Friday, June 08, 2012

It is first and foremost a Currency Crisis

The Canadian media have a knack for coming up with wrong headline to describe a crisis or scandal. Two recent examples come readily to mind. The so called robo call scandal was not about the legality of robocalls at all. It was about misdirecting voters. Some of those misdirections were in the form of robo calls. Others were not. It should have been called the misdirection scandal.

However, what really irks me is the media taking to calling the currency and bank capitalization crisis in Europe as being a sovereign debt crisis. The origins of the current crisis are not European fiscal policy. Full stop. Greece does not count; its economy is tiny fraction of the overall European economy. No, the US was not the only real estate bubble to pop in 2008. Ireland and Spain, for example, had far bigger bubbles and when their respective bubbles burst their economies and banking sectors were laid to waste. As elsewhere, Ireland and Spain sought to recapitalize their banks on the public dime. (It is a shame that so little attention has been paid to the fact that since 2008 colossal sums of private debt -- by far the largest in history -- have found their way onto public accounts. ) Ireland's decision to bail out their banks, for instance is by far and away the biggest reason why its debt to GDP ratio has gone from 25% in 2007 to 108% last year.

Of course, what separates Spain and Ireland and other Euro Zone countries crippled by collapse of the real estate market from the US and UK is that the latter still have monetary sovereignty and the former do not. For you see, when the economy is in a crapper there are a number of things governments can do with respect to monetary policy. Most notably they can reduce interest rates, devalue their currency and they can print more money (so called quantitative easing). None of these things is open to the Spanish and Irish governments. They surrendered their monetary sovereignty to the ECB and the ECB has done a terrible job managing the crisis. The ECB was slow to lower interest rates and they have only allowed one round of quantitative easing. So while both the US and UK have deficit to GDP numbers that are as equally high or higher than in Spain and both have debt to GDP ratios that are far higher, both the US and UK can borrow at record low rates and well below the rate of inflation and Spain is forced to borrow at just below 6%.

Given Germany's unwillingness to let inflation in the Euro Zone and Germany in particular to rise above 2%, the only option open to Spain and the other PIIGS is to try to deflate their way to competitiveness. With the exception of Ireland and possibly Italy, this is not likely to work. Spanish workers, for example, already earn far less than German and French workers as it is. Spain needs to develop a more educated workforce and improve its capital stock to truly compete with Germany. This is not likely to happen in the current environment.

Deflation also makes the debt crisis worse much worse. The cruel irony is this in turn feeds back into the banking crisis. As European countries sank more and more money into bailing out the banks their ability to handle these increased debt loads in the absence of monetary sovereignty has imperilled their ability to pay down debt owed to the banks and to otherwise recapitalize them. Spain can not afford an additional 100 to 125 billion dollars needed to recapitalize its banks and so has asked the Troika for help. God knows what will happen if they so no.

Investors have long worried that Spain is going to decide that things are so bad it might as well leave the Euro. The Spanish might soon agree. This in turn would surely mean defaulting on its debts owed to central European banks.

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