Updated: Beware! Austerity without end will not work and will endanger Europe!

Substantially Updated 12th November 2011

Bitte bedenken Sie! Einschränkung ohne Ende wird nicht funktionieren und kann das gesamte europäische Projekt ernsthaft schädigen! Wir müssen bessere Möglichkeiten finden, um das Wachstum in den südeuropäischen Ländern zu unterstützen. Ein taktischer Rückzug ist notwendig. Zum Beispiel könnten weitere Währungen und weniger Rentenmärkte erforderlich sein. Vollständige reserve banking eingeführt werden sollte. So europäischen Staatsschulden sollten durch private Spar-und Anlageform finanziert werden, während Geschäftsbanken sollten neue Anleihen auszugeben.

Méfiez-vous! Austérité sans fin ne fonctionnera pas et risque d'endommager sérieusement l'ensemble du projet européen! Nous devons trouver de meilleures façons de soutenir la croissance dans les pays d'Europe du Sud. Un retrait tactique est nécessaire. Par exemple, plus, en parallèle, les devises et les marchés obligataires moins peut être nécessaire. La pleine réserve bancaire devrait être introduit. Ainsi européenne des dettes souveraines devraient être financées par l'épargne privée et des dépôts, tandis que les banques commerciales doivent émettre de nouvelles obligations.

* * *

The Eurozone crisis has two elements: a crisis of competitiveness and a financial crisis. We can solve the financial crisis (as perhaps is now being done) but the underlying competitiveness crisis remains. It is the competitiveness crisis that shows the underlying structural problems of the Eurozone, and it is this problem that must be solved at all costs for the entire future of the European project (a project, of course, that Britain has never truly bought into... but that is another story).

How can the Eurozone crisis be solved? This article will describe possible solutions. The most important point to recognise is that the leading Eurozone countries (Germany, primarily, but the other members of the Eurozone too) must be able to recognise that mistakes have been made, as a first step to solving it. Austerity without end simply will not work, and may destroy much of the credibility of the entire European construction.

* * *

In the summer I visited the Pyrenees Mountains in southern France. One day, my sister and I went for a walk. All was well until we lost the main path. So we walked on, up the valley that we expected to take, and then finally got to what we thought was the right path. The guidebook informed us that we would find a lake and then a barren lunar-like landscape. We found these things, but the walk was taking us much longer than we expected. The guidebook then suggested that we should climb until we reached a ridge. We saw a ridge in front of us, but by this time it was nearly 6pm and we were less than half way through our walk. Suddenly it dawned on us that the ridge in front of us was close to the summit of the Pyrenees, and the direction we were taking was west when the route was supposed to take us North. We were in the wrong valley.

I mention this episode because it shows the necessity of recognising a wrong turn. Sometimes we need to admit errors, in order to find a better way forward and to avoid disaster. This, in a manner of speaking, is what needs to happen with the Eurozone. Recognising an error or a structural problem created by human decisions is not the same as recognising that everything we did was wrong. Rather it is a humble admission of human frailty and a call to change path, or retreat for a while, to keep the whole show on the road. I believe we can apply the same lessons to the Eurozone at present time.

* * *

There are a number of interconnected crises in the Eurozone at present. The first can be broadly called a 'financial crisis' and includes the southern European governments of Greece, Italy, Portugal and Spain, the Eurozone banks, and some central European institutions, primarily the European Central Bank and the Eurozone Stability Fund. The second, more long running crisis is the crisis of competitiveness and growth problem in the same southern European countries.

As Martin Wolf of the FT has recently pointed out [1], the solution to the crisis must involve both financing and adjustment. Financing, because otherwise southern Europe would go bust; adjustment because without it, Southern Europe would be stuck forever in a low growth, high unemployment, state. Financing has been agreed at the Eurozone summit, subject to some implementation details. What is still to be worked out how adjustments can be made.

What is adjustment? Adjustment is the process of improvement of competitiveness in countries that have on going low growth and high unemployment. Competitiveness can be measured crudely by the price of a unit of productivity; by labour costs multiplied by real productivity per unit of labour. Productivity can be improved typically in three or more ways:

  1. The exchange rate of the uncompetitive nation can devalue;
  2. Inflation can rise in competitor countries;
  3. The uncompetitive country can cut its labour costs voluntarily or through a slow, usually painful, process of deflation.
Typically, countries can accomplish a devaluation of the exchange rate rather easily; inflation in competitor countries is not usually under the control of the uncompetitive country; finally cutting the labour costs is the final option. This is usually the hardest, and is most difficult in a recession. It is an option that needs to be avoided at all costs, because the pain may prove too much for the Euro, or even for the European project in general. But it is the route taken in the Eurozone now, as the other options have been ruled out. We would be best advised to seek an alternative route.

* * *

One attractive solution to the debt crisis involves what is known as full reserve banking (or the related concept of ‘narrow banking’). Most of the money supply in the economy is bank deposits. And bank deposits are merely the bank’s 'promise to pay' currency on demand. Bank deposits differ from other promises to pay like bonds in that bank deposits can be used to settle accounts; hence they are money. So bank money is both a liability for the bank and is money. The consequences are that is possible to swap the liabilities of the state for the liabilities of a bank. The banks can issue bonds and the government can issue money. In that way, the Italian national debt would be primarily composed of private sector bank accounts at the bank of Italy (although the bank accounts could still be administered through the private banks). And the residual ‘loan fund’ could be fully private and could issue new debt and equity without major government regulation.

What are the complicating features in the European case? There are two: a) fiscal discipline in peripheral Eurozone states and b) competitiveness in peripheral Eurozone states. Can these problems be solved? Yes: but only by solving other problems too. Fiscal discipline can be enforced only by taxes that are actually collected, such as Europe-wide carbon taxes or fuel or property taxes in the specific states in question.

The problem of uncompetitiveness is harder. This can be truly solved only by Eurozone break-up or by equivalent nominal changes. But an uncontrolled breakup hits the credibility of the whole European project.

For the Euro itself, there are three options:

  1. Keep the Euro; enforce central Eurozone bonds and/or central taxes such as upstream fuel taxes and use the ECB/Quantitative Easing/Full Reserve Banking to sort out the debt crisis;
  2. Keep a pan-Euro but weaken the currency by creating a parallel currency in the northern European countries (including Germany and others); existing Euro obligations would be retained, but the North would transist to a new currency.
  3. Let Greece default and then let them leave the Euro, and see the others fall too.
All options have their advantages and disadvantages. What must be made absolutely clear is commitment either way. Either Greece has the full commitment of Germany or it does not. If it does not, Germany needs to create an alternative structure. Once we have a group with full commitment defined; full reserve banking, transfer of bank liabilities to national savings banks, or government debt purchases must be used to squash any further debt crisis, and appropriate taxes must be raised to ensure proper tax collection.

* * *
So which would be the solutions that Europe actually takes? I propose three:

First, and most important is the introduction of full-reserve banking in the Eurozone. Under this system, European depositors would finance European governments rather than financing the banks. Italian commercial bank deposits would be, in effect, transferred to the Bank of Italy, and so on.  With their liabilities to depositors taken away, Banks could issue new bonds and the money generated transferred to the central bank, to pay for the reduction in liabilities. This money could be used to purchase the outstanding government debt. Italian bank deposits amount to around €1.4trillion, a substantial part of the €1.9trillion Italian government debt.

Second is to do with currency, and is a partial retreat from the Euro idea. The plan would involve setting up an additional, initially parallel currency for the Northern European countries in addition to the Euro (which would continue to be pan-European). Over time, taxation and money issuance in a Northern-European block would be switched to a hard-Northern-Euro basis. All existing Euro-denominated nominal obligations would be paid in full but the basis of those obligations must be allowed to devalue in real terms.

Third, I wanted to mention some solutions to current account deficit financing. With monetary policy ineffective, fiscal policy must be used. But the northern European countries want to cut down on southern profligacy.  The creation of more European government paper (money or government bonds) by the Eurozone and the spending of that paper into the southern economy would be an effective way to stimulate the southern economy. But who should create what paper and for what purpose? It seems to me that the appropriate thing would be for the Eurozone to create such paper and to spend it in the south; ideally on real assets such as power stations, but could also be on financial assets such as land. In that way the deficits of the south would be financed. Deficit spending is needed by the Eurozone to stimulate the South, and that deficits spending should be used to construct real assets and to stimulate the southern European economy.

* * *

Whatever happens in the Eurozone, it is essential that a single fact be noticed. Austerity without end will not work. It will not improve southern European competitiveness enough to compete with Germany, and the unhappiness caused will derail the whole European project. So a tactical retreat is needed. Such tactical retreats need to involve financing and adjustment. But what is certain is that we need more demand in the South of Europe in the short term, and not austerity without end. Creative ideas to promote more growth are needed; and a partial and managed retreat from the monopoly of currencies and the proliferation of government debt is required. We'd be better having two or more European currencies and a single Eurozone debt, backed by common carbon or land taxes. Most importantly, a version of full reserve or narrow banking should be put in place. This would allow European savers to finance a large part of European nations’ sovereign debts and would also promote greater long-term stability in the European banking system.

[1] ‘First Aid is not a Cure’, Financial Times, 11th October 2011; available at: http://www.ft.com/cms/s/0/f84a5d76-f368-11e0-b98c-00144feab49a.html#axzz1dUeHQJH3 

0 comments: