Edmund Phelps on Why Germany is Right to Ask for Austerity

Edmund Phelps has a good op-ed piece in yesterday's Financial Times. He offers a different perspective on the crisis in Europe, arguing that it is not caused by the euro and that the fix is not to aid the insolvent in order to avert defaults.  Instead, he claims that a combination of Keynesianism and "corporatism", which he defines as, "...state projects serving cronies and vast social protection programmes, both run by elites." He argues these programs surged in the 70s and 80s in much of Europe.  By the mid-1980s Italy was running sizeable fiscal deficits and the same for France in the early 1990s.  In 1990 the Basel I agreement lowered a bank's capital requirement on sovereign debt to zero, which increased public debt.

Phelps continues, "This was wonderful in the Keynesian view: more wealth supported rising consumer demand. In the 'structuralist' view, however, it spelt trouble." Both Italy and France saw productivity growth stop in the late 90s. Incomes increased but based on debt rather than productivity. Eventually, credit markets recognized the problems and interest rates increases. Given the interconnections among European banks and the governments, all are nearly insolvent.  Phelps examines some ways in which Italy, France and Greece could move away from the status quo, but I think are unlikely to take place.

Phelps concludes by arguing that there is a split between those who want to continue with corporatism and Keynesianism, and those who want greater fiscal responsibility and a well-functioning capitalistic system. 

For anyone who has access to the newspaper, the article is worth reading and remembering.

On Europe, Again!

Europe remains the focus of much of the business news.  In the NY Times, German economist Hans-Werner Sinn offers an op-ed on why Berline is balking at a bailout.  His basic argument is that the kind of risk-sharing demanded by some pundits and politicians is only possible if the euro-zone were actually a nation with a contitution and a common legal superstructure.  Meanwhile, Gerald O'Driscoll opines in the WSJ that the euro will fail.  He cites Milton Friedman who predicted the euro would fail within ten years.  It has lasted longer than that, but O'Driscoll thinks failure is almost certain. He concludes his column with the idea that the EU should have adopted political union before creating the euro and not the other way around.  Another column offers support for Merkel's approach, arguing the lack of leadership is in the debtor nations. The lead article in the WSJ is on the spreading threat in Europe over the euro crisis. Another article focuses on Italy.

O'Driscoll referred to the time as a crisis, meaning the original idea of the Greek work that underlies the English word--a turning point. Either the currency will fail or it will recover by the euro-zone adopting more fiscal and political integration.  While O'Driscoll thinks it will fail, I still think there is a good chance the greater political integration will occur.

Is Berlin Worrying Too Much About the Wrong Historical Period?

There is an interesting op-ed in the Financial Times by Niall Ferguson and Nouriel Roubini. They point out that Europe has dithered over recapitalizing their banks, often relying on sovereign debt to do so. Of course, the sovereign debt is part of the problem now.  They also argue that Germany is key but Germany is focusing too much on the hyperinflation after WW I and not enough on 1933.  They offer some solutions that could be worked, and note that the monetary union always implied further fiscal and political integration, a point I have often made.

They conclude with:

Ultimately, as Angela Merkel, the German chancellor, herself acknowledged last week, monetary union always implied further integration into a fiscal and political union. But before Europe gets anywhere near taking this historical step, it must first of all show it has learnt the lessons of the past. The EU was created to avoid repeating the disasters of the 1930s. It is time Europe’s leaders – and especially Germany’s – understood how perilously close they are to doing just that.

Soros on the Euro Crisis

An interesting speech by George Soros on the euro crisis and the financial crisis. While not endorsing all of his points, it is worth a read.

Doom and Gloom

The news remains bad.  A NY Times article reports that the Greek government may not have enough revenues to pay its bills, such as paying employees, as early as July. The steep recession is reducing government revenues. Another article reports that Spain may need help soon because the risk premium on their bonds is becoming too high. The G-7 are holding meetings on the crisis in Europe and maybe something will come out of that. (Article here). 

A column by Martin Wolf is entitled, "Panic Has Become All Too Rational." He notes a lot of reasons to be gloomy about he world economy.  He describes the West as in a contained depression. Deflationary forces are at work as households are reducing debt levels by spending less and savng more. Government policies have prevented it from becoming a full-fledged depression, but austerity is altering that. The scariest comment he makes is that he used to wonder how the 1930s could have happened. Now he understands. Clearly, Wolf thinks it could happen again.

Is Europe Lurching Toward a United States of Europe?

Being in Germany and reading a lot on the euro crisis, I wonder if it is similar to what it would have been like in the months leading up to the Constittutional Convention that generated the U.S. Constitution in 1787.  The loose confederation of states was perceived as not working well. The men at the convention tried to hammer out a new government that would provide more integration among the states and establish a federal system with checks and balances, powers retained by states, and a federal government above all.

Each day here new articles appear that suggest further integration, then counter views, and then another step towards further integration.  Today is an example. According to an article in today's NY Times,  Germany is signalling some willingness to pooling of debt but not eurobonds. (Article is here). An article in Financial Times writes of Germany banks oppositon to some forms of a stronger banking union. The European Central Bank meets Wednesday and some speculate it may try to do more because Europeans are getting very nervous about the euro crisis. (Article is here.)

A Financial Times op-ed argues that Europe needs a Lehman moment and a Greek exit could provide that. A former head of UK Investments with Lehman Brothers, Michael Tory, writes that the American public suffered from bailout fatigue after bailouts to Fannie Mae, Freddie Mac and Bears Stearns.   Attempts to stop contagion bank by bank wasn't working and a recapitalization of the banking system was needed. There was just no political will for that action.  The Lehman bankruptcy changed things. Quickly action was taken as Ben Bernanke and Treasury Secretary, Hank Paulsen, scared Congressional leaders into action. TARP was the end result.  Tory argues a Greek exit could provide the same stimulus to action and force European leaders to take action. Tory writes, "They would face a very clear choice: unite immediately behind a comprehensive fix to secure the countries next in line (Spain, Portugal, Ireland etc) or watch the entire eurozone project disintegrate."

One part of the Lehman story Tory leaves out.  The American public did not like TARP. This is true for those on the left and the right.  Republicans who voted for TARP faced Tea Party candidates in primaries in the 2010 elections and most of them lost to the Tea Party candidates.  The politicians may have done the right thing, but they paid a price for doing so.  Might some European politicians take that as a lesson from the American experience?

Spain Calls for Centralized Control of National Budgets

Spain has called for centralized control of national budgets in the euro zone. Clearly, this is a move toward more fiscal coordination or even control by Brussels. An article in today's NY Times suggests the euro zone is lurching towards a crossroads--either it will move towards more centralization of fiscal policy or the euro will fall apart. There are renewed calls for creation of a Eurobond, which Germany still rejects.  Germany has called for increasing the powers of the European Commission in Brussels.  Ms Merkel's plans are longer term, requiring treaty changes.  Spain doesn't have that much time. Throughout the "Greek crisis" many have noted that the real concern isn't Greece but Spain. The latter is a much larger economy and any bailout at a scale large enough to be effective will be very expensive.

Martin Wolf on German Self-Interest

Martin Wolf has an interesting piece in today's Financial Times. The newspaper also has a series on the euro crisis, including a diagram showing how Greece could exit the euro zone and what the consequences would be. I believe a subscription is necessary to see the full column though so I will briefly summarize Wolf's column, "The Riddle of German Self-Interest."

Wolf says the crisis is clear, and he focuses on Spain and Italy because of their size. They are unable to manage their debts without some assistance. Much of the government's debt is held by the banks in the countries.Some of the debt has been generated to help the financially weak banks. Wolf uses a common metaphor to describe this--two drunks trying to hold each other up. Wolf argues that the austerity required by the EU is ineffective because the private sector has already gone to austerity and declining government spending keeps GDP going down. As he puts it, "The reward for pain today is pain tomorrow."

He then looks at how Germany wants the euro zone organized. He believes it is no to eurobonds, no to increase in funds for the European Stability  Mechanism, no to monetary expansion, and yes to austerity. So how do the German authorities think the slide in the periphery nations will be halted? Wolf offers two hypotheses. First, Germany believes the weaker nations will eventually pull out of the euro leaving a smaller but more stable euro. Second, they think their policies will work and things will turn around. Wolf doesn't think it will work. In fact, he thinks Germany is shooting itself in the foot since Germany relies on exports to other EU countries so heavily.

Wolf's final paragraph is:

"In October 1939, Winston Churchill said: “I cannot forecast to you the action of Russia. It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is Russian national interest.” The key in Europe today is Germany’s perception of its national interest. Once it becomes evident that their conditions will not work, German leaders will have to choose between a shipwreck and a change in course. I do not know which Germany will choose. I do not know whether its leaders know. But on that choice hangs the fate of Europe."