Greece and the Euro: Towards Financial Implosion
This incisive article by Professor Rodrigue Tremblay (image right) on the nature of the Greek economic crisis was written four years ago.
In response to recent developments, the author has written an update, which is published below.
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July 6, 2015
The EU Sows the Seeds of the Greek Economic Crisis
Prof. Rodrigue TremblayUpdate to July 2011 article entitled Greece and the Euro: Towards Financial Implosion
(scroll own for the July 2011 article)
In
sowing the seeds of the Greek crisis, European politicians have made
the same mistakes as American politicians before the financial and
banking crisis of 2008-09, that is to say encourage excessive
indebtedness of some economically weak countries with loan guarantees.
What really created the
conditions for a major financial and banking crisis in the U.S.,
starting in 1999 when the so-called Glass-Steagall Act of 1933 was
abolished by the administration of Bill Clinton, was the innovation of
insurance given to risky loans.
In the U.S., the regulatory
agencies that are the U.S. Treasury (controlled by mega banks) and the
central bank (the Fed) (controlled by mega banks) closed their eyes when
risky banking products were created, not the least being the famous
derivative products such as the mortgage-backed CDOs (collateralized
debt obligations) whose risk of default was artificially reduced with
insurance contracts (the famous Credit Default Swaps or CDS) against
payment default and issued by large insurance companies such as AIG
(American International Group). In doing so, borrowing was greatly
encouraged and bank lending became more risky. It resulted in a mountain
of mortgage debt, which led to the creation of a speculative housing
bubble that began collapsing in 2005, and which turned into a general
global financial crisis in 2008-09.
However, European politicians seem to have made the same mistake
as American politicians. In their case, they encouraged a rise in the
public debt of the poorest countries in the Eurozone by giving
guarantees against default to large banks if they continued lending to
them despite growing risks. This is what enabled a government like the
Greece government, for example, to continue piling on debt upon debt
even though lenders would have by themselves stopped lending, if they
had not received guarantees against default. Today, the Greek debt
represents an unsustainable 177 percent of its annual GDP (yearly total
domestic production). Indeed, when a country’s debt exceeds 100 percent
of its gross domestic product (GDP), creditors begin to get nervous.
They react normally by raising interest rates and by reducing the volume
of their loans.
But in Europe, politicians
wished to keep interest rates as low as possible on loans to the most
economically weak countries of the Eurozone. In doing so, they created,
in 2010, the European Financial Stability Facility (EFSF), with
guarantees from member States, in proportion to their participation in
the European Central Bank (ECB). At a minimum, the EFSF has secured 131
billion Euros of Greek debt. Thus German taxpayers, for example, are on
the hook for 41.3 billion Euros of guaranteed Greek debt, while French
taxpayers, through their government, are responsible for 31 billion
Euros of that debt, and so on for the other 17 member countries of the
Eurozone. In so doing, an economic debt problem has been transformed
into a major political issue.
Now, European politicians
who gave a public guarantee to a large part of the Greek debt fear the
political consequences if they were to pass the buck of the Greek
government’s default on its debt to their own taxpayers. On the other
hand, large banks and other lenders, confident in the guarantees they
obtained from other European governments, feel no inclination to
‘restructure’ down the Greek government’s debt. In other words,
everything is frozen. In a normal situation, creditors would bear alone
the risks undertaken in lending to a government already deeply in debt,
and they would have to write off some of the bad debt on the books.
This is
reminiscent of the American situation before the 2008-09 financial
crisis when mortgage lenders would not accept to reduce the mortgage
debts of borrowers because their claims had been secured against default
by insurance contracts to that effect. We know how it was resolved.
American taxpayers were called to the rescue of mega banks and mega
insurance companies, either directly through the U.S. Treasury or
indirectly through the central bank (Fed), the latter acquiring from the
banks toxic assets at full price. The same scenario is likely to occur
in the Eurozone, whether Greece remains or not in the monetary union. In
that sense, last Sunday’s Greek referendum on July 5 did not change
anything.
In the Greek
case, it has to be remembered that international investment banks,
especially Goldman Sachs, used derivatives and dubious accounting tricks
to camouflage the extent of the Greek government‘s debt in order to
meet the strict requirements to join the Eurozone and allow Greece to
join the monetary union. The main criteria to join the Eurozone are a
public deficit below 3% of GDP and a public debt level lower than 60 %
of GDP.
It
is on these last two criteria that Goldman Sachs assisted the Greek
government, in 2001, in presenting a rosy and false financial picture of
its real deficit and its real debt level. Why European banking
authorities allowed themselves to be lured by these tricks is another
matter that should one day be clarified.
Rodrigue Tremblay, Montreal, July 6, 2015
Greece and the Euro: Towards Financial Implosion
by Rodrigue TremblayGlobal Research, July 14, 2014
“If you can’t explain it simply, you don’t understand it well enough.”
Albert Einstein (1879-1955), German-born theoretical physicist and professor, Nobel Prize 1921
“It is incumbent on every generation to pay its own debts as it goes. A principle which if acted on would save one-half the wars of the world.”
Thomas Jefferson (1743-1826), 3rd President of the United States (1801-09)
“Having seen the people of all other nations bowed down to the earth under the wars and prodigalities of their rulers, I have cherished their opposites, peace, economy, and riddance of public debt, believing that these were the high road to public as well as private prosperity and happiness.”On the 4th of July, the credit agency Standard & Poor called Greece what it is, i.e. a country in de facto financial bankruptcy. No slight of hand, no obfuscation, no debt reorganization and no “innovative” bailouts can hide the fact that the defective rules of the 17-member Eurozone have allowed some of its members to succumb to the siren calls of excessive and unproductive indebtedness, to be followed by a default on debt payments accompanied by crushingly higher borrowing costs.
Thomas Jefferson (1743-1826), 3rd President of the United States (1801-09)
Greece (11 million inhabitants), in fact, has abused the credibility that came with its membership in the Eurozone. In 2004, for instance, the Greek Government embarked upon a massive spending spree to host the 2004 Summer Olympic Games, which cost 7 billion euros ($12.08 billion). Then, from 2005 to 2008, the same government decided to go on a spending spree, this time purchasing all types of armaments that it hardly needed from foreign suppliers. —Piling up a gross foreign debt to the tune of $533 billion (2010) seemed the easy way out. But sooner or later, the piper has to be paid and the debt burden cannot be hidden anymore.
Greece’s current financial predicaments (and those of other European countries such as Spain, Portugal, Ireland and even Italy) are not dissimilar to the ones Argentina had to go through some ten years ago. In each case, an unhealthy membership in a monetary union of some sort led to excessive foreign indebtedness, followed by a capital flight and a crushing and ruinous debt deflation.
In the case of Argentina, the country had decided to adopt the U.S. dollar as its currency, even though productivity levels in Argentina were one third those in the United States. An artificially pegged exchange rate of one peso=one U.S. dollar held for close to ten years, before the inevitable collapse.
Indeed, membership in a monetary union and the adoption of a common currency for a group of countries can be a powerful instrument to stimulate economic and productivity growth, with low inflation, when such monetary unions are well designed structurally, but they can also turn into an economic nightmare when they are not.
Unfortunately for many poorer European members of the euro monetary union, the rules for a viable monetary union were not followed, and its unraveling in the coming years, although deplorable, should be of no great surprise to anyone knowledgeable in international finance.
What are these rules for a viable and stable monetary union with a common currency?
1- First and foremost, member countries
should have economic structures and labor productivity levels that are
comparable, in order for the common currency not to appear persistently
overvalued or persistently undervalued depending on any particular
member economy. An alternative is to have a high degree of labor
mobility between regional economies so that unemployment levels do not
remain unduly high in the least competitive regions.
2- Secondly, if either one of the two
above conditions is not met (as is usually the case, since real life
monetary unions are rarely “Optimum Currency Areas”), the monetary union
must be headed by a strong political entity, possibly a federal system
of government, that is capable of smoothly transferring fiscal funds
from surplus economies to deficit economies through some form of
centrally managed fiscal equalization payments.
This is to avoid the political strains
and uncertainty when the standards of living rise in surplus regional
economies and drop in regional deficit economies. Indeed, since the
regional exchange rates cannot be adjusted upward or downward to redress
each member country’s balance of payments, and since the law of one
price applies all over the monetary zone, this leaves fluctuations in
income levels and employment levels as the main mechanism of adjustment
to external imbalances. —This can turn out to be a harsh remedy.
Indeed, such a system of income or
quantity adjustment rather than price adjustment is somewhat reminiscent
of the way the 19th century gold standard used to work, albeit with a
deflationary bias, except that it was expected to have price and income
inflation in surplus countries and price and income deflation in deficit
countries, caused by money supply expansions in surplus economies and
money supply contractions in deficit economies. In a more or less formal
monetary union, we are left with income inflation and deflation while
the central bank holds the rein on the overall price level.
3- A third condition for a smoothly
functioning monetary union is to have free movements of financial and
banking capital within the zone. This is to insure that interest rates
are coherent within the monetary zone, adjusted for a risk factor, and
that productive projects have access to finance wherever they take
place.
In the U.S., for instance, the highly
liquid federal funds market allows banks in temporary deficit in check
clearing to borrow short-term funds from banks in a temporary surplus
position. In Canada, large national banks have branches in all provinces
and can easily transfer funds from surplus branches to deficit branches
without affecting their credit or lending operations.
4- A fourth condition is to have a common
central bank that can take account not only of inflation levels but
also of real economic growth and employment levels in its monetary
policy decisions. Such a central bank should be able to act as lender of
last resort, not only to banks, but also to the governments of the
zone.
Unfortunately for the Eurozone, it currently fails to meet some of
the most fundamental conditions for a smoothly functioning monetary
union.Let’s look at them one by one.
-First, labor productivity levels
(production per hour worked) vary substantially between the member
states. For example, in 2009, if the index of productivity level in
Germany was 100, it was only 64.4 in Greece, nearly one third lower. In
Portugal and Estonia, for instance, it was even lower at 58 and 47
respectively. What this means is that the euro, as a common currency,
may appear undervalued for Germany but overvalued for many other members
of the Eurozone, stimulating net exports in the first case but hurting
badly the competitiveness of other member countries.
-Secondly, and possibly an even more
important requirement, the Eurozone lacks the backing of a strong and
stable political and fiscal union. This leaves fiscal transfers between
member states to be left to ad hoc political decisions, and
this creates uncertainty. In fact, there are no permanent mechanisms of
equalization payments between strong and weak economies within the
Eurozone. —For this reason, we can say that there is no permanent
economic solidarity within the Eurozone.
-Thirdly, the designers of the Eurozone
elected to limit the European Central Bank to a narrowly defined
monetary role, its central obligation being to maintain price stability,
while denying it any direct responsibility in stabilizing the overall
macroeconomy of the zone and preventing it from lending directly to
governments through money creation, if needs be. —For this reason, we
can say that there is no statutory financial solidarity within the
Eurozone.
Finally, even though capital and labor
mobility within the Eurozone is fairly high, historically speaking, it
is far less secured, for instance, than it is the case with the American
monetary union.
In retrospect, it seems that the creation of the Eurozone in 1999 was
more a political gamble than a well-thought-out economic and monetary
project. This is most unfortunate, because once the most estranged
members of the zone begin defaulting on their debts and possibly revert
to their own national currencies, the financial shock will have real
economic consequences, not only in Europe, but around the world.Many economists think that the best option for Greece and the rest of the EU should be to engineer an “orderly default” on Greece’s public debt which would allow Athens to withdraw simultaneously from the Eurozone and to reintroduce its national currency, the drachma, at a debased rate. This would avoid a prolonged economic depression in Greece.
Refusing to accept the obvious, i.e. an orderly default, would please Greece’s banking creditors but will badly hurt its economy, its workers and its citizens. That’s what bankruptcy laws are for, i.e. to liberate debtors from impossible-to-repay debts.
Of course, the most debt-ridden nation on earth is not Greece, but the United States.
Let me say this as a conclusion: If American politicians do not stop playing political games with the economy, a lot of Americans are going to suffer in the coming months and years, and this will spill over to other countries.
With Europe and the United States both in an economic turmoil, this is very bad news for the world economy.
Dr. Rodrigue Tremblay is a professor of economics (emeritus) at the University of Montreal and a former Minister of Trade and Industry in the Quebec government. He is the author of “The Code for Global Ethics, Ten Humanist Principles”,
