This post offers readers a fully-fledged analytical model of the unfolding Eurozone Crisis. It begins with a macro-economic analysis of the Crisis’ causes and then, importantly, models the feedback between Europe’s institutional and policy responses and the contagion process that began with Greece. For the fully-fledged (wonkish) version of the paper, click here What follows below is a maths-free summary of each of the paper’s sections.
1. Introduction: Toward a macro-model of contagion
For three years now we have been discussing the Eurozone Crisis and the contagion dynamic that brought the Eurozone on the verge of disintegration. However, to my knowledge, no macroeconomic model of this process has been offered; at least not one that depicts the dynamic feedback mechanism between the Crisis and Europe’s responses (or lack thereof) to it. With this paper, I try to make amends and to offer a simple analysis of the nexus between:
- (a) a monetary union whose very design removed internal shock absorbers while, at once, magnifying both the probability and the magnitude of a future crisis,
- (b) a political response to the (preordained) crisis that involved the creation of toxic bailout funds which accentuated the crisis,
- (c) the underlying macroeconomic imbalances which are in fact deepening, thus rendering the European Union’s fiscal and monetary strategies logically incoherent, and
- (d) a European Central Bank whose decisive intervention to offer medium term financial stability (the LTRO and OMT re-financing programs for banks Italy-Spain respectively) came at the price of reinforcing long term disintegration.
2. Europe’s Gold Standard
Setting the scene, and before discussing the Crisis itself, Section 2 describes European Monetary Union as an interesting variant of the mid-war Gold Standard. Unlike other explanations of the Euro Crisis, which focus exclusively on a prior divergence of labour unit costs and competitiveness (between the surplus and the deficit member-states), the analysis here highlights the importance of the difference in degrees of oligopoly (or concentration) in advanced capital goods sectors across the surplus-deficit member-states’ divide.
My argument is that, given the deficit economies’ lack of high concentration of networked, globalising conglomerates (which can automatically convert capital inflows into productivity-enhancing investments), monetary union occasioned large capital flows (from the surplus to the deficit countries) which, in turn, caused rampant asset value inflation (e.g. real estate bubbles) in the deficit economies and a growth rate that far exceeded the rate of accumulation in their exportables’ sector. In contrast, the surplus economies (whose manufacturing is by definition more highly oligopolised) in fact lack competitors in the deficit nations (e.g. countries like Greece produce no cars) and, naturally, experienced simultaneously (a) high investment rates into productivity-enhancing capital and (b) a considerably lower concomitant growth rate.
This combination of growth rates that exceed (trail) fixed capital formation rates in the deficit (surplus) countries gave rise to a tension between:
- the underlying economic reality of a slow burning recession in crucial sectors across the surplus-deficit nation divide, and
- the epiphenomenal growth that seems to typify the whole common currency or fixed exchange rates bloc and is underpinned by a new form of financial exploitation of working and middle classes.
At some point, this tension ruptured under the strains of an imported financial crisis which soon ignited a classic debt-deflationary spiral with the burden of adjustment disproportionately placed on the shoulders of the weakest member-states. This is, indeed, what the world witnessed in the run up to, and after, the Crash of 1929 and it is precisely the same process that we witnessed in the Eurozone recently. It is as if the common currency’s designers chose purposely not to heed the lessons of the dreadful mid-war era that conspired to cause humanity’s greatest tragedy.
Section 2 then proceeds to discuss in some detail the differences between the Gold Standard and the Eurozone construction and to offer a mathematical analysis of the steady built-up of imbalances which set the Eurozone up for a mighty fall the moment the Credit Crunch of 2007 and the Crash of 2008 hit.
3. Greece and the toxic bailout funds EFSF-ESM
In its third section the paper discusses the significance of Greece: It begins with the observation that, in their attempt
- to stop the bond markets from failing (once the Greek public sector had become insolvent),
- to avert the prospect of a default by a member-state within the Eurozone, and
- to preserve the principle of Perfectly Separable Debts upon which the Eurozone was founded,
Europe’s leaders came up with a complex loan structure. Thus, the largest credit line in human history was extended to bankrupt Greece by means of an odd loan made up of many bilateral ones (one between each of the other sixteen member states and Greece, one between the IMF and Greece and one between the ECB and Greece).
While the borrower, Greece, paid a single (exceptionally high, at least at the outset) interest rate to its European lenders (and a considerably lower one to the IMF), each of the member-states lending to Greece bore its own, separate interest rate in line with the yields of its own government bonds. So, when a few days after the Greek Bailout Mk1 was settled, Europe put together the EFSF (European Financial Stability Facility) in order, supposedly, to ring-fence the rest of the Eurozone’s susceptible sovereigns (i.e. Ireland and Portugal but also Italy and Spain), in a manner that incorporated the structure of the Greek loan. In short, the bonds that the EFSF was to issue reflected this patchwork of separate and separable loans, thus resembling CDO-like, toxic debt instruments.
Before the EFSF was established, the only institution that characterised the common currency area was the ECB; a central bank lacking a mandate to act as a lender of last resort (either for the Eurozone’s banks or for its sovereigns). So, when the credit crunch hit Europe, the scene was set for a sequential bankruptcy of pairs of sovereigns and banking systems. Remarkably, to prop up the collapsing edifice, Europe’s leadership erected around it the scaffolding of bailout funds (the EFSF-ESM) funded by toxic derivative-like bonds which contained the seed of faster contagion!
4. The EFSF-reinforced contagion
In concert with posts that have been appearing regularly on this blog in months and years past (e.g. see here and here), the fourth section of the paper explains precisely (and by means of a fully-fledged mathematical model) my claim that the toxic bonds issued by the new institutions were indeed of a toxic CDO-like nature and how their very structure gave the Crisis another twirl, ending up with the insolvency of Italy and Spain and, inevitably, with the twin interventions in 2012 of Mr Draghi, the President of the ECB.
5. The Fiscal Pact and the ECB’s ‘extraordinary’ (LTRO & OMT) programs
In addition to the toxicity of the EFSF-ESM bonds, which enabled (rather than impeding) the process of contagion, Europe did something else to deepen the Crisis: It introduced the highly contractionary Fiscal Pact in the midst of recessionary times, thus guaranteeing the unsustainability of the fiscal consolidation process. Indeed, the section demonstrates geometrically that the only way that the Eurozone could ‘pull off’ its fiscal plan under the prevailing conditions of large net private sector savings, was if it were to turn successfully into a mercantilist fiend – with both its surplus and deficit countries developing substantial current account surpluses with the rest of the world.
Importantly, Section 5 links the analysis of the EFSF-ESM’ toxicity (see Section 4) to the structural imbalances in the real sectors of the Eurozone’s macroeconomy as accentuated by the Fiscal Pact. It also offers a novel interpretation of the impact of Mr Draghi’s two main policy interventions, the LTRO and the OMT. In particular, it shows, by means of a simple phase diagram (underpinned by a system of two differential equations), how the ‘Draghi Effect’ calmed down the inter-bank and bond markets while ‘allowing’ the tectonic plates under that ‘surface’ to continue to work toward the disintegration of the Eurozone.
The section concludes, to put it succinctly, with the suggestion that never before in economic history has logical incoherence been given a constitutional expression (the Fiscal Pact) that reality is bound to wreck.
Here I present the paper’s conclusion in full:
The Eurozone was founded on two principles.
- Principle 1: That its central bank would be explicitly banned from acting as a lender of last resort (for states and/or banks facing insolvency).
- Principle 2: The principle of Perfectly Separable Sovereign Debts.
Thus the scene was set for contagion following a financial crisis that could readily cause pairs of national banking systems and states sequentially to titter on the verge of bankruptcy. Europe’s reaction was to establish a new institution EFSF-ESM that would borrow on behalf of its (still) solvent member-states in order to prevent sovereign defaults. Alas, the structure of that ‘special purpose vehicle’ was such that, with its bonds redolent with the whiff of toxic derivatives, deeper and faster contagion followed. At some point, in a bid to prevent the European Monetary Union’s disintegration, the ECB stepped in. But to be allowed to step in (with its LTRO and OMT programs) the ECB first had to enter into a Faustian Bargain with the surplus countries: In exchange of being unshackled from the prohibition from acting as a lender of last resort, the ECB had to commit to using its coercive powers in order to impose the greatest austerity upon the weakest member-states. And thus the ECB-based ‘solution’ worsens the fundamental Eurozone’s macroeconomic conundrum so as to bring temporary stability to the inter-bank and bond markets.
This paper offered a simple analytical model of the above. Its conclusion is that, at this stage of the Eurozone Crisis, the ECB’s intervention has arrested contagion at the expense of greater macroeconomic incoherence. And since the latter always, inevitably, reinforces the former, all celebrations of the Crisis’ taming are likely to prove pure folly.