DAVID “SPENGLER” GOLDMAN: EUROPE’S CRISIS IS ABOUT WEALTH, NOT GROWTH
Posted By Ruth King on June 18th, 2012
http://www.atimes.com/
Europe’s crisis is about wealth, not growth
President Barack Obama will ask the Group of 20 meeting in Mexico June 18 to present “a unified message about the importance of growth”, according to Michael Froman, his deputy national security adviser for international economics. What the Obama administration means by “growth” is that Germany continue to bail out its feckless southern European neighbors. That has nothing to do with growth. The issue, rather, is who takes the hit when Europe’s illusory wealth is written off.
Europe and America both entered the 2008 economic crisis with enormous asset bubbles. America’s was concentrated in the price of residential real estate and mortgages issued against residential real estate. Europe’s is concentrated in the debt of governments and banks. America’s asset bubble has already popped, resulting in a US$6 trillion reduction in the paper wealth of American households, with a 40% reduction in the net worth of the average American family. But Europe’s institutions continue to prop up the continent’s asset bubble.
The US government misused government subsidies via Freddie Mac and Fannie Mae to promote the housing bubble, and looked the other way while financial institutions and rating agencies created a trillion-dollar house of cards in levered mortgage-backed securities. The weaker members of the eurozone used their enhanced borrowing powers to pile up daunting levels of government and bank debt.
Behind the financial manipulation in both cases was an erosion in the foundation of national wealth, as aging populations put catastrophic pressures on national pension and health systems. In the case of Europe, the number of retirees is set to double during the next 40 years while the workforce will shrink by a third.
Exhibit 1: Europe’s working age population (15-59) shrinks by a third while population over 65 doubles
Source: United Nations World Population Prospects (Constant Fertility Scenario)
Exhibit 2: America’s working population grows but retired population grows faster
Source: United Nations World Population Prospects (Constant Fertility Scenario)
In a May 2009 essay for First Things, “Demographics and Depression,” I argued that reduced family formation had shrunk America’s demand for houses and provoked the economic crisis:
America’s population has risen from 200 million to 300 million since 1970, while the total number of two-parent families with children is the same today as it was when Richard Nixon took office, at 25 million. In 1973, the United States had 36 million housing units with three or more bedrooms, not many more than the number of two-parent families with children- which means that the supply of family homes was roughly in line with the number of families. By 2005, the number of housing units with three or more bedrooms had doubled to 72 million, though America had the same number of two-parent families with children.
The housing bubble eventually had to pop, and the result was a $6 trillion write-down in American wealth. Europe’s demographic problem is far worse. Europe also requires a massive reduction in private wealth, as Nobel Prize winner from Columbia University, Edmund Phelps, explained in a January 12 op-ed in the Financial Times:
What must be done? Italy, Portugal and Greece must do without the deals that made state borrowing so cheap for them – the ill-deserved AAA ratings and the outrageous exemption of banks from capital requirements on sovereign debt holdings. Another must is a wealth tax, so that net wealth bears some resemblance to the true value of what Italians can be expected to produce, net of expected labor costs in the future. And next time an economy is in the throes of exchange rate over-valuation, it must jettison the urge to run fiscal deficits.
Some European countries, to be sure, can mitigate their demographic dearth through immigration. After the Thirty Years War of 1618-1648 wiped out most of his people, the Elector of Brandenburg, Friedrich Wilhelm I, invited French Huguenots, Poles, Jews, and others to settle in what later became Prussia. German was a minority language in Berlin during the 18th century, and might be a minority language again in the 21st century. The smartest Greeks and Spaniards may decamp for jobs in Germany.
Europe’s nominal wealth is embodied disproportionately in national debt and in the banking system, especially in the debt of the banking system. To reduce the paper value of wealth would be an overtly political act, rather than a quasi-market phenomenon as in the United States. All of Europe’s politics now revolves around the question of whose wealth gets taxed. If Spanish pensioners are told that their pensions will be reduced by a big margin because the Spanish banks made too many bad loans to construction companies while the government looked on, they rightly will blame the government. This may destroy the delicate fabric of Spanish political life. That is unfortunate, and it may be unavoidable.
There are many ways to write off the nominal wealth to levels that correspond to economic reality. The simplest and best would be for Spain, Italy and so forth simply to impose a wealth tax. But wealthy southern Europeans have been hiding their wealth for generations precisely in order to avert such an eventuality. Another way to have a de facto wealth tax is to devalue the currency, which makes everyone (but especially people of modest means) much poorer, while reducing the real liability of debtors (mainly the government). And yet another way to tax wealth is to wipe out the value of assets.
Americans accepted the overall reduction in wealth because the housing bubble was a people’s Ponzi scheme, as I wrote in this space (See The people’s Ponzi scheme, Asia Times Online, August 16, 2011). Americans speculated on their own houses, and lost. So did the Irish, who glumly accepted the consequences.
Not so the Spanish: the massive misdirection of credit to the construction sector focused on corporate rather than household lending. Financial institutions issued debt in the astonishing volume of 109% of GDP (about three times the level in the United States). The construction sector ballooned to a size large than manufacturing (vs a fifth of the manufacturing sector in Germany and a quarter in the United States).
The massive issuance of financial institutions’ securities constitutes a large portion of the wealth of Spaniards; they sit in pension funds and life insurance portfolios. Wipe out their value, and Spaniards will have to accept pension reductions. That is precisely what should be done: the banks are valueless, and their liabilities should be erased so that an external buyer can recapitalize them. The Spanish won’t like it a bit. Nor will other Europeans.
The alternative is to place a de facto wealth tax on the frugal and industrious northern Europeans, by extending Germany’s (and Holland’s) balance sheet until the euro weakens drastically, raising the cost of imported goods for the Germans. It is unfair to tax German wealth in order to maintain the wealth of the rest of Europe, and the Germans won’t like it.
In neither of these scenarios is an uncontrolled financial crisis a necessary outcome. That is a bogeyman that economists use to frighten naive and impressionable heads of state. It is entirely possible to let the Spanish banks fail, wipe all their equity and debt, and then bail out the French banks who own a great deal of the senior debt of Spanish banks. There will be no chain reaction, because the European Central Bank can simply put a circuit breaker wherever it wants.
Making a horrible example of Spain is the best alternative, in our view. Spain probably will devolve into political chaos, but the global effects will be easily contained. And Spain’s misery will persuade the Italians that fundamental reform is far preferable to repeating the Spanish experience.
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Europe’s crisis is about wealth, not growth
By Spengler
As the Chinese say, kill the chicken and let the monkey watch. If Italy with its $2 trillion in external debt were to fail, the situation would be truly dire. But there is no need for that to happen; although Italy’s sovereign debt is above 100% of GDP, private debt is only 45% of GDP, the Italian state has saleable assets worth perhaps 40% of GDP, and Italy has hundreds of first-rate manufacturing companies that are market leaders in their own fields (unlike Spain, which has very little first-rate manufacturing).
The political Gordion Knot must be cut somewhere, and the easiest place to do it is in Spain. The results will be frightful for the Spaniards but salutary for everyone else. The alternative is to reward bad behavior with bailouts and penalize frugality and
industriousness. To call this a “growth policy” is perverse. How can it foster growth to arbitrarily shift rewards away from market winners and assign them instead to market losers?
Nobel Prize winner Robert Mundell, the father of the euro, told Canada’s Financial Post (June 8),
“The euro is not the problem. The problem within the European Union and the European Monetary Union is government deficits and the debts of a few countries, mostly in Southern Europe. It is a failure of fiscal discipline that has threatened the solvency of the debt-ridden countries whose high deficits are due in large part to the current recession in Europe and more generally the slowdown of the world economy. The debts would only become a problem for the euro if these deficits led the European Central Bank (ECB) to create substantial inflation to try to bail out these countries.”
Central banks can’t expand their balance sheets forever. Or can they? In the current issue of Foreign Affairs, the journal of the Council on Foreign Relations, CFR economist Sebastian Mallaby argues in all seriousness that the central banks are “supermen” who can print as much money as they want:
By December 2008, the Fed had extended fully $1.5 trillion in emergency financing to markets, dwarfing the $700 billion bailout fund authorized by Congress through the Troubled Asset Relief Program (TARP). Central banks on the other side of the Atlantic have acted with equal resolve. For much of 2011, Europe’s political leadership bickered about the details of the European Financial Stability Facility (EFSF), a TARP-like bailout fund with an intended firepower of 440 billion euros. Then, one day last December, the European Central Bank provided 489 billion euros to the continent’s ailing banks, and in February 2012, it repeated this stunt, effectively conjuring the equivalent of two EFSFs out of thin air through the magic of the printing press. Since the start of 2007, the ECB has purchased financial assets totaling 1.7 trillion euros, expanding its portfolio from 13 percent to over 30 percent of the eurozone’s GDP. That means that the ECB has printed enough money to increase its paper wealth by an amount exceeding the value of eight years of Greek output.
This superman act has, at least as of this writing, saved the euro system from breaking up. Without the central bank’s extraordinary support, private banks across the eurozone would have struggled to raise money and would have collapsed … For the foreseeable future, therefore, the ECB can keep on printing money to prop up banks.
Mallaby ignores the enormous difference between the United States and Europe. America undertook a $2 trillion expansion of central bank assets while household assets shrank by three times as much, that is, by $6 trillion. The national balance sheet as a whole shrank in the United States, but has yet to shrink in Europe. McKinsey Consultants estimate that the US has reduced overall debt by 15% since the crisis, while Europe’s debt has risen. Mallaby is only looking at half of the balance sheet; his article recalls the ethnic joke about the accountant who ran off to Brazil with the accounts payable.
Except for Greece, which has already cut the value of its bonds by 50% to 70%, Europe has written off little of its own asset bubble. The $1.3 trillion debt of Spanish financial institutions remains on the books of Spanish pension funds and insurance companies (as well as French and other European banks). The ECB has lent 1.7 trillion euros (US$2.15 trillion) to private banks to replace deposits removed by depositors who expect them to go bankrupt eventually. If the ECB keeps printing money, the value of the euro will plummet and the cost of oil and other imports will soar. Europe will lose wealth through currency devaluation, and the biggest losers will be the prosperous European nations who have viable financial assets, namely the Germans and Dutch.
Penalizing good economic management and rewarding bad economic management is not a “growth” policy, whatever the Obama administration might think; it is a formula for perpetual stagnation. It is sad that the Spanish will have smaller pensions, just like municipal workers in San Jose, California (which also cut pensions due to a budget crisis). The only way to get back to growth is to clear away the phony valuations of paper attached to insolvent institutions. Once the liabilities of the Spanish banks are wiped clean, an outside buyer – perhaps China or a sovereign wealth fund – can buy in and reconstruct the system. That is what happened in Thailand in 1997 after the banking system collapsed during the great Asian financial crisis.
A middle position argues that insolvent European countries should get bailouts if they cede power to Brussels. That is the gist of all the plans now circulating to fix Europe’s financial problems. “Bailouts have to be linked to some transfer of fiscal authority from countries that have become insolvent to the European Commission acting under the auspices, for constitutional correctness, of the European Council,” Mundell told the Financial Post. That is also the German position, although one suspects that it is a polite way of postponing demands for more German money.
Supposedly the enlightened bureaucrats of the European Commission (perhaps with the connivance of the International Monetary Fund) will force reforms onto weak and ineffective national governments. The big stick from Brussels might actually help some countries, under two conditions. The first is that reform is what a country requires, and the second is that a political party is in power that can use external pressure to push through reforms it wants to adopt in any case.
In small ways, this already is occurring: Portugal’s bailout by the European Community and the International Monetary Fund has empowered young reformers who are selling off state assets, reforming labor laws, and breaking up old monopolies.
Exhibit 3: Percentage of underground economy activity vs labor force participation rate
Portugal has a high labor force participation rate (which simply means that the Portuguese work on the books and pay their taxes) and a relatively low share of underground economic activity. Greece has a much lower labor force participation rate and a much higher share of underground economic activity. Portugal’s problems are treatable; Greece might be too far gone.
Excepting Portugal, the Mediterranean countries combine a pre-modern hostility towards central government with a post-modern indifference to the national future. At just 1.4 children per female, Italy and Spain have some of the lowest fertility rates in the world, which is to say that its citizens are unlikely to sacrifice their pleasures and prerogatives for a national future to which they do not contribute by raising children. Neither country’s elite evinces a sense of national obligation. To pay taxes is to play the fool. Italy has a great deal of private wealth and very low levels of private debt (which is only 45% of GDP, one of the lowest ratios in the developed world). If Italians were public-spirited, it would be a simple matter to stabilize the country’s public debt, which is tantamount to saying that if we had some meatballs, we could have spaghetti and meatballs, if we had some spaghetti.
If Italians and Spaniards treat their own national government as a hostile entity to be frustrated and evaded at every turn, how would they resound to a fiscal boss from Brussels? The notion that supranational controls can accomplish what national governments have failed to accomplish is one of the stranger ideas to achieve broad purchase in public policy.
Spengler is channeled by David P Goldman, president of Macrostrategy LLC. His book How Civilizations Die (and why Islam is Dying, Too) was published by Regnery Press in September 2011. A volume of his essays on culture, religion and economics, It’s Not the End of the World – It’s Just the End of You, also appeared last autumn, from Van Praag Press. |
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