The Euro Crisis: is history repeating itself?

Jim Stewart: It is a “common view ... that the world was headed for a massive payments crisis in which several European countries would default on their debts, setting the stage for a general restructuring of all international commitments”.

So writes Liaquat Ahamed in his book ‘Lords of Finance’ (p. 326) in describing the prelude to a conference in 1929 called to reach a final settlement to the German Reparations issue. The conference succeeded in reaching agreement but on terms which eventually lead to financial chaos in Germany and helped precipitate the great depression of the 1930s. Policies that are now regarded as disastrous, were held widely by key decision makers and dogmatically argued. The analogy with policy making and events in the period preceding the great depression of the 1930s and today are striking.

Personal animosities, then as now, are widespread. In 1929 the Governor of the Federal Bank of New York and in effective control of The US central banking system described his German opposite number as an “.. ..exceedingly vain man. This does not take the form of boastfulness as it does a certain naive self assurance” (Ahamed, p. 281). For recent 2011 examples, see Lord Myner's comments on Michael Barnier, the Commissioner for internal regulation. Media reports often cite German annoyance with French Government policies and proposals, see for example here. At an EU summit in October, President Sarkozy is widely reported as telling The Prime Minister of the UK "You have lost a good opportunity to shut up.". Kauder (a leading member of the CDU) has described UK policy as irresponsible and self interested.

But the main problem is the prevailing consensus (held for example by the President of the ECB, the new Prime Minister of Italy, the Governor of the Irish Central Bank etc) that the solution to current economic problems is austerity plus maintaining the solvency of the banking sector at any cost. For short hand this can be termed the Goldman Sachs consensus. The increasing irrationality of such a policy is becoming obvious even to some former supporters. Some examples:-

(1) Ireland, even though it is dependent on IMF and EU loans, and has suffered a hugh recession and economic collapse, was required to pay bondholders in a failed bank even though these bondholders were not covered by any guarantee;
(2) The ECB intervenes in the sovereign bond market while at the same time stating such support will be limited and undesirable. The net effect is that those who wish to sell government bonds such as banks have been able to do so without any medium term effect on bond yields. In effect, such intervention is another support to the banking system.
(3) Where default is both desirable and certain, as in the case of Greece, policy makers perform numerous contortions to try to ensure such a default does not trigger an ‘event’ resulting in the payout on a Credit Default Swap Contract. A Credit Default Swap is similar to insurance on a bond. If the bond defaults the insurance is paid. Such contracts would appear to be one of the greatest financial frauds perpetrated in recent history. Given that policies to ensure debt write downs are not technically a default, buying a CDS contract on government debt, means that the contract will not pay up in the event of default. In any case, in the highly desirable event of a write down of Government debt generally in indebted countries (where Government debt was greater than 60% of GDP, as in the case of Belgium, Ireland, Italy and Portugal), CDS contracts would also not pay out because the counterparty would become insolvent. This is because it is most unlikely that, following the bailouts due to the subprime crisis of AIG and other financial firms, there could be a second massive transfer of resources from the state to the banking sector.

As in earlier periods of financial crisis, commentators assume rationality by decision makers. However key decision makers should be judged by what they say, as distinct from what we hope they think. Take the case of the recently appointed President of the Bundesbank . In a recent interview with the Financial Times, the Bundesbank President stated that the correct response to Greece is “implement what has been decided”. The problem is what has been decided cannot be implemented. Greece does not have the necessary administrative or technical skills, never mind the political will, to implement IMF/EU proposals. The problems with Italy are seen as a problem of “confidence”. Italy has many problems, both political and economic. These reforms will take many years to implement. The lack of confidence in Italian Government bonds is immediate. The Bundesbank President considers the key competitive strength of Germany results from labour market reform. The key strength of Germany relates to its innovative, high productive economy, with a skilled labour force, extensive infrastructure and success in tax compliance (for example using leaked information on deposits held in Swiss bank accounts by German nationals to ensure tax compliance).

There is widespread support for issuing Eurobonds. There are arguments for and against such a proposal (see for example the recent Green Paper on Stability Bonds (Annex 2). Issuing eurobonds could help in the current crisis if applied only to new bond issues, and if existing bonds were not converted into new bonds. Instead they could be transferred to a debt management agency for all or some of the most heavily indebted countries. These bonds could then be written down in value and held until redemption. This is in contrast to the proposals in the EU Green Paper on Stability Bonds, which does not envisage or discuss writing down the value of existing bonds. In addition, the Green Paper does not refer to or discuss the very different economic policies pursued by central banks in the US, UK and Japan, that is large scale intervention in the bond market referred to as ‘quantitative easing’, and the consequent effect on bond yields.

But comments by key decision makers on such a vital topic have been meaningless. For example, the President of the Bundesbank has dismissed arguments in favour of Eurobonds by stating such a policy would be “like drinking sea water to kill thirst”. These and other comments do not give any confidence that key economic policy makers are intellectually equipped to deal with the current crisis.
There is no modern equivalent to Keynes. As in the 1930s, we may have to wait until current policies have demonstrably failed, and are widely recognised to have failed, before there is a change in policy. The cost and problems created could be enormous.

The forthcoming Budget in Ireland is given much media attention. The forthcoming EU summit on 9th December could take decisions that will influence our economic destiny for the next decade.