Sunday, December 12, 2010

Economics 12/12/10: Europe's crisis won't be solved by the ideas advanced to-date

The most revealing feature of the EU response to the current crisis is the nation states' and Brussels/Frankfurt total denial of the real problem. We are witnessing a debt crisis stemming from unsustainable levels of liabilities piled onto weak economies in order to finance various forms of social welfare state.

This fact is clearly revealed in the 'solutions' being discussed by the EU leaders:
  • Tax and fiscal policies harmonization - Harmonizing PIIGS, German, French and other fiscal systems will not achieve more transparency or discipline than the already existent SGP criteria for deficits and debt allowances delivers on the paper. Nor will it provide for better enforcement of these rules. More importantly, it will not reduce the unsustainable levels of debt accumulated by the citizens and sovereigns of Europe. Instead, the divergence between fiscal objectives of the younger and/or less developed states and those with older population and capital and consumption bases will be amplified.
  • The idea that centralized bond issuing mechanism will solve the current crisis is basically equivalent to believing in self-healing properties of the disease that's killing you. Bond markets are shorting European sovereign debt not because it is issued by decentralized authorities, but because EU sovereigns have borrowed too much already and/or assumed too much of the private banking sector debt. To issue even more debt, underwritten by the very same sovereigns is like combating a hangover by drinking more whiskey in the morning. Common EU bond issuance will be repeating the fallacy of securitization that has resulted in the markets saturated with AAA-rated mortgages packages blending AAA and subprime loans.
  • Increasing EFSF funding will not solve the problem, for it assumes that EU states are facing a cash flow problem, not a structural debt overhang. As I said before in the Irish and Greek cases - issuing more debt to pay down old debt is simply not going to be a long-term solution to our difficulties.
  • Finally, the idea of national currencies or two-tier Euro is even more denialist in its nature than all of the above proposals combined. The argument against it is provided in my article in today's Sunday Independent here.
The core problem is that the EU and the national governments remain blind to the main issue at the center of the current crisis: European social welfare states have accumulated too much debt to sustain status quo. These debts were accumulated via various channels:
  • The sovereign channels operated in Italy, Portugal, Belgium and Greece;
  • The depressed consumption transferred private incomes into public in Germany, Austria, Hungary, Slovenia and the Nordics;
  • Banking debts socialization and obligations transfers from public spending to private liabilities has led to the debt explosion in Ireland
But across the entire Europe, either Governments or private sector or both simply live well beyond their means. The only resolution that can restore health to our economies rests with a two-step structural change:
  1. Restructuring debts to reduce debt burdens on the real economy, followed by
  2. Restructuring economies to make them leaner, fitter and capable of sustaining growth
Both require re-thinking of the European social welfare state system with a view of making it's core principles sustainable in the environment of economic growth we can deliver. Nothing else will do the job.
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