The PIIGS Problem: Maginot Line Economics
by Marshall Auerback, Fellow and Contributor to the Roosevelt Institute’s New Deal 2.0
Marshall Auerback warns that Germany’s obsession with a defense against the external threat of inflation is blinding them to the real risks facing Europe.
The Maginot Line, named after French Minister of Defense André Maginot, was a line of defenses which France constructed along its borders with Germany and Italy after suffering appalling damage and casualties during World War I. The French thought they were now protected from a repeat, and believed the defenses impenetrable.
Chatting to a number of German participants at last week’s Institute for New Economic Thinking (INET) conference, we couldn’t help getting a sense of the economic parallel in regard to Germany’s deep resistance to greater fiscal expansion as means of dealing with the problem of the “PIIGS“.
The Problem:
Germany’s fiscal deficit fetishism is largely a product of that country’s own hyperinflation experience during the Weimar Republic. As deeply ingrained as that trauma remains in the German psyche, it is now taking on an almost hysterically irrational quality as evidenced by the latest “rescue package” for Greece. Its EMU “partners”, led by Greece and soon to be followed by Portugal, Spain, Ireland and Italy, are increasingly being forced to embrace Germanic-style hair shirt economics, because the obvious fiscal response is constrained via self-imposed rules inherent in the rules governing the European Monetary Union. These rules are regarded, almost to a man, as “sound economics” by Germany’s policy makers and the vast majority of its citizens (if one is to measure this via the national polls, which continue to indicate visceral hostility to “bailouts” for “lazy Greek scroungers and tax dodgers”). We wonder if they’ll still be feeling that way if the contagion extends to Berlin and Paris.
Historians all know how effective the Maginot Line ultimately proved for the French in terms of defending a German occupation of their country during the Second World War: the Germans were able to avoid a direct assault on the Maginot Line by violating the neutrality of Belgium, Luxemburg and the Netherlands, whilst the Luftwaffe simply flew over it.
Likewise, we think Germany’s “Weimar 2.0″ phobia is based on similarly flawed “Maginot Line” thinking, thereby generating a correspondingly ineffectual response to the EMU crisis. It’s becoming a story of intellectual hubris, defending “good economics”, Germanic-style, over common sense.
Judging from the market’s reaction to the 45m euro rescue package of Greece, it appears that the EMU and, by extension, the euro, have dodged a bullet for now. But the PIIGS problems remain. The terms and conditions include IMF ‘austerity’ measures, which will act to slow the economy of Greece and the entire EU — which is already dangerously weak to the point of promoting higher budget deficits through low tax revenues and high transfer payments. All of which serves to further weaken the creditworthiness of all the member nations.
It also increases the euro debts of the other contributing nations because they are being forced to contribute to this funding package for Greece. The implication of the same type of ‘rescue’ for the larger euro nations is not pretty. Expect much higher levels of stress for the remaining euro member nations presumed to be ’strong’ as the same kind of forced austerity appears in store for other “violators” of the Maastricht Convergence Criteria. Think about Spain, which now has 20% unemployment, or Ireland, which has a classic Iceland problem, given that the liabilities of its banking system vastly exceed the country’s overall GDP.
The underlying assumption of the rescue package is not sound. The stronger nations still think by offering a big enough “guarantee” the markets will take up the slack and finance Greece for them. But the markets now want to see the cash and, more importantly, they want a firm demonstration that the funding guarantees provided will help to sustain the ability of nations like Greece to service its debt without turning the nation into an industrial wasteland. The markets no longer believe in a “contingent liability” model, which is something akin to indicating that you have a rich relative who can help you out if needed. The EMU’s “rich relative” has already indicated that this is verboten, but it has denied Greece and the other PIIGS nations the means to grow adequately to service debt going forward.
The Prognosis:
The euro should therefore fundamentally remain on the weak side after a temporary bout of short-covering, as the high levels of euro national government deficits are adding the non government sectors’ holding of euro denominated financial assets. And the austerity measures are likely to increase euro government deficits and thereby exacerbates potential national insolvency problems amongst the euro zone nations.
The common Germanic retort to this line of thinking is that a default in, say, California, would no more threaten the viability of the dollar than a Greek default would endanger the euro. Perhaps, although the Lehman experience should have taught us all that the negative externalities of such an event can seldom be determined in advance, given the opacity of today’s funding mechanisms. Additionally, the United States of America is an existing NATIONAL fiscal authority which can respond to the growing problem of state insolvency via dollar creation and corresponding revenue sharing with the states. No such comparable fiscal entity yet exists in the euro zone.
Although we have hitherto characterized Greece as the EMU’s “Lehman” problem, the rescue package announced on Monday makes us that think that the better parallel for Greece might well be Bear Stearns. Bear’s “rescue” in March 2008, initially looked like it enabled the global financial markets to avert a growing crisis in the asset backed securities markets. What it did in reality was kick the can down the road, as the underlying structural problems which created the crisis in the first place remained unresolved. The credit crisis that began in August 2007 involved failure of both the liquidity and the solvency risk systems. The consequent freeze-up arose because the subsequent bankruptcy of Lehman and collapse of AIG destroyed the markets’ expectations (built up by years of bailouts) of their being an ultimate market maker, which would always be able to deal in these securitized instruments.
By the same token, the creation of a common currency via monetary union has created market expectations that one country’s paper is as good as another, which explains why, for so many years, “fiscally profligate” nations such as Italy were able to borrow at Germanic level interest rates. But the decision a few months ago by the European Central Bank to block a basic “repo” function — namely, the purchases of a number of European commercial banks of Greek government debt and exchanging this debt via repos with the ECB for German and French government paper is what appears to have initially triggered the Greek crisis and raised issues of Athens’s potential insolvency.
From what we understand, the cessation of this repo function was largely done at the behest of the Germans, who saw this activity as a kind of “back door monetization” which would lead inevitably to inflation. This, despite the fact that the entire euro zone is characterized by huge unemployment , high output gaps, and collapsing domestic consumption. All of this at the core is being driven by Germany’s pathological fear of inflation which they see as the inevitable consequence of excessive government budget deficits.
But Germany’s irrational fears of inflation are storing up the conditions for a far greater crisis down the line. The euro contagion could now very well spread to Italy Portugal Spain and Ireland, all of which (under the terms of this package) have to lend to Greece, at around 5%. So what happens to their funding costs? They go north of 5% as a next step. In the US, when good banks took over bad banks, they became bad banks themselves (see Bank of America and Countrywide). And what about the seniority structure of these loans? Do they subordinate Greek Government Bond holders? One assumes yes, but this is not made clear by the rescue package. In short, this appears to be a cobbled together solution, and it won’t work for a Spain or an Italy. There’s no clarity even on how it gets ratified. The EU says it’s done, but Germany and Holland say they need Parliamentary approval (which can easily be delayed).
Let’s be clear: in the aftermath of World War I, German production capacity was either significantly damaged, or redirected toward output required by the military. The Allied blockade further restricted imports well into 1919, and in 1923, French and Belgian troops occupied the Ruhr valley which held a good deal of Germany’s manufacturing base. All of these measures significantly restricted Germany’s capacity to produce, fueling the distributional conflict that fed the hyperinflation.
There is nothing like that today in Germany, yet “Weimar 2.0″ thinking predominates in much the same way that “Maginot Line” thinking dominated French thinking in its defense establishment. The obsession with a”defense” against the “external” threat of inflation, is blinding Germany. It doesn’t see the risk that the collapse of aggregate demand within the European Monetary Union will ultimately lead to a collapse in Germany’s export sector (a large chunk of which is the product of intra-European trade), and the corresponding extension of the “PIIGS” disease of slow growth and high unemployment to the heartland of the euro zone. We know how it ended for France, once the Maginot Line proved to be a defense more apparent than real.
We hope that Germany’s similarly “successful” defense of inflation does not lead to a comparably disastrous result for Europe today.
Europe appears to be headed for one nightmare after another. If Italy rolls over, look out.
Germany’s leadership is crazy.
Paul Krugman is concerned. Note his closing remarks about the USA. Grim.
http://www.nytimes.com/2010/04/09/opinion/09krugman.html
AP’s Greg Keller, Katie King, Daniel Woolls, and Aoife White have a good summary piece.
http://www.businessweek.com/ap/financialnews/D9F1M9C01.htm
Marshall,
Good post. I have read a lot about this lately and you do miss one important aspect of this. The Germans really don’t feel that the Greek Government will get its act together. they are also worried about the other sothern tier Euro nations – paticularly the Italy and Spain. The last thing the Bundesbank wants to do is get in the situation where they are constantly bailing out Greece/Italy/Spain every few years. That’s why the tough austerity measures. They need to be tough on Greece to hopefully keep the much larger Italy/Spain problem from happening. Make the Euro solution more painful than the national solution if you will.
The inflation fear just adds fuel to the fire.
Right now, from all I’ve read, the Greek government has really no will-power to actually impose any fiscal discilpline on itself either short or long term. Why should the Germans just throw good money after bad? Think of trying to fill a bucket with water but the bucket has a hole in the bottom. The argument seems that if they don’t Greece could pull the entire structure down. So what provides the Greek government any incentive to get their act in order when they can blackmail the Germans/ECB every few years?
A better solution might be to kick Greece out of the Euro and left them inflate their debt away (devalue their currency) to solve their problems. Even then I’m not sure it will help the Greeks…
Islam will change
Buff,
If Spain and Italy hit a wall, then much of Europe will be at risk. The economy of Italy has already been affected because Germany dragged its feet on the Greece issue.
There is a lot at stake should the European situation begin to unravel. Eastern Europe may very well come apart at this rate.
Take a look at Krugman’s piece. Worrying about inflation at this point is not the primary issue.
Germany isn’t taking its thinking far enough. The Maginot Line mentality is very much alive in Germany.
But is Germany’s primary worry really inflation? Or is it countries getting a free ride off Germany. I equate this to the American anger over the bank bailouts. Frankly, Greece can fix this easily by breaking away from the euro. The euro will see some short term volatility, then be stronger withoutvthe deadweight of a fiscally irresponsible Greece, who lied about their situation in the first place.
Mcwop,
Fine. Based on that approach, how many of the 27 member nations should be dumped from the EU? Or barred from using the EU monetary system? And what does this indicate for the other nations seeking membership in the EU?
Spain and Italy are large economies, ranked high on the global list. Should they also be pushed out of the EU? What should the EU do about the East European members?
The financial house of cards in Europe is filled with problems. One good spreading financial fire and the EU may in real trouble.
Denmark and the United Kingdom were wise not to be dragged into the EURO currency. Once a nation gives up its own currency, quite a bit is at stake should economic or national budgetary events go poorly.
http://en.wikipedia.org/wiki/European_Union
.
The Euro will be “gone” at some point. It will either be in the next 2 years, or it will become a seriously devalued currency. I think the lesson here is that you cannot create lots of debt without consequences.
MG,
I read some more last night. Basically even if Germany backs the loans 100% it has no garentee that the Greek Gov. won’t be back for more in 2-3 years. And the Greek government politically cannot take the steps necessary to bring its fiscal house in order – loan or no loan. And that is the crux of the problem.
Worse it sets the precedent for Germany to bailout the out-of-control spending of Italy and Spain. I side with the Germans. If Greece, Italy, and Spain need the cash they need to get their fiscal house in order. Which means some tough love for the prolific spenders in these governments. The guy with the cash gets to call the tune.
The parallels with California are striking.
Islam will change
Perhaps the question that Europeans ought to be asking is how other monetary unions covering diverse regions with often poorly coupled economic situations manage to survive — the US, Canada, Australia … to some extent Italy and Germany itself. When you think about it, Newfoundland’s economy has little in common with Alberta’s and neither speaks the same language as Quebec. Somewhere in the mechanisms/policies/conventions that allow those countries to work (assuming that one credits Italy with working) is probably the answer to how the EU and the Euro countries should address their problems.
The socialist policies are working well in the “PIIGS” states. We need to go more in that direction. The riots in Greece look like fun. That’s what is so great about having the Democratic Party in power, and having a President like Barack Obama. They provide the confidence we need, so that some day, we can end up just the hero nations of the EU.
Once we increase the handouts, grants, unemployment benefits, medical benefits, retirement benefits, housing benefits, educational benefits, and labor benefits (such as up to 5 or 6 weeks of paid vacation every year) just like our hero’s in the EU, then this country will finally live up to the standard the rest of the world expects from us.
I am confident that the Democratics and the President can get this job done for us!
The problems in the EU have less to do with socialist policies and more to do with the currency union and the Maastricht treaty rules they operate under. The rules were set by Germany (since they had the strongest currency that was being scrapped for the Euro)for the most part, and they happen to like to produce way more than they can consume, live austerely and deny themselves an “easy” life. I guess its sort of a self flagellation for their behavior the prior 60 yrs. So what you are left with is a policy which is skewed to a certain behavior which is not necessarily “economically” better but is more of a philosophical preference. What is easy for Germany to do is absolutely impossible for the entire EU to do,( unless they all net export to the rest of the world and try to compete with China and Japan). SOMEONE SOMEWHERE has to consume all the surplus that is being produced by Germany so someone needs to be profligate spenders and not net savers in order for this thing to work. Its not very helpful to deride your profligate spending neighbors whom you rely on to sell your surplus crap to, when in fact you need their profligacy.
This was a currency union that was made to fail and needs to either be restructured (like the US with its states) or scrapped and each sovereign nation issuing its own currency as much as it wants and being as austere or profligate as it wants.
What would be wrong with 5 or 6 weeks of vacation Jimi? Do you have something against time off?
We have over 20% of the workforce idle and we are producing everything we need right now right?
You go ahead and offer to cut your pay 20% and take only one week of vacation, just for the good health of your company. Go ahead Jimi be a company guy.
Well if it seriously devalues then all goods denominated in Euros become cheap and there will be a nice export boom. Good for Germany and France.
I agree about the “cannot create lots of debt without consequence” statement but then again its kind of a broad statement, that doesnt really get to the heart of the matter. Not all debt is alike and not all debt is bad, while even non debt spending has consequences.
I think all these situations have started to show the fallacies inherent in our understanding of currencies. People talk about strong versus weak currency. They decry the devaluing of our dollar yet want China to stop devaluing their currency relative to ours. Do we want a weak or a strong dollar? Which is it?
I think we need to stop worrying about currencies and worry about PEOPLE and making sure they have jobs. Whatever happens to the currency is completely manageable. If it becomes weak relative to the Euro, lets ell stuff to Europe for a while if it becomes strong relative to the Yen lets buy stuff from japan for a while. In the meantime lets make sure we can make everything we need for ourselves here at home and not NEED to import. Lets import because we want to not cuz we have to.
Actually the parallells with California are completely overblown. Californias debt to GDP is less than a tenth of Greeces AND California is a part of the USA which has no stupid Maastricht treaty to deal with in handling state fiscal matters. California has a great tax collection system they just happen to be hamstrung by a legislature which has, for completely ideological and not economical reasons, made it virtually impossible to raise taxes.
Thanks Marshall
Much better discussion over here on Marshalls piece than over at Yves place. I really am glad to see Chartalists/MMTers like Marshall and Rebecca getting more face time over here. Its part of that “last mile” that has been discussed over at Bill Mitchells “billy blog”
Why is it phrased “countries getting a free ride off of Germany” ?
Germany loves to make more than they can use and they make things very well. But they need customers not people who also want to make more than they can use. Imposing German values on the entirety of the EU is just wrong. Mainly because what Germany does CANNOT be applied everywhere so why act like it could or should?
***What would be wrong with 5 or 6 weeks of vacation Jimi?***
The memory span of our resident conservatives isn’t all that great Greg. For example they tend to forget exactly who was driving when the US economy went over the cliff. I fear that if they took five consecutive weeks of vacation, they’d probably forget where they work.
True dat Codger
Dear anglo saxons, if you want to play the other debtor nations against Germany, it would be wise to not refer to them with insults like pigs. Not that the rest, the anti German rambling mixed with odd nostalgia towards a war that killed 50 million would be any better.
Ever thaugh that you might have it backwards, that its not the traumatic German expirience,but rather the traumatic American expirience with high unemployment and deflation that puts you in irrational panik mode?
VT,
The difference is that in the US, Canada, Australia you have a central democratically elected government responsible to all the people. That is not the case with the EU. The EU is not soveriegn over Germany or Greece (unlike Canada’s gov is soveriegn over Alberta and Quebec).
You could probably get this to work if you turned the EU into some version of a United States of Europe, with a central government soveriegn over the individual parts (where now Greece and germany play the parts of Alberta and Quebec). I just don’t see that happening anytime soon though.
Thus you keep having the situation where the Germans have to bailout the Greeks with no gareentee that the Greeks won’t be back next year for another bailout. I side with the Germans from what I see about the Greeks – The Greeks arn’t going to stop the bleeding. Even the attempt would get the current Greek Gov. thrown out of office. And their replacements would get the message also.
Islam will change
There are certainly differences although Canada and Australia are much less centralized than we Americans tend to think. Things like the Canadian single payer health system are actually run by the provinces.
In any case, it’s hard not to have sympathy for both the Greeks and the Germans. The Germans because none of this is their fault and they have pretty much worked hard, played by the rules, and paid for one enormous bailout out of their own pockets when they integrated East Germany two decades ago. Greece’s problem appears to be that there is no tool available to them to equitably shrink their economy. This is going to be even more evident if Spain and Ireland follow Greece. Spain didn’t do anything wrong other than have a real estate boom. And Ireland’s problems are hauntingly familiar — real estate bubble and failure to regulate its banks.
I would hope that the Germans would be a lot more enthused about bailing out Greece if the action were part of a real solution to Greece’s problem.
We’ll possibly see how well the US handles this sort of situation in about 18 months if California defaults. I think Schwarzenneger — who appears to be the first competent governor in 40 years — will get them through one more crisis this fall. But the only other California politician with a functioning brain — some time insurance commisioner and Lieutenant Governor — John Garamendi — has dropped out of the governor’s race on gone off to Congress. So, I expect — barring a sudden outbreak of sanity — when the state runs out of money again in late 2011, that’ll likely be the end of extend and pretend in that part of the world.
“I would hope that the Germans would be a lot more enthused about bailing out Greece if the action were part of a real solution to Greece’s problem. “
I thinnk the Germans would be very enthused if they believed that the Greeks just needed this to get to a solution. I don’t see teh Greeks getting there. We’ve seen rioting already this year and it will get worse if they hit the austerity measures needed to get their economy back on track.
And I totally agree with you on California. I wish old Kevin Drum would focus more on his home state like he used too. He was one of the originals that I started reading way, way back. I even used to comment a lot. But his comment section has mostly turned into a mono-culture with very little discussion. Something I think rdan is not given enough credit for keeping both sides in the discussion.
Even if it means tolerating all you commie-loving lefties 😉
Islam will change