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A brief history of European debt

by Aaron McCormack on February 9, 2012

One of the comments posted on the site (thanks Paddy) prompted me to rewind and try to explain from first principles how we have arrived at the current situation in Europe.  Further, to outline the implications for all of us depending on whether or not a deal is really done in Greece.

Let’s begin with some rules of the road….to some they may seem obvious but in nearly all cases they are worth repeating.  In the USA in particular, some of these facts tend to get lost in the political spin.

1. There is a “law of conservation of money” – much like the laws in physics around conservation of energy.  Money always ends up somewhere once created.  Don’t confuse it with value – if your house is worth $500,000 on paper it doesn’t matter until you sell it of course. However, if a share is priced at $100 on the stock market someone has physically paid that amount for the share at some point.  That money went somewhere.  Money borrowed by developers goes somewhere.  Money borrowed by governments or banks goes somewhere.  Internet stock bubbles moved lots of money to a lot of different places – but the money all went somewhere. It cannot just disappear.
2. When central banks or governments print money, it makes everyone else’s money worth that little bit less (in extreme cases it leads to high inflation).  Remember the price your parents paid for a house in the 60s or 70s – seems very cheap now, doesn’t it? Inflation paid for much of their house.  It’s great for people who owe money.  Not so good if you have savings. So, printing money is not “free” but it is used as a short-term way to try to inject “life” into an economic system that is struggling.  It can’t become the norm.

3. Governments can and should borrow money – just not too much.  That is because, unlike the rest of us, they never, in theory, have to pay back the principal – they just roll it over into a new loan each time it comes due.  If you never have to pay the principal, only the interest, you can borrow a lot of money and put it to work, assuming that you have useful (value-creative) things to do with the money (emphasis mine).  However, if the interest payments become too much, the act of borrowing will begin to drag on a nation’s economy.  Economists believe that once borrowings equal around 100% of an average economy’s GDP then borrowing is hurting, not helping.

So, what happened in Europe since the Euro was created?

It is tough to generalise – in reality most countries have a slightly different story all the way from the Irish property and banking bubble right through to the mess that is the Greek public finances and all the lies that were told to get Greece in the Euro and to keep it there.

However, underneath the “progress” of most Western economies in the last decade has been a huge expansion in credit and thus in debt.

People, companies and countries have used debt as a method of supporting ever-better lifestyles.

In the USA you will know about the propensity of the American consumer to borrow money in order to purchase (largely Chinese) goods.  The US government spend trillions on wars and awarded a hefty set of tax cuts in the main to richer folks (the famous Bush tax cuts) whilst government spending, in particular on healthcare, has continued to rise massively. 

The US government has borrowed to make up the difference in income and expenditure.  I have written a number of posts about how the US political system is making it difficult for leadership here to change course. But, safe to say, since the US housing bubble popped the US government has printed a ton of new money and borrowed a ton more to try to prevent collapse (which has worked) but doesn’t seem to be able to really kick-start its economy back to growth rates of 4% that are necessary to support a country with a growing population and high expectations for standards of living.

My argument would be that in the USA, as well as in most of Europe, the new globalized world order will see a relative rise in prosperity for billions of people in China, India and South East Asia and that this will come at the expense of general prosperity in traditional Western economies.  Countries like the USA will have to work very hard and very smart to create enough value-adding work to meet the rise in population and pay for all the government-originated social programs that they want to have.  The debt boom that we have experienced in the past 15 years or so has largely been the consequence of governments doing whatever they can to deal with those tectonic shifts in our world.

In Europe the story is a little more tricky – and it is important to remember that it is interconnected in a sense with the USA because money is fairly liquid between the two blocs, and because the cultural aspects of global financial organizations and orthodoxies are driven mainly from the USA.  Until recently, one large difference in the Eurozone is that the ECB was not trying to create money.

However, the underlying narrative of building up “too much debt” remains true for Europe as well as the USA.  The source of much of the money that was lent to the people and governments of Europe is actually Germany.  That country was only recently surpassed by China as the world’s largest exporter.  I’ll bet you didn’t know that Germany has larger exports than the USA, despite being about a quarter of the population?  Around 40% of Germany’s trade is with other Eurozone countries.  Germany’s banks have lent large amounts of the cash generated from those exports back to Eurozone countries – confusing a lack of currency risk with a lack of absolute risk.

In the good times this money merry-go-round works fairly well, because overall value is being created.  In normal circumstances, Germany’s own currency would have become more powerful and its standards of living would have risen (along with workers’ wages), making its exports more expensive.  Once exports get too expensive, countries trading with Germany buy less of their goods (perhaps buying domestically) and this “cools off” the German economy.  However, in Europe there is no Deutschmark.  There is a Euro. 

The creation of that currency has seen periphery countries become more expensive – it’s like Germany has ended up exporting some of the normal impacts of an economy that is doing very well.  And it is at this point that cultural memes come into play.  It is not unfair to say that Germans, on average,  are more frugal than many other nations surrounding them.  They kept costs in check domestically.  The didn’t allow wages to spiral out of control.  The unified a nation and brought living standards for tens of millions of former East Germans to a better level.  They have a debt/GDP ratio of 80% – not stingy by any stretch of the imagination but still higher than the original Eurozone pact of 60%.

So much for Germany – what was going on the periphery?  It can be summed up as “living beyond our means”.

In Ireland this was bank-fueled and it is the collapse of the banks (then guaranteed by the Irish government) that has caused our debt crisis.  The government was seemingly relatively well run compared to its peers.  But remember the whole rule about conservation of money – it goes somewhere.  If the banks lost a ton of money on bad loans, where did that money come from and where did it go?

The money came mainly from the now-infamous bondholders.  Some also came from shareholders, and some was from depositors. The money was lent to developers and to the people of Ireland for mortgages.  The developers spent it on land (bought from farmers or anyone lucky enough to own a good plot) and on the materials and labour needed to build houses or commercial property.  The new job attracted plenty of folks from other parts of the EU with the skills that were needed.  People spent these wages on goods and services – everything from necessities to “nice-to-haves”.  The people selling all these goods and services did nicely too.  People put more money in their own pockets by borrowing against the rising values of their houses.

The government was in on the act too.  Higher salaries with more people earning them, combined with higher levels of spending,  means higher revenues for the government from VAT and income tax.  Stamp duty on property.  Taxes on materials and goods.  Taxes on all the new cars and drivers.

It wasn’t hard to run an apparently decent government P&L when revenues are booming.  How we wish now for a rainy day fund….

Greece was different.  In Greece, the government was the primary actor in borrowing.  In Ireland the government certainly presided over the macro conditions that permitted it to end up on the hook for all the bank debt, but it didn’t (at least at the time) over-borrow itself.

But in Greece, the government borrowed vast sums of money to continue to prop up a country that was already fairly much bankrupt.  Since it was deemed inconceivable to have a Eurozone without Greece in it, both the Greeks and the EU worked hard to make it look like Greece were making the entry criteria.  Helped by those wonderful folks at Goldman Sachs, Greece cooked the books.

Beneath the stats, there is a terribly badly run country.  The government has made huge promises that it cannot possibly keep in terms of employment laws, tax collection (they don’t), public sector services and pensions.  It truly is a country living well beyond its means.

And that is where we get back to some cultural issues – the frugal Germans may enjoy the relaxed lifestyle when they holiday in the Peloponnese, but they see the Greeks as a nation who have lived beyond their means for far too long.  The Irish had a decade-long party that they need to pay for, they say.  But the Greeks, and other Latin countries where the government debt is high and the level of perceived austerity is low, need to be taught a lesson if they are to be allowed to stay in the Euro club.

Now, in the true free market world if you borrow money and cannot repay it, the lender suffers along with the borrower.  They lent foolishly.  They should have done more due diligence before handing the money over.   But the normal rules of capitalism are not allowed to apply to the Wall St banks and the banks at the heart of Europe.  In our new “finocracy” or “banktocracy” they are protected at all costs.  This is at the heart of why the normal rules of capitalism are not allowed to act.

So much for what has happened – where do we go from here?

For Ireland, the government is determined to stay on the path of slowly bleeding the country dry to pay the gambling debts of bankers.  Worse still, those European banks probably don’t own much of the original debt any more – if they had at least some sense they have sold it on at 60 or 70 cents in the Euro to some hedge fund or distressed asset firm.  That the Irish government is now rewarding those folks with a full payment of that debt at 100cents in the Euro (even if it was never guaranteed in the first place) is mind-boggling.  It shows just how deep into the “save-the-Euro, damn the consequences” culture the new Irish government have found themselves.  It could have been so different….

So, the ordinary Irish citizen is being screwed with their pants on, as they like to say here in America.  What of the Greeks?

Whatever happens in terms of the future of Greece within the Euro, something like the austerity measures being proposed by the troika will have to happen in any case.  If Greece leaves the Euro, repudiates all its debt (i.e. doesn’t pay any of it) and goes to the Drachma it will still be fundamentally bankrupt.  People will not get what they were promised.  They will have to get over that and deal with it. 

People will need to work longer hours, with more in the private sector than there currently are.  They will need to work until later in life.  They will need to pay higher taxes.  They will have less benefits than before.  Pensions will have to be cut.  With a new devalued currency and lower costs, Greece will not only see a tourism boom but should be able to export more.  That may deliver a passable standard of living after the initial wrench…but true prosperity as many may see it today will require much deeper change.

The likelihood is that there will be a deal between the Greeks and the Troika, but that it may not pass parliament nor withstand the public outcry and possible violence.  The Greek people will tell their government and the troika on the streets what Papandreou wanted them to tell everyone through the ballot box – “we would rather cut our losses and go back to the Drachma than suffer all these further indignities within the Euro”.  Whether they are right or wrong is a different matter.  The country isn’t just a democracy – it is the birthplace of democracy.  It would be a foolish person who would openly say that the electorate of a state are too stupid to be allowed their way.

Even if the deal does get forced through, it will likely be on the basis of fictional mathematics – the hope being that extending and pretending a little while longer will give breathing space for a global recovery to kick in and for economic growth to start to paper over the cracks.  Coupled with the huge liquidity being pushed into the Eurozone by the ECB’s “cash for trash” scheme, perhaps Euro leaders believe that buying time is all they need to do.

More likely Greece and Ireland, Portugal and Italy will continue to bounce around from crisis to crisis every time there is debt that needs to rolled over for their sovereign governments.

Only a crisis bigger than cutting Greece loose will prompt a serious questioning of “saving the Euro at all costs” and alternatives such as a two-tier Euro will be considered

Whatever happens at the meta-level, the citizens of Europe are living beyond their means in the aggregate.  Let’s not think that solving this currency crisis will fix that.  The debt bubble has trickled like water into all the little pores, cracks and holes of our lives and our economies.  Like water in the walls and foundations of a house, it will continue to cause damage every day we let it sit there.

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