Revolt of the debtors

The Greek debt crisis that erupted in 2010 is back, and again threatens the stability of the Eurozone. That crisis was the result of two factors. First, an unbridled spending drift of both the private and the public sectors in Greece during the boom years of 2000-2010, which led to unsustainable large levels of debt. Second, reckless lending to Greece by Northern Eurozone banks. At no time the Northern bankers asked themselves the question of whether the Greeks would repay the loans.

The European Unions chose to resolve the debt crisis by punishing the Greeks and by saving the Northern banks. A punitive austerity program was imposed on Greece, whose effects are now visible everywhere in this country. A decline in GDP of close to 25% since 2010, a rise in unemployment to a level we have not seen since the nineteen thirties, and impoverishment of large parts of the Greek population.

The banks went largely unpunished. True there was a debt restructuring of the Greek debt held by private investors. Some banks paid the price of excessive credit granted to Greece, but most banks escaped this fate by dumping their Greek claims onto the public sector. Those claims are now in the hands of national governments and the European Central Bank. And these want to have their money back whatever the consequences may be for the Greek people and the Greek political system.

The official narrative of this approach is that the intense austerity that was imposed on  the Greek population is inevitable and in the end will bear fruit.

Inevitable? Yes, of course, if the intention is to safeguard the interests of the creditors then there is indeed only one possibility: the Greeks have to pay the full price.

Will it pay off in the end? Yes, of course if austerity is maintained long enough it will succeed in creating surpluses and transfers of resources from Greece towards the rich North of the Eurozone.

This narrative, however, loses sight of the political upheavals triggered by the human misery that results form intense austerity. The millions of people who are pushed into misery by the creditors from the North of Europe are not passive subjects. They not only protest in the streets, something the creditors can easily live with. They also vote for those political parties that promise them that there is a better way to deal with the problem. And these are the parties that are out to break the established political and social order.

It is appalling to see that the European political elite has been living in a cocoon, failing to take into account the political and social implications of the intense austerity programs they imposed in countries like Greece (but also in other countries of the periphery). This political elite still has not learned the lessons. The first reaction of the German minister of finance after the announcement of new elections in Greece was that the discipline needed to be continued rigorously.

What is to be done? Much will depend on the election results in Greece. The far-left party, Syriza, seeks to weaken the intensity of the austerity programs and to negotiate a debt restructuring with the European authorities.

It is quite surprising to find out that these demands, in fact, are based on a correct analysis of the Greek problem. Despite the austerity, that has been extraordinarily intense, the Greek public debt has increased and now exceeds 170% of GDP. The burden of this debt is so high that future Greek governments will not be able to continue to service it.

Instead of denying this reality the EU finance ministers should start facing it. They should begin to think about how they can ease the debt burden of Greece. Denying this reality condemns Greece to many more years of misery and will encourage extremist political movements in the country even further.

The risk today is that the political leaders of the Eurozone refuse to relieve the Greek debt (and that of other countries of the periphery). In that case, a fundamental crisis in the Eurozone is inevitable. Even if Syriza does not make it at the coming election, extremist parties will gain the upper hand in future elections. This will be very disruptive for the Eurozone as a whole.

History teaches us that after a debt crisis a balance must be found between the interests of creditors and debtors. The unilateral approach that has been taken in the Eurozone in which the debtors have been forced to bear the full weight of the adjustment almost always leads to a revolt of these debtors. That is now underway in Greece. It can only be stopped if creditors dare to face this reality.

The dangerous ambitions of the European Central Bank

Last week the European Central Bank published the letter it sent on August 5, 2011 to the then Prime Minister of Spain, Mr Zapatero. That was at a time of intense crisis in the Eurozone. Many thought that the Eurozone would implode.

The ECB’s letter to the Spanish government is not the only one the ECB sent to Member States' governments. A similar letter was sent to the Italian Government. The letter is of great significance because it reflects the ambition of the central bank to determine macroeconomic policies in the Eurozone. This ambition should be checked, for two reasons.

First, the letter illustrates the intensity of  the micro-economic management the ECB intends to apply in crisis countries. The letter contains a detailed list of what according to the ECB needs to be done in the labor market. Thus, collective agreements should be abolished and should be organized at the level of the individual firms. In addition, these agreements should not contain indexation clauses, even when these are entered into freely. Two things stand out here. First, there is the detail of the measures that the ECB would like to impose. In doing so, it substitutes itself to national governments in the formulation of national economic policies.

Second, it is striking to find that these policy prescriptions are based on an economic theory for which there is actually no serious empirical evidence. On the contrary, there is a strong empirical research suggesting that the degree of decentralization of wage bargaining should not go too far. The consensus among economists is that wage bargaining at the level of individual companies harms the economy, because it can easily give rise to a wage-price spiral when an external shock such as an oil price increase occurs. Yet extreme decentralisation of wage bargaining is what the ECB wants to impose in member-countries of the Eurozone. The policy that the ECB seeks to impose is not based on evidence but on ideology.

The second reason why the ECB’s ambitions in setting the policy agenda in the Eurozone must be checked has to do with governance. The ECB is a public institution, which has been given a strong status of political independence. The latter implies that politicians should abstain from interfering in monetary policy. They should certainly not give instructions to the central bank on how to conduct monetary policy. The reverse, however, is equally true. The political independence of the ECB can only be safeguarded if that institution keeps itself aloof from the political process and abstains from giving instructions to governments about how economic policies should be conducted. The ECB sins against this principle. In doing so, she puts her own independence at stake.

The ECB has set itself the target of keeping inflation close to 2%. It is failing spectacularly in reaching that objective and as a result, creates a risk of deflation that today increases the debt burden of national governments. An institution that fails to achieve its own objectives cannot afford to impose its ideas on national governments, lest these governments will turn themselves against the ECB.

The instructions the ECB gives in its letter to the Spanish government lead to an even more fundamental governance problem. The ECB consists of civil servants who bear no political cost of the decisions they try to impose on national governments. The latter bear the full political costs of these decisions. They risk to be thrown out of office when they implement policies forced upon them by the ECB. The civil servants of the ECB go home unharmed. This is a governance structure that is unsustainable and that will be rejected. It is important that the ECB realises this and reduces its ambition to rule the politicians. Failure to do so will greatly harm the ECB.

Stress-testing the banks. A difficult balancing act

The European Central Bank is becoming the singe supervisor of the large and medium-sized banks in the Eurozone. Before taking on this responsibility it was important for the ECB to be well informed about the health of the Eurozone banks. This health report was released last Sunday.

What is most striking is that relatively few banks failed the test, i.e  only 14 out of 130. That is quite a success. Was the exam too easy? At first sight this does not seem to be the case. The ECB examined, for example, what the effect would be of a decrease of GDP by 5% spread over two years on the value of the banks’ assets. That is quite a steep recession, comparable to the one that hit the Eurozone in 2008-09. Of course, the ECB could have investigated more pessimistic scenarios. For example, it could have asked what would happen if a new crisis erupted in the government bond markets? The ECB investigated only mild increases (2 to 3 percent) in the government bond yields. During the period 2010-11, these increases were much larger, reaching 10 percent or more. Should the ECB not have been tougher and simulated more intensely negative economic shocks?

This is like asking how pessimistic a central bank should be? There are negative scenarios that are so unfavorable that not even half of the banks would survive these. A new debt crisis like the one we experienced in 2010-11 is such a scenario. Such a negative scenario is not even very unlikely. But should a central work out the consequences of a disaster?

The ECB walks on a tightrope. An overly pessimistic scenario that would lead to the conclusion that more than half of the banks are at risk would be the equivalent of a terrorist suicide attack.  The publication of such a scenario by the central bank would lead to an immediate banking crisis. A central bank that cares about financial stability should not place a bomb in the market place. The ECB has not done so.

Yet the ECB did not fall into the other extreme. It did not let all the banks pass the test. Fourteen banks failed. This is not a high number. But neither is it a ridiculously low number that would have harmed the reputation of the central bank. The ECB carefully considered how far it could go in balancing the need to maintain financial stability with the desire to keep its reputation intact. The ECB seems to have succeeded in this balancing act.

Should we expect that the bank stress-test now is the beginning of a new era and that banks will be willing to expand bank credit, as the Vice-President of the ECB, Vítor Constâncio, suggested? This is highly unlikely. The depressed nature of bank credit today has much to do with the fact that economic activity in the Eurozone has slowed down again. As a result, the demand for credit by firms and consumers remains low. In order to overcome this, it will be necessary to stimulate aggregate demand. The best way to do this is by increasing public investment.  Put differently, the stress-test was necessary to create the conditions for banks to start lending again. But such an increase will only be possible if the Eurozone ends the period of austerity and starts stimulating investment again.  Unfortunately, the resistance towards fiscal stimulus is the highest in those countries that face the least financial constraints to engage in such policies.  

How to stop aggression

The Russian military invasion of Ukraine has paid off. The Crimea is now part of Russia. Some Eastern regions of Ukraine also risk becoming incorporated into Russia in the near future. Where will this end?

Putin knows that the West is not willing to send soldiers to Ukraine to defend the sovereignty of that country. This gives him a strategic advantage over the West. In addition, it gives him an incentive to continue his aggressive and expansionary policies.  We should therefore not be surprised that new aggressive moves will be initiated elsewhere (in the Baltic countries for example where large Russian minorities live).

Up to now the West has reacted in a feeble way. Financial assets of important Russian individuals have been blocked. Russian companies are prevented from borrowing in financial markets or from transferring assets. These things hurt but insufficiently so. Putin will not be stopped by the West’s half-baked sanctions that have little impact on the Russians economy.

In order to stop aggression a policy must be implemented that will really hurt the Russian economy. This policy can only work if it hurts the Russian revenues from exporting oil and gas. How can this be done without hurting the West?

Today, imports of Russian crude oil account for 34% of total EU imports of crude oil. For gas this percentage is 32%. So we are very dependent on Russia for our energy imports. What about the Russian dependence on us?

The export of crude oil from Russia to the EU now accounts for 84% of total Russian oil exports; the percentage for gas is 80%. Those exports are of great importance for Russia and for the Russian budget. In fact the sales of Russian oil and gas to the EU provide for more than half of all Russian government revenue. Thus it can be said that Russia is more dependent on its exports to the EU than the EU is dependent on Russian oil and gas imports. That creates an opportunity to put pressure on Russia in order to increase the economic cost of aggression.

Here's what I would do if I were European policymaker. I would impose a tax on oil and gas from Russia. Such a tax would have the following effects. First, EU importers would have to pay more for Russian oil and gas and would therefore look for alternative sources of supply. This would reduce the demand for Russian oil and gas. Since the EU is a very big player this effect would be big also. Second, and this follows immediately from the first effect, Russia would have to lower the price of its oil and gas so as to find other buyers in the world. This would create an important shortfall in Russian government revenues, reducing the capacity of Russia to wage wars.

One may object here that this tax would also hurt us because it would raise the price the EU consumers would have to pay for oil and gas. This is not the case, however. The import tax generates revenues for the EU-governments. These revenues could be used to compensate the EU-consumers. Alternatively, they could be used to promote policies aiming at making us less dependent on fossil fuel. Whatever we chose to do with the tax revenue, we would not be harmed by it.

This is an application of what economists call an “optimal tariff”. By the very fact that we are more important for Russia than the other way around, we can exploit our strong economic power and impose an import tax that maximizes our welfare and reduces Russia’s. We should do just that.

Some will argue that Russia could retaliate by stopping the export of oil and gas to the EU. My contention is that Russia would not do this. Such a retaliation would lead a decline of government revenues of more than 50% leading to a paralysis of the Russian government. It would hurt Russia much more than it would hurt the EU.

The European Union has the economic power to confront and to stop Russian aggression. It must use this power.

Stop structural reforms, start public investments

Slow growth in the Eurozone has become endemic since the start of the sovereign debt crisis in 2010. This is made very clear in Figure 1, which contrasts the growth experience of the Eurozone with the non-Eurozone EU-member countries since the start of the financial crisis in 2007.  What is striking is that up to the Eurozone sovereign debt crisis of 2010 the growth experiences of the Eurozone and non-Eurozone countries in the EU were very similar. Both groups of countries saw their boom collapse and turn into a deep recession in 2008-09. Both recovered relatively quickly in 2010. Since 2011, however, the two groups of countries depart. The Eurozone experiences a new recession and since then has experienced a growth rate that on average has been 2% below the growth rate of the EU-countries that are not part of the Eurozone.

Source: Eurostat

What happened since the start of the sovereign debt crisis that has led to a  systematic decline of economic growth in the Eurozone as compared to the non-Euro EU-members?

In Brussels, Frankfurt and Berlin it is popular to say that this low growth performance of the Eurozone is due to structural rigidities. In other words, the low growth of the Eurozone is a supply side problem. Make the supply more flexible (e.g. lower minimum wages, less unemployment benefits, easier firing of workers) and growth will accelerate.

This diagnosis of the Eurozone growth problem does not make sense. As is made clear from Figure 1 the Eurozone countries recovered as quickly from the recession of 2008-09 as the non-euro countries. If the problem was a structural one, it also existed in 2008-09. Yet these structural rigidities did not prevent the Eurozone countries from recovering quickly in 2010. Why then did structural rigidities from 2011 on suddenly pop-up to produce lower growth in the Eurozone than in non-euro EU-countries, while they did not play a role in 2010?  Although this supply-side story does not hold water, it continues to provide the intellectual underpinnings of the Eurozone policymakers who continue to insist on structural reforms.

There is a better explanation for the Eurozone growth puzzle. This is that demand management in the Eurozone was dramatically wrong since the start of the sovereign debt crisis. The latter led the Eurozone policymakers to impose severe austerity on the peripheral Eurozone countries and budgetary restrictions on all the others. This approach was based on a failure to recognize that the Eurozone was still in the grips of a deleveraging dynamics. After the debt explosions in the private sector during the boom years, private agents were still deleveraging. As a result of austerity, both the private and the public sector tried to deleverage at the same time. This introduced a deflationary bias in the Eurozone that led to a new recession during 2012-13, the second one since the start of the financial crisis in 2007-8.

One of the most spectacular manifestations of the ill-advised austerity programs was the strong decline in public investment in the Eurozone. This is shown in Figure 2. It shows that after the sovereign debt crisis the Eurozone governments, in the name of austerity, decided to dramatically reduce public investment. How they could hope that this would promote economic growth will remain a mystery.  In fact, such a decline in public investment is sure to lead to lower production possibilities in the future, i.e. to less supply in the future.

All this leads to the question of what to do today? Governments of the Eurozone, in particular in the Northern member countries now face historically low long-term interest rates. The German government, for example, can borrow at less than 1% at a maturity of 10 years. These historically low interest rates create a window of opportunities for these governments to start a major investment program. Money can be borrowed almost for free while in all these countries there are great needs to invest in the energy sector, the public transportation systems and the environment.

This is therefore the time to reverse the ill-advised decisions made since 2010 to reduce public investments. This can be done at very little cost. The country that should lead this public investment program is Germany. Public investments as a percent of GDP in Germany are among the lowest of all Eurozone countries. In 2013 public investment in German amounted to a bare 1.6% of GDP versus 2.3%  in the rest of the Eurozone.

Source: Eurostat

Such a public investment program would do two things. It would stimulate aggregate demand in the short run and help to pull the Eurozone out of its lethargic state. In the long run it would help to lift the long-term growth potential in the Eurozone.

The prevailing view in many countries is that governments should not increase their debt levels lest they put a burden on future generations. The truth is that future generations inherit not only the liabilities but also the assets that have been created by the government. Future generations will not understand why these governments did not invest in productive assets that improve their welfare, while these governments could do so at historically low financing costs.