Regardless of the plan that is presented over the weekend, the European Union is doomed in the medium term. The reason is that none of the solutions being contemplated address the central cause of the current European crisis.
Let us be clear about the things that are NOT the central cause of the European crisis:
- Growth rate of government spending.
- Tax rates that are too low.
- Low levels of bank capitalization.
- Insufficient sources of funds to finance deficits and debt.
Many readers will find it strange that I say that these problems are not the central cause of the European crisis. After all, these are pretty much the only issues that the media focuses on.
But the fact is that these are not the main problem.
The critical issue at the heart of Europe’s problems is something that many have never even heard of: Purchasing Power Parity (PPP).
Europe’s Original Sin
Before countries like Greece, Portugal, Ireland, Spain and Italy decided to join the euro area, they had relatively high inflation rates. Furthermore, due to high levels of macroeconomic instability generally, interest rates in these countries were high, and long-term financing options were virtually non-existent.
When the aforementioned PIIGS countries joined the euro area, they pegged their national currencies to the euro at a fixed exchange rate. As I explain in detail in “Europe’s Crisis And the Folly Of The Gold Standard,” and “Greece, Germany and The History of the Gold Standard,” this exchange rate peg is no different from a gold standard peg.
The problem is that after the PIIGS nations adopted the euro, their internal inflation rates were higher than for the rest of the European Union – i.e. the purchasing power of the euro in the PIIGS nations declined relative to the purchasing power of the euro in other nations. This inflation differential and resulting divergence in purchasing power occurred for several reasons.
- Inflationary inertia and expectations. Folks in the PIIGS were historically accustomed to relatively high inflation. Inflation remained relatively high after adoption of the Euro from sheer force of habit or inertia.
- Capital inflows. Repatriation of foreign savings and foreign investment flowed into those countries leading to economic booms that fueled relatively high inflation.
- Credit expansion. Credit was typically unavailable to consumers and businesses prior to introduction of the euro. A stable currency enabled banks to obtain relatively stable and low cost funding that facilitated an enormous expansion of credit. Pent-up aggregate demand was able to manifest via credit availability. This, in turn, fueled the economic boom and relatively high inflation.
- Fiscal policy. In theory, the PIIGS countries should have ran budget surpluses in the boom times to moderate growth via counter-cyclical fiscal policy. Instead they took advantage of relatively easy financing to fund deficit spending thereby adding to aggregate demand and inflationary pressures.
The relatively high inflation rates in the PIIGS meant that business costs increased at a higher rate than in the rest of the EU. The purchasing power of the euro declined in those countries – meaning that you could by fewer inputs of labor, materials and other inputs for a given amount of euros. Thus, over time, the PIIGS economies became uncompetitive. PIIGS began to import far more than they exported thereby provoking large current account deficits.
In a fixed exchange rate system – including a gold standard system – current account imbalances lead to a loss of specie and monetary astringency. This situation is eventually corrected through a combination of high interest rates recession and deflation until purchasing power of the common currency increases and the balance of payments is restored.
During the first years after adoption of the euro, this correction mechanism did not work and large imbalances accumulated. Why? The enormous investment inflows that financed investment booms centered on the real estate and tourism industries more than compensated for the outflows caused by the trade deficits. Thus, the loss of competitiveness was masked and went unchecked.
However, when the investment boom came to its inevitable end, the PIIGS were left with high-cost and uncompetitive economies. As money flowed out of the PIIGS through the trade account (via a trade deficit that had become structural), and investment inflows slowed, monetary astringency followed. The result was rising internal interest rates and a halt to growth.
Under a fixed exchange rate system, the only way to correct this problem is via recession and deflation. The problem is that the imbalances built up by the PIIGS were so large that the amount of recession and deflation necessary to restore balance became untenably high. Thus, the only way to counteract brutal recessionary forces was via fiscal deficit spending. This is the origin of the debt spiral and the untenable sovereign debt position that these countries currently find themselves in.
Current Plan Does Not Even Address The Cause Of The Crisis
The root of the PIIGS crisis is PPP imbalances and resulting current account deficits. The vast majority of the public – including the investing public - does not understand this. The public thinks that the PIIGS crisis is a simple matter of fiscal indiscipline and that it can be resolved via fiscal austerity. Not all of the PIIGS problems are rooted in fiscal profligacy, and certainly, fiscal austerity is no part of any viable solution.
Current account deficits, in the absence of capital inflows to compensate, make it impossible to run a balanced fiscal budget without inducing massive recession.
The problem is that any attempt to reduce the fiscal deficit without correcting the current account balance will ultimately fail. Why? The reason is that fiscal austerity will only cause further contraction of economic growth and reduction of tax receipts.
In a flexible exchange rate regime, a country can freeze or even cut government spending and still be able to grow the economy if the exchange rate is devalued. The economy is able to compensate for the contractionary economic effects of fiscal austerity via expansionary economic effects of an increase in net exports. This is how Asian economies were able to work their way out of their crisis in the late 1990s.
In a fixed exchange rate regime, trying to balance the budget deficit via spending cuts or tax increases is like a dog chasing its tail. You can never cut spending or raise taxes enough to balance the budget, because resulting contraction in private sector economic activity will reduce government tax revenue by a roughly proportional amount.
This is precisely the situation faced by Greece today and it is the reason why I warned in February of 2010 that any attempt to “solve” Greece’s problems via fiscal austerity was destined to fail. In “Will Greece Repeat Argentina’s 2001 Fiasco,” I clearly forewarned that Greece’s situation was remarkably similar to that of Argentina in 2001 and that austerity policies in the context of recession within a fixed exchange rate regime would relegate the Mediterranean nation to certain disaster.
In theory, balance could be eventually restored to the PIIGS via severe economic contraction and deflation. However, as a practical matter, this is not an option. With unemployment around 20% and youth unemployment above 40%, the PIIGS nations simply cannot socially or politically withstand a PPP adjustment via economic contraction and deflation.
In the medium and long run, the only solution to the PIIGS economic problem is via a downward adjustment of national purchasing power that restores competitiveness and enables balanced growth. As a practical matter, this can only be achieved through adjustment of the exchange rate. But since the PIIGS are pegged -or “crucified” in the memorable phrase of William Jennings Bryan - to the euro, this option is presumably not available.
It is a sad fact that the only viable solution to the central economic problem faced by the PIIGS – adjustment of the exchange rate - is not even being discussed. That is why any and all plans discussed this coming weekend at the EU summit are destined to fail in the medium and long terms.
Could an announcement over the weekend cause U.S. equity markets (^GSPC, ^DJIA, ^IXIC, ^NDX, SPY, DIA, QQQ) to rally significantly? For reasons that I outline in the next article in this series, I believe this is becoming increasingly unlikely. However, it is possible.
But mark my words: even if a solution is announced over the weekend that is received well by the market, it will not be long before we are back to square one and another PIIGS-driven European crisis is front and center once again.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am long SPX puts and DBC puts.