It Works Until It Doesn’t

The Euro came into being in 2002, replacing many national European currencies with a common currency. There are 16 members, with the largest economies being the Germans, French, Netherlands, Italy and Spain. The launch of the Euro was done successfully and it brought down transaction costs and financing costs across the Euro area, and was part of a broader movement of labor and services across the region (not as simple as the currency conversion, however).

The Euro was originally at around 80 cents to the dollar; it has gone as high as $1.50 to 1 USD and currently ranges around $1.30 – $1.40. This appreciation has been significant, caused both by policies that weakened the USD and strengthened the Euro.

While the Euro has been a successful currency and has brought benefits to the region’s economies, particularly the weakest economies (like Greece, Spain, Italy, Ireland, and Portugal, the “PIIGS”), recently the region has had difficulty with high budget deficits and the specter of outright default in these weaker countries.

While all parties benefit from having the Euro, some parties benefit more than others, and are “free riders” – particularly the weak Mediterranean countries that would never have such low financing costs and ability to easily raise funds in the bond markets without the implicit backstop of the German, French and Dutch treasuries.

There have been various crises that the Euro has faced, and the countries have responded to claim fealty to the Euro and pledge support to the flimsiest members. Notably there is the crisis in Greece with monstrous budget deficits, almost no tax compliance and a completely uncompetitive economy; and the crisis in Ireland, whose country and banks have been knocked flat by a giant bubble in the property sector.

Now, however, the core problem is rising again, which is the fact that at some point the rich countries will have to officially “backstop” the weaker countries or they will not be able to refinance their mounds of debt at favorable rates, which in turn will topple their finances like a Jenga tower with the bottom block yanked out.

This happened in the United States; when the crisis hit in 2008-9, the US Government effectively nationalized Fannie Mae and Freddie Mac and took over the US housing market, probably picking up $400 billion or so in losses, as well as backstopping US banks, GM, and even many states and local government entities through various stimulus measures and “Build America” bonds. While painful, at least the US government was bailing out US entities; while we can gnash our teeth and call for punishment (including criminal punishment) for those responsible, at least we are trying to clean up our own mess.

But it seems incomprehensible that Germany and other strong Euro-zone countries will just indefinitely prop up the spendthrift and uncompetitive countries; it isn’t that this is a liquidity crisis (short term cash flow) – this is a solvency crisis, meaning that they can’t pay their bills now (at incredibly favorable interest rates that they received today with Euro financing and the implicit backing of the strong countries like Germany, which will soon evaporate) or later; the debt burden is just too high. And Germany isn’t linked to say, Portugal, the same way that the United States is bonded together. Would the US risk our currency, solvency, and standard of living to backstop another country; maybe if the impact was small, but not forever and not if the impact was large to our net financial position, especially if it wasn’t linked to an imminent military conflict.

Assuming at some point the rich Euro countries give up the ghost, then the smaller countries won’t be able to finance their debt in the markets at reasonable rates, and some sort of restructuring will occur. Perhaps they will get some help, and each may have unique fates, but the current plan of implicitly relying on the stronger countries will evaporate.

This doesn’t necessarily mean that the Euro is dead; we will just move into a new era where countries will have to deal with the consequences of huge deficits each in their own way and take their own steps to be competitive and get their finances in order. It isn’t clear what happens next.

The lesson for us in the United States isn’t to be smug; it is to be terrified. While the US has many advantages over these other countries, we need to realize that confidence in the markets exists, and then it is GONE. There may be signals in advance, such as the earlier crises that hit the Euro, and today’s TARP and ultra-low interest rates may be our same markers towards insolvency.

It works until it doesn’t.

Cross posted at LITGM

9 thoughts on “It Works Until It Doesn’t”

  1. Carl, I beg to disagree about the weaker economies. Greece was helped by Goldman Sachs to cook their books to gain entry. The Germans and French all knew the condition of the government and the temperament of the people. They turned a blind eye, figuring they could leverage it somehow. So they were also complicit in allowing entry and they took advantage of the Greeks in doing so.

    The Italians, who realized the problem in plenty of time — which was being locked into low interest rates and prevented from raising rates or devaluing currency to correct the problem at the outset — did not have the nerve to leave the euro when they should have.

    The Irish government and their “jobs for the boys” ruling destroyed this country ( I live in Ireland) despite the public voting down Lisbon the first time. The public was coerced “to get it right” the second time. The Irish taxpayer should not be responsible for the banksters’ manipulation of fictitious accumulated debt that has nothing to do with them or the people of any of the eu nations. We are scapegoats and patsies in this.

    I leave you with this thought : Debt to Whom and for What, precisely?

  2. While I have some sympathy for the richer countries in the European Union, it seems to me that there are two sides to every transaction and that Germany et. al could hardly manage to run a consistent surplus without the PIIGS countries. Those countries wouldn’t be able to run deficits if someone wasn’t willing to loan them the money so the blood seems to be on the hands of all countries in the EU. It seems to me that the issue is a great deal more complex than the rich are going to have to backstop the poor.

  3. The lesson for the US is still the same. The Greeks and the Irish enjoyed the bubble and then it ended. Even though I knew it was illogical, I enjoyed the absurd value my house assumed. Even though I was appalled at the prices I saw on new homes, it didn’t occur to me that the “value” of my own home could fall so far. Hard lessons are still lessons.

  4. Dont forget that no matter how well the German govt may keep it’s books, it is German banks who foolishly lent into the Irish property bubble that are really being bailed out in the irish bailout (ad they are the major bond holders).

  5. Maybe, look at it this way. The backstopping by Germany is the price they have to pay for their successful colonization of the Mediteranean countries. Hitler tried to take over Europe, and he paid in defeat. The post WWII Germans have gotten workers, markets and warm vacation spots from their southern neighbors. Now they will have to pay the bills, but Josef SechsFlaschen (sorry, lame) probably won’t go along with it quietly.

  6. I think there are a lot of valid comments here and I am not an expert on all topics.

    In particular, I was just saying that in the end it seems unlikely to me that the rich EU countries will indefinitely backstop the poorer countries and that it all must come to an end.

    I don’t know what this means for the Euro but the weaker countries will not be able to issue debt at these low rates which will likely push them into insolvency.

    What happens next is that the countries will have to find a way to work it out and likely will get some, but not nearly enough, international assistance.

    Agreed that this will start to smash the banks that hold all this PIIGS EU debt as if it was issued by Germany, when it isn’t. If they are smart they are probably dumping this already on whomever will take it.

  7. I think we should call the PIIGS the GIPSI. After all, that seems to be the order in which this crisis will eventually unfold.

Comments are closed.