It’s been a busy weekend for finance officials in Europe. That’s a sure sign that things are getting serious. Weekend meetings in the northern hemisphere are all about getting a soothing message out before markets open in Asia on the Monday. We saw plenty of Sunday press conferences in the US during the dark days of 2008.
Last week was a shocker for Europe. The Irish bailout plan did nothing to assuage the markets’ fears about the financial contagion spreading to Portugal and then Spain. Bond yields in those countries rose significantly last week, making it more expensive for their governments to borrow funds.
So what went on over the weekend?
Well, European Union Finance ministers signed off on a €85 billion ‘rescue’ package for Ireland. More on that in a moment.
It was also proposed that Europe’s current bailout fund, due to expire in 2013, be replaced with a permanent ‘European stabilisation mechanism’, and that rules relating to private creditors and possible (probable) future debt restructurings be brought into line with IMF regulations.
According to a Bloomberg article, this means ‘investors won’t automatically take losses to share the cost with taxpayers as German Chancellor Angela Merkel initially proposed to the consternation of bond traders.’
The aim, of course, is to inject a shot of confidence into the market. Banking is a confidence game. It relies on someone lending to someone who lends to someone else, and so on. Once the chain of lending is broken, usually because of a loss of confidence, that’s when the game is up.
This is what is happening – in slow motion – in Europe. The market is slowly but surely losing confidence in the current structure of the Eurozone and the European Union (EU). But the determination of EU officials is heroic. They wont let the euro experiment fail without an almighty fight. Hundreds of billions of euros that don’t yet exist will be pledged to maintain the status quo.
But it can’t possibly work in the long term. Let’s look at Ireland’s bailout package to see why.
According to the Financial Times, of the €85 billion total, approximately €50 billion will supplement the Irish government’s finances (depleted because of their prior attempts to bail out their banks). Bank recapitalisations will absorb €10 billion while the remaining €25 will go to the banks if needed. (They’ll need it).
Now, in addition to being saddled with an extra €85 billion in loans, at roughly 6% interest, the Irish people will be subjected to a four year austerity package that aims to cut €15 billion in spending.
How the economy will achieve sufficient growth to pay down its debts is anyone’s guess. More importantly, will the Irish population actually allow the EU’s plans to play out?
This is where we come to the reason why the euro experiment, in its current form at least, is doomed.
What is happening in the peripheral countries of Europe now is similar to what occurred on a global scale in the Great Depression.
In the lead up to the 1930s depression, the global economy boomed on the back of massive credit expansion. The reasons behind the credit boom are complex but basically, the rules of the classical gold standard gave way to what became known as a gold exchange standard after WWI.
This allowed both the Bank of England and the Federal Reserve to pursue very easy money policies, particularly in the second half of the 1920s.
When the bubble burst, in 1929, the fact that currencies were still tied to gold meant that the adjustment had to be borne internally. That is, wages, prices, etc were required to fall to correct the imbalances built up during the boom.
Democracies are not especially equipped to deal with ‘internal adjustments’, which is another name for deflating an economy’s price structure to bring it back into balance. It can be done after minor booms (eg, 1921) but not after massive credit binges such as was experienced in the last 1920s.
And in the 1930s there was no social safety net. So it’s not surprising to note that Britain abandoned gold in 1931, the US in 1933, and France in 1936.
By abandoning gold, these countries effectively devalued their currencies and tried to shift the necessary adjustment from an internal to an external one. But when everyone tries to do the same thing, it loses its effectiveness. This was one reason (amongst many) why the Depression lingered.
Perhaps you can see the parallels in Europe today. Greece, Ireland, Portugal and Spain are all experiencing depression like conditions because they are tied to the euro. The euro allowed them all to party hard under low interest rates but its now its enforcing a long and painful hangover.
Under the current system, these countries cannot default on their debt and devalue the currency. Sticking with the euro will tie them to a painful internal devaluation. But without debt restructuring as well, this is likely to fail. In a few years time, their debt-to-GDP ratios will still be sky high.
This whole rescue business is about protecting the banks from defaults. The idea is to get the banks to build up their capital bases so they can begin to absorb some losses. But that will take years.
In the meantime, do you think these countries’ people will stand by and accept austerity measures while bankers and those who lent to the banks receive taxpayer-funded bailouts? Ireland has done so for a few years now but the political situation there is looking fragile.
Last week, the markets lost faith in the ability of the EU, ECB and IMF to hold the eurozone together. This latest series of announcements may take some pressure off for another few weeks, or even months. But the euro and the eurozone cannot continue to exist in their present form.