When it comes to the euro zone, 1+1 = 2: whatever the economists and politicians say
There are three main establishment views on the crisis. The first suggests that we can carry on kicking the can down the road. If we reduce government spending in the indebted countries, growth will fall, they argue, but, if we carry on as we are, we might be able to grow out of debt. This view seems to be losing traction, not least because the markets don’t accept it, so debt funding costs escalate in any case.
The second suggests a major EU role in supporting indebted countries. Even central banks are being brought into this now. Various mechanisms are being used to provide central support for the debt markets of the indebted countries. The obvious consequence of this will be fiscal centralisation at the EU level (because responsible states will not wish to be held accountable for the decisions of irresponsible states again) and inflation (as central banks buy bonds that turn out to be more-or-less worthless). The idea of centralising fiscal policy is, in my view, completely wrong but at least it has a certain consistency about it. Central banks are making an error in helping ease the problems in the bond market because they are mistaking a liquidity problem in which (it can be argued) central banks have a legitimate interest for a solvency problem (in which they do not).
The third view – often expressed by slightly more free-market economists – is that we should not do anything to assist the indebted governments but EU governments should recapitalise the banks that fail as a result of holding government paper that is written down. This is as seductively dangerous as the second approach.
In both the second and third approaches, responsible EU governments are paying for the decisions of irresponsible governments – in the third approach, by the back door. Both approaches will lead, ultimately, to fiscal centralisation at the EU level. But, the problem with the third approach is this: who recapitalises the banks? It will have to be less-indebted EU governments. As Italy and Spain are in the circle of countries who are on the edge of defaulting, this only really leaves France and Germany of any size. If France borrowed money to recapitalise EU banks, it is likely to run into trouble itself. If France then defaults, then we are left only with Germany. But, if France defaults, more banks will be in trouble and the future German taxpayer will find themselves in the impossible position of making good the promises of the whole of the public (and much of the private) sector of the rest of the EU. This position is not tenable, even if it is followed by fiscal centralisation.
Some thought has to be given to the underlying economic nature of the position we are in. With regard to public sector debts, the position is simply as follows. Both with regard to explicit borrowing and implicit borrowing (social security liabilities) this generation has had the benefit of consuming at the expense of the next generation. This is a wealth transfer to this generation. With regard to explicit borrowing, we have been able to consume government-funded services without paying taxes; with regard to implicit debt, we have been able to promise ourselves pensions without making the sacrifice of saving. It is increasingly obvious that the next generation is either unwilling or unable to pay the bill (regardless of the legal status of that bill). This unwillingness leads to a wealth transfer straight back to the next generation at the expense of this generation (and natural justice is restored in my view whatever the legal situation…). That wealth transfer can take place in one of two ways:
1. Central banks can buy worthless bonds and prop up banks and create money to meet its liabilities (something the ECB may do in any case, to some extent, because of the government bonds on the ECB balance sheet). The losers then are those with nominal assets and cash as inflation takes hold. Those with indexed contracts will not suffer so much. This is a wholly arbitrary way of dishing out the pain.
2. We can allow governments to default and wind up the bust banks that hold the bonds in an orderly fashion. Those holding equities and bonds in the banks will suffer a huge wealth loss and that is exactly as it should be. To repeat, if the inter-generational roundabout is changing direction so that the current generation is no longer able to throw the cost of its consumption onto the next generation, there has to be a wealth loss by somebody. It is much better if it is those who took the decisions to invest in the banks in the first place.
As noted above, the other possibility, is that the German taxpayer meets the cost (directly under the second view above and indirectly under the third view). This effectively means that tomorrow’s German taxpayers pay more taxes to ensure that the taxpayers of other countries have their consumption bonanza of the past couple of decades validated.
The straight fact is, 1 + 1 = 2. No politician can change that. We have tried to load debt onto the next generation; the next generation has said “enough is enough” and there is going to be a wealth transfer in the other direction. The EU should have spent the last 12 months figuring out how to deal in an orderly way with the bankruptcies and insolvencies that will result in the financial sector.