Europe's financial crisis: Its Titanic Moment

No other ship has captured the world`s attention, quite like the Titanic. Tragically though, the unsinkable Titanic sank to the bottom of the ocean floor on its maiden voyage itself.

Europe, at present, seems to be having a Titanic moment of its own. The continent that once ruled the rest of the world seems to have hit an iceberg of loose policymaking and is soon sinking into the abyss of financial depression.

The Titanic did not prepare for any worst case scenarios, 20 life boats were all it had onboard. Have the major economies of Europe worked out any plans to manage the crisis? Will they manage to keep the ship afloat or is it too late to save the ship?

After Greece, Italy is the latest European country to enter a full-fledged financial crisis mode. Now though Italy`s crisis has little to do with the parallel drama in Greece, the country`s economy is plunging back into deep recession. Lack of growth prospects is the main reason that is sapping the credibility of Italy`s public accounts over the medium term. So, thankfully this is not a contagion effect. Nevertheless, it is bad enough news.

At first glance, it may seem strange for Italy to be in such deep trouble, considering that in the 1990s the country had the same debt/GDP ratio as today and in fact faced much higher interest rates. Take a look at the charts below for a sense of Italy`s Debt / GDP ratio and bond yields during that period.

Italy`s Debt (as % of GDP)

Italy`s Bond Yield

Let`s rewind a little to the 1990s to understand why Italy had such high interest rates then. Well, bond investors demanded a rather large risk premium to compensate for the currency risk. To restore competitiveness and deal with inflation which tended to be higher than most of Italy`s important trading partners, Italy`s own currency then, the lira, was devalued from time to time.

And then, Italy`s membership to the European Union (EMU) sparked hopes for the elimination of the existing currency risk. As bond investors increasingly thought the membership would be real, interest rates started shedding the risk premium. This caused a decline in interest rates which reduced financing cost, in turn reducing the budget deficit, and ultimately causing the decline of the debt/GDP ratio.

These lower interest rates and additional capital inflows helped to boost the economy. However, Italy`s tendency to create more inflation than its trading partners remained the underlying problem.

However, once within the EMU, Italy could not use the method of devaluation to restore competitiveness anymore. This slowed the country`s growth to barely a crawl and worsened the budget deficit. So, you had the debt/GDP ratio climbing again, while interest rates stayed put.

At present, bond investors are asking for a risk premium simply to compensate for an increased default risk. The Greek default has woken bond investors up to the eventuality that countries in a currency union are borrowing in a (foreign) currency which they cannot control.

With bond investors attaching a higher risk premium, interest rates are rapidly rising; contributing to the already dismal state of affairs. Higher interest payouts are increasing the budget deficit, which is causing an increase in the debt/GDP ratio. Higher deficits are also forcing austerity, creating a possibility of lower growth and thereby lower tax revenues. This would undoubtedly strain budget deficits and increase debt further. Sigh!

The crucial mistake was that the fundamental Italian problems of low growth and higher inflation were never really addressed. In reality, a country within a monetary union cannot accumulate inflationary differences for too long because it cannot devalue its way out of the resulting loss of competitiveness. This will ultimately result in significant low growth.

Ironically, the entire European currency scheme was simultaneously brilliant and unfortunately unwise. The genius of the experiment which was created after decades of planning lay in the fact that the united currency was supposed to prevent policy makers from creating money out of thin air that would otherwise promote loose government spending. The common currency which was launched with the underlying expectation of uniting diverse nations to facilitate trade, peace and prosperity in the region, almost seemed like a recreation of an older, freer, more-rational world. During the planning of the Euro, advocates envisioned a strong currency and a union where nations would not be able to just let their currency weaken. To stay competitive, governments would have to adopt structural reforms and rigid labor markets and high-cost government pension plans would gradually wither away.

It was the perception of getting something of value without any meaningful sacrifice that initially fostered the EU Monetary Union. The fiercely nationalistic European countries were willing to surrender minor sovereign powers only if it had something for them in it. To the relatively weak European economies, a single currency seemed like a great idea.

The common currency aimed at moving closer to the virtues of the gold standard that restricted government`s reflationary policies by building in certain safeguards. There would be a single central bank, and sovereign countries would have to give up autonomous control over monetary policy. The same would apply to national finance: no more endless running of deficits, and no more free-spending legislatures.

Nations would have to agree to such terms, including harmonized regulatory systems, in order to enter the currency union. In the frenzy to establish the unison, the underlying issues were totally overlooked. Weaker countries joined the union and brought along their debt loads and feeble banking systems.

In its early stages, the Euro seemed just perfect to its members. Post the introduction of the Euro, the southern countries experienced a wonderful boon time. Interest rates on government bonds fell dramatically due to the new perception that the European Central Bank would operate as a guarantor of the debt of all Eurozone countries. ‘One interest rate fits all` became a disaster. The weak participants borrowed at 4% instead of 8% and the result was a flurry of spending that ended up in today`s insolvencies. These low rates also allowed a massive influx of imports into the problem countries, which caused major imbalance of trade deficits. This also brought about borrowing in foreign currencies, which turned into a nightmare, particularly in Eastern Europe.

The problem here was that the countries had not actually given up all their fiscal authority. Most importantly, their banking systems still had control and, thanks to fractional reserve banking, they still could create money in a way that could not be controlled by the central bank. This stage fostered tremendous growth in unsustainable debt.

No monetary union can function without a political union which is needed to control Fiscal Policy. The strategists of the EMU understood this well, however, the sovereign leaders chose to overlook this in their quest for cheaper money to finance election freebies and avoid unpopular, pressing economic realities.

Now the EMU has hit its iceberg.

Instead of confronting the core issue, the EMU has conjured a ?1.2 trillion bail-out fund - European Financial Stability Facility (EFSF) in a bid to buy time. This facility seeks uber-leverage through "first loss" insurance of bonds. The amount needed to prevent the Euro from collapsing over the next two years runs into multiple trillions of dollars ? an amount that even the solvent European countries do not have, and in such a situation using derivatives in place of cash is simply a prescription for disaster. With such a step, debt may be addressed, but the core economic and financial problems that were responsible for these problems will remain unanswered.

Bailouts are not the answer to the EMU`s fundamental problem of the gap in competitiveness between the northern and southern countries. The south has been forced into austerity, which limits their chances of bridging this gap. The likely end product will be a deflationary spiral and eventually deflationary depression.

Experts have also suggested a stronger fiscal union as a plausible solution which would imply the end of individual country sovereignty. However a stronger constitution is first needed to set this in play. And such a system would bring along its share of challenges. For instance, smaller nations cannot be allowed to falsify their balance sheets, nor could the `one interest rate for all` logic be used. Equal treatment to nations like Ireland, Portugal, Belgium, Spain and Italy would be required else they would be forced to abandon the Euro. These nations, in their present standing, would not be able to survive even another year or two of austerity.

It sure is difficult for policymakers to see their experiment fail. However, the strongest economy in the EMU ? Germany ? is not going to take to these issues lightly. In all due probability, the next German elections will see a staggering house cleaning in the Bundestag.

The Euro was a brilliant idea to keep the ruling government in check. The gold standard had served the same purpose with efficiency and consistency over a number of years. However, the Euro experiment was flawed due to its structuring / strategy. A common currency without a political union is an implausible situation. The Euro created rules for functioning without any internal policing, an oversight that was well handled by the gold standard. In the gold standard, if one country debauched the currency, gold would flow out, the nation would lose credibility and capital would flee to places that appeared financially serious. The Euro mechanism lacked these internal checks.

The world is awash in government debt and both Italy and Greece are but the tip of the iceberg. The solutions are just extended versions of currency debasement that will pose much bigger problems in the long run. Until the elected representatives stop spending more than they tax, there is no real hope that the situation will improve. And until then, it might appear prudent to own gold in a hope that it would safeguard against the woes of currency debasement and the ills of current disastrous policy making; as it used to under the gold standard.

Data Source: Republicbroadcasting.org