematic by the policy reaction of the mainstream EU economists.
In the face of the downturn where people are saving and not spending, and the rate of interest is rising not falling, the fools at the EU say that the answer is that the government should raise taxes and cut expenditure. But this means that the economy will contract more.
What do you think happens when the government reacts to a slowing economy by raising taxes? Obviously, the economy slows more. In Italy, to take the most current example, this increases the risk on Italian assets – and Italian interest rates rise more. How dumb is that?
Thus, unlike the US or Britain (or Japan in its 1990s crisis) interest rates in the peripheral countries of the eurozone rise in a recession.
This obviously means that the euro is a perversion when it comes to the ‘normal’ functioning of economic policy. Its inconsistencies make the problem worse. All this makes the break-up of the euro probable, because it is a destabilising influence.
In good times, the euro ensues that too much money flows into growing countries, pushing good, sustainable growth into dangerous boom territory. In contrast, in a recession, too much money leaves countries because investors believe that the country won’t be able to pay its debts. This makes a bad situation worse and drives recession to depression.
So what happens next? A two-speed euro is the most probable outcome now, where we and the rest of the periphery join a weaker, ‘soft’ euro currency, while the core remains in the ‘hard’ euro.
For the likes of the French, they had better drive this forward quickly because, the longer they wait, the more likely it is that France will join us in the ‘soft’ euro and that would be a political disaster for the euro federalist fetishists in Paris.
In reality, the political irony is that a two-speed Europe will not be instituted to save Italy, Greece, Ireland or Spain, but to save France.Â Plus Ã§a change, plus c’est la meme chose.