Last Sunday Michael Burke had an article in the Guardian’s Comment is Free on the European Banking Association’s stress tests and the current Eurozone debt crisis. Michael argues that the spending cuts imposed on “bailed out” economies are being imposed as a mechanism to save European banks, and the conditions around the paying of those unacceptable debts are reducing the abilities of the economies to recover.  The resulting renewed economic slowdown, rising unemployment and the falling prices of commercial and residential property in turn provides additional risks to the banking sector. Although it’s widely publicised that the stress tests did not take into account the possibility of a Greek default despite its widely perceived inevitability, they did acknowledge this risk of continuing poor economic performance as a result of the repayment conditions, showing an awareness that is completely lacking in the EU’s political leaders.

Below is an essay by Michael Burke that was first published in the current issue of the Soundings Journal on the nature of the Eurozone sovereign debt crisis. Republished with the permission of the author and Lawrence & Wishart, the publisher of Soundings.

Although written in April, the article remains extremely relevant in that it highlights the fact that the current ’sovereign debt’ crisis only began in 2010, two years after the beginning of the crisis and that it was not as a result of “high public spending” in what are now considered to be fundamentally weak Eurozone economies. Rather it was because of ECB actions around the banking crisis. That is, while lenders had been content to provide credit to distressed economies within the Eurozone, preferring to invest in what were safe government bonds rather than traditional private investment, the ECB decision to refuse to continue providing liquidity to ‘addicted’ banks within peripheral countries closed off previously available avenues of independent borrowing and forced them instead to rely on the extortionate ESFS. The willing assistance of the Irish government in all this shouldn’t be discounted of course. Or as Michael concludes, “[Irish economic] policy has delivered Irish savings and future incomes up to an EU/1MF debt-collection agency acting on behalf of Europe’s banks. The terms of the imposition are so onerous that the IMF is made to look like the good cop.

Denial is one of the phases of response to trauma. The denial that has been a leading component of the traumatic economic crises across Europe has taken the peculiar form of non-identification. So, the Dublin government asserted that it wasn’t Greece in a vain attempt to advertise its underlying strength- before the EU and IMF came to call. Greek protestors said they weren’t Irish, meaning they wouldn’t meekly accept the cuts. The Portuguese authorities denied that they were either Greek or Irish and would avoid calamity altogether. They are surely right on the first count, and may even be proven correct on the second. Over on the influential IrishEconomy blog, they were generally insistent that Ireland wasn’t Belgium - not a reference to the potential division of the country into two separate entities but an assertion that, while Belgium could afford measures to stimulate the economy, the Dublin government had none.

It was necessary to turn to the coarse argot of the financial markets make a positive ID. The crude acronym for all the countries; they are PIGS:  Portugal, Ireland, Greece and Spain.

Identity Mix-Up

The offensive ‘PIGS’ label implies a chronic economic mismanagement of a known group of countries, and a certainly degree of inevitability regarding their fate. But the term itself obscures an important ideological sleight of hand; the ‘I’ used to stand for Italy and its high level of public debt. Ireland’s low-tax, low-spending regime was never considered to be a crisis-prone economy in the ideology of neoliberalism- in fact it was a model of that ideology.

But this perception; that a group of countries were basket-cases of high government debt levels and ballooning public sector deficits inevitably leading to crises when Great Recession began, owes more to mythology than economic reality. For the Euro Area as a whole the economic slump began in Q2 2008. Before then, Greece had the highest public sector deficit in the Euro Area equivalent to 6.4% of GDP (1). But Ireland and Spain had Budget surpluses, the latter a significant one, while Portugal’s deficit was proportionally the same as that of France.

Likewise, the accumulated Greek government debt was over a 100% of GDP prior to the recession, and more than one-third higher the average in the Euro Area. But Irish government debt amounted to no more than one quarter of GDP, the lowest in the Euro Area apart from Luxembourg. In addition, Spain’s government debt was little more than a third of GDP, and half the Euro Area average. The two highest debtors following Greece were Italy and Belgium, who have not yet come under sustained pressure let alone crisis.

Therefore it is difficult to sustain the argument that the crisis was one in which highly indebted or high-deficit economies became the target of financial markets anxious about the increasing prospect of debt default.

This is because the source of the crisis in Europe cannot be found in the public sector. The main features of the crisis in Europe were the near-collapse of the banking system and a slump in activity led by plunging private sector investment, which fell at more than 3 times the rate of the overall decline in GDP. A fall in public sector savings (rising deficits) is unavoidable when both parts of the private sector are increasing their savings, households and businesses. But the response was varied. Outside of the economic disaster that was Thatcherism, deep cuts in public spending had not been the norm since the 1930s. Only the Dublin government shifted straight into Thatcherite mode. Elsewhere the response was generally to increase government spending. But that dynamic led a synchronised increase in the funding requirement of European and other governments. This was well within the capabilities of the financial markets to provide, who were in any event busy shunning corporate borrowers and looking for a home for their capital. But the crisis-hit countries were those who were reliant on foreign capital irrespective of the state of government finances, and whose banking system had become a net drain on the economy.

This dependency can be highlighted in the current account balance of payments, which represents net borrowing/lending from overseas for any economy. The prior existence of large current account deficits is a feature common to all the crisis-hit countries in the Euro Area. For Greece the 2007 was equivalent to 15.7% of GDP, Portugal 10.2%, Spain 10% and Ireland 5.5%. By contrast, countries such as Germany maintained a large current account surplus, 7.6% of GDP, with the Netherlands surplus of 8.4%. The average current account surplus across the Euro Area was a modest surplus of 0.2% of GDP.

It should be stressed the current account balance is not primarily an indicator of competitiveness, as it is quite possible to have a large trade surplus and yet maintain a wide current account deficit- as is the case in Ireland. In this case the current account deficit represents an extraordinarily high level of indebtedness, the interest payments on which far outweigh the positive inflows from net exports.

In the table below, the 2007 components and level of the current account balance for key EU economies is shown.

*rounded to sum to the current account balance

Table 1. Current Account Balances and Their Components For Selected EU Economies in 2007, % GDP

The economies most affected by the crisis have in common the vulnerability that they are dependent on foreign capital inflows to offset their respective significant current account deficits. For most, but not all, this was a function of poor competitiveness within the Euro Area, as indicated by their trade deficits.  A certain level of positive net inflows to the private sector - in the Greek case very sizeable inflows mainly related to the shipping industry - were insufficient to offset large, or extremely large trade deficits.

These private sector inflows were one of the first casualties of the crisis with global trade volumes in 2009 declining by more than 3 times the rate of the decline in world GDP.  In that circumstance it the slump in private sector inflows that was inevitable.  But the crisis-hit countries of the Euro Area also have in common a structural weakness in the public sector, which makes them extremely vulnerable to the swings in the private sector-driven business cycle.

While the government revenues as a proportion of GDP were 45.3% of GDP in the Euro Area as a whole in 2007 among the crisis group of countries, the highest level was in Spain at 41.1% and the lowest in Ireland at 36.8%. Put another way, Irish taxation, overwhelmingly the main source of government revenues, would have had to rise by a quarter in order simply to comply with the Euro Area average. By contrast, the ‘core’ countries all had taxation levels well over 40% of GDP, in some cases closer to 50% of GDP.  (In Britain, New Labour’s unwillingness to tax at even the rate that Thatcher had also left the economy vulnerable to the fiscal effects of the private sector crisis).

To the Slaughterhouse

While individual European economies may have strong trade links with the rest of the world, the Euro Area as a whole is a largely self-contained unit. The very modest current account surplus already noted is within the realm of statistical discrepancy. Effectively the current account is in broad balance, and the trade balance has a modest surplus over the long run.

The clear implication is that significant imbalances exist within the Euro Area and are contained within it- that one economy’s deficit is offset by another’s surplus.   That being the case any crisis which included a sharp deterioration in the availability of credit through the banking system would almost inevitably lead to a series of country-specific crises of liquidity. A sustained liquidity crisis inescapably becomes a solvency crisis.

Almost inevitably is the key phrase.  Because one of the features of the crisis was a sharp fall in the demand for imports in the crisis-hit countries, the actual requirement for overseas funding dropped sharply during the crisis, by over 2.5% of GDP in the crisis-hit countries. Therefore the flow of funds required dropped significantly. And, since market mechanisms exist for the attraction of overseas capital through the yields on international bonds, there was something of an automatic adjustment process allowing both sovereign and corporate borrowers access to that capital.

As the crisis took hold this automatic mechanism saw peripheral country bond yields move higher versus Germany, which is regarded as the benchmark in Europe. The trajectory of 10 year German, Spanish and Irish government bond yields during the crisis period of 200 and 2009 is shown in the chart below.

German yields actually fell sharply as the crisis mounted as that benchmark status was reinforced by investors switching out of riskier government bond markets and into the German safe haven.  Consequently yields in those riskier markets rose relative to Germany. But even for countries such as Spain the nominal level of government bond yields fell over the period, belying any idea that financial markets were increasingly wary of increased government deficits or the likelihood of sovereign default. On the contrary, at that time it was corporate debt, especially bank debt yields which ballooned, precisely because this was the locus of the crisis. By comparison almost all government debt was regarded as a relative safe haven.

Strange to recall now but a host of bank bonds had the highest AAA credit rating or equivalent at the beginning of 2009, higher than many European countries, and their yields soared into double digits before bankruptcies and bailouts followed.

Chart 1

The exception in this process was Ireland. But Ireland had taken exceptional measures in cutting government spending and raising taxes on individuals. Every other OECD economy, bar Berlusconi’s Italy, had taken some sort of government measures to revive the economy. By contrast, the Dublin government achieved what its supporters described as ‘first-mover benefits’ from immediately attempting to correct the public sector deficit by reducing spending.

In general the stimulus measures were adopted in 2009. Some countries, notably the US, France and, to a less extent Germany increased those measures in 2010. In that regard, Germany provided the surprise, with the Rightist Coalition government led by Mrs Merkel having been elected on a traditional platform of fiscal rectitude with hardman Finance Minister Schauble almost immediately announcing a bigger stimulus package in 2010 than they had in 209.

But the Greek crisis exploded in May 2010, for reasons we will examine below.  Until that time, with the exception of Dublin, governments in all the main European economies had adopted stimulus measures. In the table below, compiled from the ECB and a variety of national sources, the size of those measures and their effects are shown.

The ECB has detailed the scope of the stimulus measures, while national Finance Ministries or central bank data have been relied on for data on the fiscal impact of the stimulus. The column detailing the growth of taxation receipts relates to the 8 months to July 2010 data, compared to the same period a year ago .

The most striking feature is that in all cases, without exception, taxation revenues are increasing and the deficit is falling in those countries which adopted measures to boost growth. By contrast, in the one country which did nothing to boost activity, Berlusconi’s Italy, taxes continue to wilt and the deficit is higher in the first half of this year than in the same period in 2009.

Table 2

It should also be noted that the size of the stimulus measures has some relationship with the pay-off in terms of the subsequent growth of taxes. But there is not a direct correlation. This is because the composition of the measures is also significant. In Keynesian terms, it is because differing types of stimuli have different multipliers attached; they have a widely differing ‘bang-for-buck’, with investment the highest multiplier of all. This is highlighted in IMF research examining the effectiveness of various types of fiscal stimulus.

The researchers applied seven econometric models (including two from the U.S. Federal Reserve, as well as the European Central Bank, the IMF, the European Commission, the OECD and the Bank of Canada) to the issue of how to revive economic activity via government spending. In the jargon, these are the ‘multipliers’, the economic impact of changes in fiscal policy. The main conclusion was that “the multipliers from government investment and government consumption [general government spending]…are clearly larger than…” all types of tax cuts and only “….targeted transfers [to the poor] come close to having the same multipliers as government spending” (p.16). They found that with interest rates low the cumulative multiplier for government investment is 3 times the initial outlay over 2 years. Similar results were found in separate IMF research, taking the opposite process where the cumulative multiple was found to be 5 times the initial cuts to government spending over 6 years, when interest rates are low and fiscal tightening is taking place elsewhere.

Yet according to the ECB just 28% of the entire stimulus measures across the Euro Area were public investment. The remaining two-thirds were measures to support household consumption and businesses. But the different impact of these can be noted from the from the fact that the latest estimates from Eurostat are that EU household consumption rose by 0.6% in 2010, while investment (gross fixed capital formation) will fall again, by 0.8%

That is to say, the measures to boost private consumption have had a modest positive effect, whereas the measures to support business activity have not produced a positive result.

Lessons From Madrid

If we take the case of Spanish state, which had the largest package of measures, there was a vigorous economic response, not readily the meagre recovery in aggregate GDP, up just 0.3% in the first half of his year. However it a surge in import demand that masked the much stronger rise in the domestic economy and arithmetically subtracts from it. The final consumption expenditures of households, government and the non-profit sector rose by 1.9% in the first half of this year. As a result of this rising activity, the public sector deficit halved in the first 7 months of 2010. Rising taxes are overwhelmingly responsible, €18.5bn higher of a total €21.3bn improvement.

Of course the combination of EU, ECB, IMF, ratings’ agencies and financial markets all conspired since to strong-arm the Spanish government into adopting massive spending cuts, which were implemented after these data and will impact fully only with their own time lag. A rear-guard action in the form of clinging to cherished investment projects and a modest rise in the minimum wage will not be enough to prevent this capitulation from wrecking both the recovery and the improvement in government finances. The net effect will be a markedly slower growth path and renewed widening of the public sector deficit.  Based on the latest forecasts for the European Commission, by 2012 the economy of the Euro Area as a whole will be 10% below its pre-recession trend, Spain will be 20% below.

The Role of the ECB

The financial market’s crisis in early 2010 led to the announcement of a package totaling €110bn in an attempt to resolve the Greek crisis. When that proved insufficient to create a firewall around other sovereign bond markets, a €750bn package was announced. That in turn proved to be insufficient to prevent the crisis engulfing the Irish government bond market and the subsequent intervention of the EU and IMF with a bailout package of €85bn.

Greece maintained a large public sector deficit and growing public indebtedness over a sustained period prior to the crisis.  Greece is one of the very lowest tax regimes in the EU, with the hugely profitable shipping industry effectively untaxed. It is the shipping and related industries (especially leasing) which is the source of the large private sector current account inflows noted previously.   A Rightist government had publicly been admonished by the EU for presenting false public accounts. In the years 2000 to 2003, the public deficit was understated by 10.6% of GDP. And, in a tell-tale sign of the unreformed nature of Greek society since the 1970s, more than half of that, 5.5% of GDP was on military spending.

However, the international crisis did not hit Greece particularly hard, the decline in output initially only about half as steep as the Euro Area as a whole and international forecasts projecting an earlier recovery than most. Yet Greek government bond yields climbed rapidly and the credit ratings’ agencies were warning of debt downgrades with a clamour to rein in government spending, although strangely, no-one ever mentioned curbing military spending.

The ECB’s intervention at this point was decisive. It announced to the financial markets that it would in effect no longer accept downgraded Greek government debt as collateral for its loans to European banks. Since the banks themselves were increasingly turning to the ECB for liquidity as all other sources had dried up, this announcement obliged those banks to dump holdings of Greek government debt and refuse to buy any more at auction.  Thus the Greek government felt cnstrained to turn to the EU itself for funds. Instead of European solidarity, it got an IMF-style bailout with the Fund acting as the junior party to the EU itself. As the citizens of large swathes of Africa, Latin America and South-east Asia know too well, this is a recipe for draconian cuts in public spending, combined with forced privatisations and the firesale of national assets to overseas capital.

The groundwork had been laid by the policies of successive Greek governments, but the architect of the country’s demise was the European Central Bank.

It is important to be clear on the flow of funds in the bailout. Europe’s banks are the main holders of Greek government debt although hedge funds and other vultures have increasingly joined their ranks. The bailout is a bailout of the creditors, not the stricken Greek economy. Greece is loaded with further debts in order to fund the bailout, and ferocious cuts in public spending are a vain attempt to generate a surplus to service that debt. As the Financial Times’ Martin Wolf remarked, this is worse than Argentina’s debt crisis, as the creditors are being paid to escape, and there is no-one to replace them.

The ECB had earlier declared that accepting lowly-rated Greek government debt would compromise the integrity of its balance sheet.  However, once the creditors were paid in full for their failing investment, the spending cuts introduced and the privatisation programmes agreed, the ECB was able miraculously to accept Greek government debt as collateral - even though it had by now been downgraded several notches, close to ‘junk status.  Greek society bound hand and foot to the requirements of Europe’s banks, the ECB’s work was done.

No Longer a Tiger

Effectively the same grim pantomime was played out in the Irish crisis, with domestic property speculators and bankers playing the role of Greek shipowners and Generals. The role played by the ECB was the same.

Relative to the size of the economy the Irish banks are the most highly indebted in Europe because of their excessive lending. As both deposits and commercial funding sources have dried up the Irish banks have turned increasingly to the ECB for short-term loans. But in response the ECB and its president Jean-Claude Trichet began a public campaign against this increased borrowing by the banks, and, pointedly, that Irish banks were the main culprits. They were called ‘addicts’ and Trichet’s patience finally gave way as he declared that there would be a forced reduction in these loans.

The shares in the Irish banks plunged towards zero as a result, and the Dublin government responded in now traditional fashion- by offering another taxpayer funded bailout of zombie banks. It was this decision which finally closed the bond market to Irish government borrowing as financial markets reflected the belief that the further bailout would lead the state to insolvency.  The EU and IMF have since imposed a €85bn rescue of Europe’s banks on Irish taxpayers, beginning immediately with €17.5bn in taxpayers’ savings in the National Pension Reserve Fund and elsewhere, supplemented by €67.5bn in new debts. The punitive nature of the imposition from the EU may be judged by the fact that the interest it charges on these loans is double that of the IMF’s 3%. It was accompanied by another series of austerity Budgets, which will bring the total fiscal tightening up to nearly 20% of GDP, more than double the Tory-led Coalition’s cuts in Britain.

As with Greece, the decision which provoked the crisis - in Ireland’s case the removal of ECB liquidity has now been reversed.  Job done.

The Dublin government presides over the lowest-tax, lowest-spend economy in the Euro Area, the very model of neoliberal economic policymaking.  But not for much longer. The ruling coalition has fallen and dubbed the first casualty of Europe’s economic crisis. The bank bailouts last year took the public sector deficit up to one third of GDP, double even that of Greece. The bank guarantee is also the largest and extends to all creditors, including international bondholders such as the Russian oligarch Roman Abramovich. In a reprise of the colonial relationship that both governments would prefer to forget, the major holders of Irish government debt are British banks, with state-owned RBS at the front of the queue.

In the North of Ireland, the peace process has led to a reduction in the number of British troops on the streets and their forts, although economic policymaking is less benign, with a recession there now stretching into its fourth year compared to a year and half for Britain. But in the Southern jurisdiction, economy policy has delivered Irish savings and future incomes up to an EU/IMF debt-collection agency acting on behalf of Europe’s banks.  The terms of the imposition are so onerous that the IMF is made to look like the good cop.

The scale and type of these exactions are unprecedented in Western Europe in the post-War period. We will have to look to the lessons of Latin America and elsewhere to learn how to remove them.

Notes

---

(1) All Data from Eurostat, Report of the Euro Area, Winter 2010, Statistical Annex, unless otherwise stated