It's Wednesday, and today I discuss the latest US inflation data, which shows a significant…
German economist Hans-Werner Sinn, who has been implacably opposed to the Eurozone bailouts and so-called debt mutualisation is at it again with an article in the UK Guardian yesterday (October 22, 2014) – Europe can learn from the US and make each state liable for its own debt – calling for Eurozone states to be forced to take responsibility for their own public debt and became bankrupt if that responsibility leads private creditors to cease providing funds to these states. Like all these vehement (and often German) perspectives on the Eurozone crisis, his solution based on a comparison with the federal arrangements in the US, leaves out the crucial element that renders the comparison invalid – the lack of a federal fiscal function in the Eurozone (compared to the US). Further, his solution would have led to the Eurozone breaking up in 2010 had it been implemented at that time. It’s what happens when one is blinkered by an ideology that does not permit evidence and experience to modify its more extreme dimensions.
I have discussed the ideas of Hans-Werner Sinn previously in these blogs – Rescue packages and iron boots and Defaulting on public debt as a way to progress and Selective versions of history, driven by a blinkered ideology, always fail.
It seems that Dr Sinn is not an adaptive creature who learns from his mistakes.
Back in 2012, Dr Sinn appeared before the German Constitutional Court which was considering whether the European Stability Mechanism (ESM) is “compatible with Germany’s constitution”. In this regard, there was an interesting article on German economist Hans-Werner Sinn in Der Spiegel (July 1, 2012) – Professor Propaganda Is German Economist Exacerbating Euro Crisis?.
His opposition to the Eurozone bailouts was expressed in this New York Times article (June 13, 2012) – Why Berlin Is Balking on a Bailout where he wrote:
… such a bailout is illegal under the Maastricht Treaty, which governs the euro zone. Because the treaty is law in each member state, a bailout would be rejected by Germany’s Constitutional Court … [and] … a bailout doesn’t make economic sense, and would likely make the situation worse. Such schemes violate the liability principle, one of the constituting principles of a market economy, which holds that it is the creditors’ responsibility to choose their debtors. If debtors cannot repay, creditors should bear the losses.
If we give up the liability principle, the European market economy will lose its most important allocative virtue: the careful selection of investment opportunities by creditors. We would then waste part of the capital generated by the arduous savings of earlier generations. I am surprised that the president of the world’s most successful capitalist nation would overlook this.
When I read this article I wondered why he hadn’t recognised the massive failure of the “liability principle” to allocate investment resources appropriately.
The massive pre-crisis German trade surpluses were not being used to reward their own workforce in the form of real wages growth. Given the stifled domestic demand, the German funds flowed south. The speculation in Greece and Spain came from German (and French) money.
How much capital was wasted through the folly of the financial markets as a result of this crisis? The idea that you leave it to the ‘markets’ to resolve everything assumes that they are working for the good of all humans and are effective in doing so. Neither proposition is remotely true.
Further, the ‘markets’ are not even effective at advancing private interests at times as the GFC proved without doubt.
But I agreed with him that the bailout strategy currently in place will never work because it is accompanied by austerity which kills growth and therefore kills the wherewithal to pay back the debt.
In the Spiegel article, Dr Sinn is reported as telling the Constitutional Court that there would be “bottomless pit” and the ESM would become a “machinery of asset destruction”. He was, of-course, referring to financial asset destruction, which is really the problem.
The world is obsessed with financial assets and forgets that there is massive asset destruction going on every day as a result of this misplaced emphasis. I am referring to the entrenched mass unemployment which is wasting the most valuable assets that an economy ever has.
Youth unemployment (official or hidden) and underemployment above or approaching 50 per cent in many nations now constitutes massive asset destruction.
Fiscal austerity is a brilliant machine for ensuring this destruction persists and increases.
Dr Sinn’s belief that the “liability principle” (that is, the free market) will stop this destruction is misplaced. Without strong regulation and government deficits (typically) mass unemployment and rising inequality become the norm rather than the exception.
But he is still at it in 2014. In the Guardian article he writes:
The eurozone should emulate the US approach in how to maintain stability in a monetary union
Really. If that was to be then there would be a major federal fiscal function created as the responsibility of the European Parliament (being the only elected body that spans all the Eurozone nations. It would stand ready to transfer massive amounts of euros to beleagured Member States, who had surrendered their currency-issuing capacity when they joined the monetary union.
But the blinkered Dr Sinn does not really want there to be a true emulation of the federal-state arrangements in the US existing in the Eurozone.
What he wants is something far more limited, which would actually destroy the Eurozone.
He asserts that:
… a fundamental flaw in the structure of the European Monetary Union … [is the absence of] … the liability model …
Yes, he is still on about that.
He claims that the alternative to the liability model – “the mutualization model” – aka the collective bailout model is failing to stop nation states building up debt and violating the fiscal compact – the revised Stability and Growth Pact (SGP), which “sets a strict ceiling for a country’s structural budget deficit and stipulates that public-debt ratios in excess of 60% of GDP must be reduced yearly by one-twentieth of the difference between the current ratio and the target”.
He is keen to tell us that the fiscal compact, which tightened the SGP straitjacket even further, was “as the quid pro quo for Germany to approve the European Stability Mechanism”. We know that the Germans bullied the other nations into agreeing to tightening the constraints, which had already created massive damage across the Eurozone economies.
The fact that the French and Italian governments, the other big economies in the currency union, are now proving that they cannot politically sustain the austerity required to satisfy the revised SGP rules, given the sustained mass unemployment and rising social instability (which manifest in the May European Parliament elections), is testament to the inapplicability of these rules to the real world.
They just blow economies up when aggregate spending is weak. People will not tolerate mass unemployment, increased poverty rates and widening income inequality forever. There will be a point where society will fight back against the mindless technocratic rules that the Germans and Dr Sinn seem to think are reasonable.
The recent decline in economic activity in Germany is also testament to the unworkability of the fiscal structures imposed on the Eurozone by the technocrats.
Dr Sinn’s solution to the malaise is to abandon the mutualisation model and force each Member State to take:
… responsibility for its own debts, with its creditors bearing the costs of a default. Faced with that risk, creditors demand higher interest rates from the outset or refuse to grant additional credit, thereby imposing a measure of discipline on debtors.
So, if a nation is facing insolvency, the private bond markets will refuse to grant it additional credit. It will then default – become bankrupt given that the ECB would not be able to intervene as it did in May 2010 with its Securities Market Program, which saved the Eurozone.
What would happen then?
Well the state would have to severely cut spending very quickly and try to raise extra tax revenue. In Greece’s case, the public debt ratio jumped from 107.4 per cent in 2007 to 148.3 per cent by 2010. Between 2008 and 2009, its primary balance (that is the difference between spending and tax revenue net of interest payments) went from 4.8 per cent to 10.5 per cent of GDP. Real GDP growth fell by 3.1 per cent in that year, the relative calm before the storm.
Remember, that significant parts of the rising deficits in the Member States were due to the cyclical effects on their revenue. Unemployed people pay no income taxes and VAT taxes fall when spending falls. Trying to constrain those cyclical effects with discretionary cuts to net spending, which is what the SGP in all its incarnations requires only makes the initial spending collapse worse.
If the government had have been forced to close its primary deficit of 10.5 per cent in that year imagine what would have happened to total spending and growth. It was bad enough. In the ensuing years, with the bailouts, mass unemployment rose beyond 25 per cent and youth unemployment touched 60 per cent.
Without the bailouts, Greece would have left the Eurozone. It would not have been able to politically sustain the social unrest that would have accompanied the economic disaster that would have occurred.
Dr Sinn seems to think that these nations would simultaneously resist reintroducing their own currencies (and thus abandoning the Eurozone) and bear the costs of massive unemployment and increased poverty. He is living in a dream world and should get out more.
If Greece had have paved the way to exit the Eurozone other nations would have soon followed. Maybe not the culturally compliant Ireland but almost assuredly Spain and then Italy. Both would have been able to observe that with its own currency in place, Greece would have resumed growth almost immediately and staved off the disaster that followed and endures to this day.
Dr Sinn seems to believe that his plan:
… would serve notice to investors that they cannot hope to be saved by the printing press in times of crisis, and would thus compel them to demand higher interest rates or deter them from granting credit in the first place. This would lead to greater discipline among the eurozone’s indebted countries and save Europe from a debt avalanche that could ultimately drive currently solvent states into bankruptcy and destroy the European integration project.
His plan would not “ultimately” create bankruptcy but, rather, would immediately force nations into bankrupt states with mass unemployment.
Forcing nations to live under the German yoke would also increase the right-wing extremism that is now mounting in Europe and surely undermine the European integration project more quickly than anything else that could be contemplated.
What is his motivation? Well he thinks the Eurozone should emulate the US. He thinks:
The best example of the liability model is the United States. When US states like California, Illinois, or Minnesota get into fiscal trouble, no one expects the other states or the federal government to bail them out, let alone that the Federal Reserve will guarantee or purchase their bonds.
US states can go bankrupt – that much is true. And the Federal Reserve doesn’t buy the debt of the States. Again true.
But that is as far as the comparison goes.
The US comparison
The first point to note is that the US suffered a terrible recession as a result of the collapse of the housing market and the subsequent spread of panic, which severely undermined total spending in the economy. Even with an active federal function and currency sovereignty the US downturn was severe and prolonged.
What that told us was that the fiscal stimulus, massive though it was in the US, was still inadequate and was not sustained for long enough. The intervention as a percent of GDP could have been much larger.
The amount of federal net spending that was injected into the US economy directly through the Federal fiscal balance in 2008-10 via discretionary stimulus measures and the automatic stabilisers (lost tax revenue and increased unemployment benefit payments) was huge as you can see in the following graph.
Second, given the US issues its own currency, the bond markets were never in a position to push yields up even though the US government matched that increase in net spending with debt issuance. The joint operations of the Federal Treasury and the Federal Reserve Bank (central bank) kept bond yields down to very low and stable levels.
There was never question of the government running out of funds despite all the debt ceiling hysteria which was just a demonstration by the Tea Party idiots of their lack of spine – all talk and no action when the crunch came.
The bond markets were told categorically by the central bank that it had unlimited funds to buy public debt and could create those funds out of thin air.
Third, the federal stimulus was not limited to its own expenditure. It also dramatically increased grants to the State and Local Governments. The next graph shows the Total Federal Outlays for Grants to State and Local Governments in the US as a percent of GDP.
That big spike in 2010 is what properly constructed federations can do when the federal fiscal capacity takes responsibility and seeks to redress regional variations in economic outcomes.
There were major handouts to the States and Local Governments to individuals and also capital investment programs.
Clearly not sufficient to prevent the severe recession and the States themselves cut back heavily. But things would have been much worse without those transfers between levels of government.
Dr Sinn steadfastly refuses to accept the need for a federal fiscal capacity in the Eurozone, which would act like the US Treasury and ensure that asymmetric spending collapses across the Eurozone space would be addressed with federal transfers.
He doesn’t want to emulate the US federal system only parts of it.
If he truly wanted to emulate the US system then there would be a major federal fiscal function created as the responsibility of the European Parliament (being the only elected body that spans all the Eurozone nations.
It would stand ready to transfer massive amounts of euros to beleagured Member States, who had surrendered their currency-issuing capacity when they joined the monetary union.
Those transfers would likely create sufficient economic activity at the state-level that state bankruptcies would be unthinkable.
That is enough for today!
(c) Copyright 2014 BIll Mitchell. All Rights Reserved.