Notes on The Eurozone Crisis

December 30, 2011

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By Deepankar Basu

Excerpt: While there are many interesting dimensions of the crisis, I would like to focus in this note on three crucial factors: a credit crunch, government “austerity” measures, and a sharp fall in consumer and business confidence. This note provides an explanation of some of these recent developments, and develops the argument that the only way to “solve” the Eurozone problem and avert disaster for the global economy is to push for a progressive resolution of the structural factors underlying the sovereign debt crisis.

Introduction

The global financial and economic crisis that erupted in 2008 in the US has been understood by most political economists as a structural crisis of neoliberal capitalism. Key characteristics of neoliberal capitalism gave rise to three important developments in the US: increasing inequalities of wealth and income, a speculative financial sector and a series of asset bubbles, the largest being the housing bubble from 2000 to 2007. When some interest rates on variable rate mortgages were suddenly adjusted upwards in 2006-07, many mortgage borrowers started defaulting on their mortgage payments. This initiated the bursting of the housing bubble, and within quarters ended the long debt-financed boom of the 2000s (Kotz, 2009).

The effects of the deflating bubble in the housing market was magnified many times by several factors: the fragility of the financial system (resting on mind boggling amounts of debt), the opacity of financial instruments like mortgage backed securities (MBS), and collateralized debt obligations (CDOs), the heavy use of short term funding (through what has come to be known as the wholesale funding market), and the enormous burden of debt on working and middle class households. These magnification factors deepened the initial downturn into a deep and prolonged recession in the US that gradually spread to other countries, including countries in the Eurozone. As tax revenues plummeted (and automatic welfare expenditures increased) with the recession, government debt started building up, leading in late 2009 to the beginnings of the sovereign dent crisis in Europe, the second saga in the unfolding global economic and financial crisis of neoliberal capitalism (Lapavitsas, et al., 2011).

Instead of tackling the structural factors behind the sovereign debt crisis in a progressive manner, governments in the Eurozone have been, for the past two years, trying very hard, on the one hand, to protect the interests of large financial corporations, bondholders and core country industrial giants, and on the other to continue with the so-called austerity measures. While it has been clear to many observers of the scene that this course of action will not work, three factors developing rapidly in the Eurozone area over the last few months suggests that things are in fact getting worse. If these factors are not dealt with decisively, it might even tip the Eurozone countries (and a large part of the world economy) into a depression.

While there are many interesting dimensions of the crisis, I would like to focus in this note on three crucial factors: a credit crunch, government “austerity” measures, and a sharp fall in consumer and business confidence. This note provides an explanation of some of these recent developments, and develops the argument that the only way to “solve” the Eurozone problem and avert disaster for the global economy is to push for a progressive resolution of the structural factors underlying the sovereign debt crisis.

Credit Crunch

In a sign of the deepening sovereign debt crisis, problems of financing government debt have gradually moved from the periphery (i.e., Greece, Ireland and Portugal) to the core (i.e., Spain, Italy, Belgium and France). Even Germany had trouble offloading all its government debt on November 23rd, 2011. But why do governments need to borrow? Because their revenues (coming mainly from taxation) is usually lower than what they spend (on national defense, infrastructure, on the public sector, on welfare measures, and other such things). The excess of spending over revenue is usually bridged with borrowing from the market by selling (i.e., floating) bonds to large banks and institutional investors. At any point in time, the outstanding stock of debt of the government is the accumulated result of all its past net borrowings.

So why are European governments having difficulty borrowing from the market right now? Because debt levels have become large (relative to GDP) for many countries hit badly by the global recession of 2008 (as we have already pointed out). As government (or sovereign) debt has ballooned, investors who lend to the governments (by buying their bonds) have become increasingly wary of the ability of the governments to honor their debt. Institutional investors like hedge funds, money market mutual funds and pension funds now fear default on the debt issued by many Eurozone governments. The wariness of institutional investors to sovereign debt, in turn, creates problems for banks. Why?

Banks in Eurozone countries are drawn into the story because a large part of Eurozone government debt is held by them (i.e., the banks had bought the bonds floated by governments to borrow from the market). Thus, investors have not only been wary of buying government bonds but have also started withdrawing funding from (i.e., refused to lend to) many European banks, especially those that are thought to hold large quantities of European sovereign debt. Especially important in this respect is the sharp withdrawal of US money-market funds (MMMFs) from the short term bond market (a mechanism by which European banks borrow from the financial markets: yes, even banks have to borrow!). By some estimates, since May 2011 these money-market funds have withdrawn 42 percent of their funds from European banks (The Economist, Nov 26-Dec 2, 2011). American MMMFs are some of the largest institutional lenders to European banks; hence, their withdrawing from the short term bonds markets in Europe is deeply problematic. Why?

A problem exists because typically the value of assets (an important category of assets of banks are the loans that they make to firms and households) held by banks exceeds the value of their deposits. Hence, banks must bridge the gap. They do so by borrowing for short periods (sometimes as short as a day) using various kinds of financial instruments (like repurchase agreements, interbank deposits, large denomination certificate of deposits, commercial papers, etc.) from what is nowadays called the wholesale funding market. When institutional investors like American MMMFs buy these short term commercial paper, for instance, they, in effect, lend money to the banks, and help them bridge the gap. If institutional investors such as MMMFs and pension funds cut back on their lending to banks (for instance, by refusing to roll over short term debt), this reduction in the availability of short term funding might create severe problems for the banks.

There is one characteristic of wholesale funding that makes it susceptible to sudden (and often irrational) withdrawal. To understand this, we need to contrast wholesale funding (which is now prevalent) with deposit funding (which was prevalent a few decades ago). In the old days when banking was a straightforward and boring affair, and banks used deposit funding, a large part of banks’ source of funds was deposits by ordinary households. To preempt the problem of bank runs (a situation where all or most of the investors of a bank come asking for their deposits at the same time, leading to a failure of the bank), governments typically insured the deposits, a lesson learned the hard way during the Great Depression. With their deposits insured by the government, depositors did not have the necessity to withdraw their funds even when they thought a bank would fail; this prevented bank runs.

With the growth of wholesale funding the financial system is once again open to phenomenon similar to bank runs because wholesale funding is not insured by the government. Thus, wariness among investors about the health of any large bank (or group of banks) might very easily become turn into a general panic because the funds lent to banks via the wholesale funding market is not insured. This makes the wholesale funding market susceptible to sudden withdrawals, often leading to failure of financial institutions that rely on wholesale funding, as happened in the case of Bear Stearns.

If wholesale funding is suddenly reduced, banks are in a soup. To cover the gap between assets and liabilities, banks must then either raise new capital by issuing equity (i.e., issuing ownership shares) or reduce their asset holdings by selling them off (or borrow from the government). But investors are anyway wary of banks’ financial health; hence, issuing new equity will be quite difficult at this point. Therefore, banks might be forced to sell off their assets, for instance, by reducing their loans or withdrawing their lines of credit to firms (lines of credit are a form of loans to firms).

Banks will also be forced to raise capital or sell off assets because of regulatory requirements. On the basis of a fresh round of stress tests, the European Banking Authority announced on December 9, 2011 that European banks needed to raise $152.7 billion because the sovereign debt crisis might worsen (New York Times, Dec 9, 2011). Both regulatory pressures and the drying of sources of wholesale funding might lead to drastic reductions in the assets of banks. By some estimates, European financial players are expected to sell or write down more than $1.8 trillion worth of loan assets over the next decade (New York Times, Dec 8, 2011).

The attempt to reduce the ratio of assets to capital is known as deleveraging. If the process of deleveraging at banks continues and intensifies, the outcome might be an economy-wide credit crunch that reduces the availability of credit for capitalist firms and households while raising the interest rate on available credit.

The situation described above is generally disastrous. Firms require short term credit for their daily operations such as meeting payrolls, overhead costs, keeping inventories stocked, keeping supply chains working and so forth. The credit crunch will impact the ability of firms to continue operating at normal levels of capacity. Consequently, there will be sharp reductions in investment expenditures, employment and capacity utilization. Cutbacks in investment spending will reduce demand for capital equipment and overall aggregate demand. Reductions in orders for capital equipment will especially hurt the German economy, which is quite dependent on industrial production and exports.

Austerity Only Makes Matters Worse

Compounding the credit crunch problem are the austerity measures adopted by all European governments. These measures reduce expenditure and increase taxes in order to reduce government deficits (as we have already seen). Cutbacks in government spending and increases in taxes, at this particular moment, however, amount to the worst possible policy stance, reducing aggregate demand even further, and pushing the economies deeper into recession. The intergovernmental treaty that was agreed upon by 17 eurozone member states on Friday, December 9, 2011 in Brussels will only make matters worse because it increases pressures on peripheral countries to more strictly adopt austerity measures. In essence, all the member states have now agreed to go back to the original rules whereby government budget deficits need to be kept below 3 percent of GDP and total government debt lower than 60 percent of GDP (New York Times, Dec 9, 2011).

High levels of uncertainty about the prospects of the Euro, austerity measures and credit market difficulties will furthermore impact on the levels of confidence of working and middle class households. Households will consequently reduce consumption expenditures, especially of big ticket durable goods like automobiles, leading to further declines in aggregate demand and industrial production. If households hold large amounts of debt, for instance due to the build-up of debt during a real estate boom, then the deleveraging process might take hold here even in the household sector, worsening the problem.

Since export markets in the US and the rest of the world are not quite booming (China and India are slowing down, and the US is barely growing), aggregate demand stimulus from external sources cannot act as a buffer against the massive shortfall in domestic demand. The probable outcome is that the Eurozone is headed for a sharp recession. If the European Central Bank does not take steps to unfreeze the credit markets and prevent a full blown banking crisis, and if the European governments do not reverse the austerity measures, the recession might well turn into a depression. The recession, or depression, will increase the strains on the single currency. In the worst case scenario, it might even plunge not only the Eurozone, but the world, into a depression.

Foreign liabilities in the periphery

The possible contours of a Eurozone breakup and consequent depression are not difficult to discern. Recall that the monetary union rests on structural inequalities between core countries like Germany and France and peripheral countries like Greece, Ireland and Spain. A strongly neoliberal policy stance kept wages flat in Germany. Thus, even with rapid productivity growth, peripheral countries lost competitiveness to German firms. Capitalist firms in the core (especially Germany) rapidly increased their market shares in the periphery (Greece, especially) (Lapavitsas, et. al., 2010). This meant that Germany was selling much more to the peripheral economies than it was buying from them, creating trade deficits for the peripheral countries and trade surpluses for itself.

The surpluses in Germany were then recycled to the peripheral economies as loans to finance their trade deficits, increasing foreign liabilities (i.e., borrowing from core country banks and financial institutions to finance the trade, and current account, deficits) for the peripheral country private and public sectors. This was especially true for Greece, but also for other countries too. Another route that led to the increasing of foreign liabilities for peripheral country economic agents was the flood of cheap credit from core country banks and financial institutions to finance real estate booms; this was especially true for Ireland, Spain and Portugal. Hence, both trade deficits (arising from structural inequalities between core and periphery) and the flood of cheap credit (during the credit boom of the 2000s) increased the foreign liabilities of the peripheral countries (the foreign liabilities of Greece, Ireland, Portugal and Spain are, as of November 2011, close to 100 percent of GDP) (The Economist, Nov 26-Dec2, 2011).

Loss of policy options for the periphery

Why could the peripheral economies not deal with the growing foreign liabilities?

By joining the monetary union and adopting the Euro, the peripheral countries had given up control over their nominal exchange rates (the price of their domestic currencies in terms of foreign currencies). Hence, they had given up one important policy instrument that could be used to increase net export earning and thereby pay down the build up of foreign liabilities.

In the absence of the nominal exchange rate, the trade imbalance could be addressed by relative price changes between the core and periphery (i.e., by a relative decline in the prices of peripheral country goods and services relative to their counterparts in the core. Since core countries like Germany and France refused to tolerate even moderate levels of inflation (because of the dominance of neoliberal ideology), the required relative price adjustment could only take place through deflation, and the massive levels of unemployment that go with it, in the periphery. In essence, this policy move means imposing the costs of adjustment completely on the working class in the periphery (for details see: http://sanhati.com/excerpted/2381/).

Stagnation will make matters worse

But ironically, stagnation in the periphery will make matters worse. Let us first look at peripheral governments. Tax receipts will fall and welfare payments go up, increasing the budget deficits of governments and making investors even more wary of lending to the sovereign entities. Next, let us look at private banks in the periphery. The deep stagnation will mean write-downs of many existing loans, putting strain on their capital. The credit crunch that is already going on, on the other hand, will only increase the cost of borrowing and reduce the supply of funds for these already hit banks.

Both these developments will mean that the ability of the peripheral economies to service their foreign liabilities will be severely curtailed. In the worst case, there will be a default by a peripheral country government or the failure of a big bank in one of the peripheral countries. Either of these events might force the country to exit the monetary union and give up the Euro.

This might very soon lead to a run on the banking system of other vulnerable economies. Depositors might start withdrawing their money from the banks of vulnerable economies and moving it to core country banks to prevent a loss of their savings due to giving up of the Euro and the adoption of an alternative domestic currency. Such a bank run might lead to widespread bank failures (as was common in the US economy during the late 19th and early 20th century).

Widespread bank failures in the periphery might come back to hit financial institutions in the core because of their exposure to these economies. The initial defaults might cascade through the system not only breaking up the Euro but plunging the whole area, and given its large size possibly the world economy with it, into a depression.

Who will gain, who will lose?

Acute observes of the Euro scene have been pointing out for the past two decades that there is an inherent class bias at the very heart of the design of the European Monetary Union (EMU) and the single currency: it is a neoliberal project through and through, which systematically increases the power and wealth of capital vis-a-vis labour across Europe. How? By attempting to operate as an alternative international reserve currency to the US dollar, the euro projects the interests of the core country (mainly Germany) financial and industrial sector onto the world scene. It is, therefore, no wonder that enormous costs are being imposed on the working and middle class people in the peripheral countries to make sure that the euro continues to remain viable. But is the German working and middle class gaining from this arrangement? No. Once we remember that the “competitiveness” of the German economy was based on severe wage repression and not on rapid productivity growth, we can immediately see that the currently-designed EMU and the single currency is not in their interests. Thus, it is clear that neither the German nor the peripheral country working class benefits from the EMU and the single currency. A working class alternative to the capital-dominated EMU is sorely needed.

(I would like to thank Shiv Sethi and Taki Manolakos for helpful comments on an earlier version of the article.)

References

Kotz, D. 2009. “The Financial and Economic Crisis of 2008: A Systemic Crisis of Neoliberal Capitalism,” Review of Radical Political Economics, 41(3), pp. 305-317.

Lapavitsas, C., Kaltenbrunner, A., Lindo, D., Michell, J., Painceira, J.P., Pires, E., Powell, J., Stenfors, A., and N. Teles. 2010. “Eurozone Crisis: Beggar Thyself and Thy Neighbour,” Research on Money and Finance Occasional Report 1.

Lapavitsas, C., Kaltenbrunner, A., Lindo, D., Michell, J., Painceira, J.P., Pires, E., Powell, J., Stenfors, A., N. Teles., and L. Vatikiotis 2011. “Breaking up: A Route out of the Eurozone Crisis,” Research on Money and Finance Occasional Report 3.

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