Fed’s Assistance to European Only Prolongs the Agony
Federal Reserve assistance to shore up Europe’s sagging banks may be good geo-politics but it is bad economics. Only abandoning the euro, not printing money and Teutonic austerity, will fix Europe’s banks and economies.
When introduced in December 1998, the exchange rate for the euro against the dollar was set at the average of values for the currencies it replaced and then left to float-find its value through supply and demand in foreign currency markets.
Although EU treaties and bureaucracy did much to harmonize regulatory and social policies across the continent, EU governments remain sovereign. The quality of economic policy, pace of productivity growth and competitiveness evolved differently across euro economies.
Over time, the euro became undervalued for Germany and other northern states-and their exports became artificially cheap-and overvalued for Portugal, Italy, Greece, and Spain-and their products artificially expensive. The northern states became export juggernauts at the expense of Mediterranean states, who endured chronic trade deficits.
Either trade deficits are financed by inflows of private investment or borrowing abroad-private companies from Germany and other northern states building factories with the euro earned exporting south, or Mediterranean economies borrowing.
The investments never came-at least not in adequate size. For one thing, the largest of the northern juggernauts, Germany publicly exhorts its industrial prowess but privately manipulates domestic industrial policies to keep the lion share of its manufacturing employment at home or selectively in Eastern European states that fit its foreign policy. Public ownership in major industrial enterprises and banks, and union participation on boards of directors help enforce this quiet but effective mercantilism and is deeply rooted in German history.
German bragging about economic reforms and engineering genius is a great public hoax. German productivity simply does not justify a 31 hour work week, and its export is firmly rooted in an undervalued currency, virulent state-capitalism and protectionism.
Southern Europeans, much like Americans during the heady days of the last decade, borrowed too much. Privately, they borrowed to finance homes and credit cards from banks in Germany, France and foreign countries. Publicly, their governments sold bonds to foreign banks to shore up social programs-not much different in their scope and generosity from the rest of Europe-and to paper over high private sector unemployment that is endemic in economies with overvalued currencies.
The solution being offered by Germany and other northern states are direct loans to the Mediterranean governments, forgiveness of public debt held by private banks and other private creditors, slashing public spending, and driving unemployment above 15 or 20 percent to push down wages and make their economies more competitive. The theory is they will attract more foreign investment if their workers are paid less.
Germany, Holland and others are not about to let their industrial giants move factories and jobs south, give up their large trade surpluses, and the pretense that their gold plated job security guarantees and social benefits result in super-human competitiveness-something their Anglo-Saxon brethren could never accomplish. Hence, the Mediterranean states will never have the exports and earn the euro to pay what they owe.
Essentially, European banks have two kinds of loans on their books-dollar denominated debt, much of which is backed up by mortgages and loans to Americans and corporations who need dollars to engage in U.S. and global commerce. And euro-denominated sovereign debt and the loans to ordinary citizens, who face financial stress in economies enduring recessions hastened and exacerbated by the austerity demanded by Germany.
The Federal Reserve is lending the European Central Banks, who in turn lends those funds to euro-country banks against their dollar-denominated loans. It doesn’t fix the problem that those banks hold too much euro-denominated debt-Mediterranean states bonds and private loans-that will ultimately fail.
The only sane option is for the Mediterranean states to reform their social policies to promote more flexible labor markets and attract private investment, drop the euro, remark public and private debt to the reestablished national currencies, and let falling values for those currencies in foreign exchange markets impose haircuts on creditors.
Devaluation would permit the failing economies to increase exports and repay more of what they owe. The losses imposed on private creditors by devaluation would be much less than the losses they endured if the EU continues the myth the euro is essential to European unity.
Sadly, the economic maelstrom now imposed on Europe by the architects of German mercantilism may destroy any political will to continue the EU when the euro is finally abandoned.
Peter Morici is a professor at the Smith School of Business, University of Maryland School, and former Chief Economist at the U.S. International Trade Commission.