ITS GREEK TO ME – WAIT – OR IS IT GERMAN !
Posted by svazarkar on November 3, 2011
Over the past year the European debt crisis has been under constant focus and has been driving market volatility around the world. Recently, on Oct 27th 2011 the major EU powers came up with a package of over 130 billion Euros only to find that the government in Greece went weak at its knees making it almost certain that the deal will not survive and Greece may not continue to be part of the EU.
What lead to this collapse? Below is an attempt to translate this Greek problem in layman’s english.
Lets start with the formation of the Euro itself:
In 1848 a famous French writer named Victor Hugo said these words: “A day will come when all nations on our continent will form a European brotherhood… A day will come when we shall see … the United States ofAmerica and the United States of Europe, face to face, reaching out for each other across the seas.”
While the idea dates back to early 1920′s and the end of the second world war, it was not until late 1960′s that a firm ambition to form the Euro zone was accepted by the major European powers
The key drivers behind the formation were simple:
Create a strong political and economic bloc
Ensure countries work together instead of against each other and avoid the great wars that had affected the continent
Creation of a common currency that would help prevent devaluation of the EU currencies and provide an alternative to the growing significance of the US dollar
There were some though conditions set to enter the Euro monetary system:
Abolish individual currency and monetary system -Basically give up control of monetary policy allowing the ECB (European Central Bank) to set interest rates
Budget deficit of less that 3% of GDP
Debt ratio of less than 60% of GDP
However, even with these strict conditions there are inherent flaws. The main one being the economic characteristics. Even if one meets the overall criteria (which in case of Greece was fudged to start with), the economies of developed countries like Germany and France are very different than those of the PIGS (Portugal, Ireland, Greece and Spain). The German’s are highly productive with strong private enterprise and a highly educated workforce. The PIGS on the other hand are public sector dominated socialist economies. These economies have inherently different economic cycles and abilities to compete.
This is not to say that there were no benefits at all of creating a common currency. The issue is that these benefits are skewed in favor of the stronger more developed countries or let me state it this way, certain countries (e.g. Germany) were significantly better positioned to benefit from the common currency than others (e.g. PIGS) and they did this with impunity,
So in addition to the financial mismanagement on part of the poorer countries of the EU we also had a case of excessive and rampant lending to people who could not afford those loans. Sounds familiar to what happened in the US housing market ? Yes, because it is.
So lest take a closer look at how a country like Germany benefited and to some extent contributed to the problem.
The German’s were the biggest beneficiaries of the formation of the Euro, now let me highlight that it does not make them guilty by any means. They were just better prepared to benefit from a common currency and as a result were able to enjoy the full benefits of the Euro while shifting the costs to others. Here’s how:
1. STOP CURRENCY APPRECIATION:
German’s which constitute about 1% of the world population are producing 9% of the worlds export, to put this in perspective from an economic stand point that would mean significant trade surpluses with almost all its major trading partners. Now, in absence of the Euro, these trade surpluses would have meant a significant strengthening of the German Deutsche Mark (DM), which, would have made German produce expensive and non-competitive in the export market i.e. that BMW would have cost a lot more to produce and would price itself out of the market.
However, if you co mingle Germany with other poorly performing countries in the Euro zone this increase in the value of the Euro is significantly tapered.This is because any gains made in the Euro by German productivity is offset by lack of productivity in other Euro zone countries. So the German products continue to remain competitive in the export markets.
(Note: A good example of this is to see how the Swiss Franc has appreciated over the last 1 year, leading to significant action by the Swiss government to control this rise)
2. PROVIDE A STABLE MARKET:
Now if you are one of the most prolific exporters it helps to get a free market. The formation of the Euro zone provided a large, free and most importantly a very stable market to German products. Now imagine you are able to trade with all these other rich and poor countries in the Euro zone and not worry about fluctuating regulations or exchange rates. So within the Euro zone the german exports were never impacted by strengthening of the Deutsche Mark (DM) or the devaluation of its trading partners currency. Stable and uniform benchmark interest rates and regulations also helped its cause.
3. MAKE OTHER COUNTRIES NONCOMPETITIVE:
The single currency not only benefited germany, it actually harmed the other countries. In an ideal world these countries would have devalued their currency to promote exports. This was no longer possible, in fact any appreciation in the value of the Euro (primarily caused by stellar growth of German exports) actually made exports of poorer Euro zone countries noncompetitive since they had no ability to compete with the German economy on productivity. This impact was not just restricted to their exports but also affected their internal domestic market where it was easier for German exports to compete.
4. THE LENDING SPREE:
It never helps if your trading partners are suffering and are running out of cash. So to help them you lend some money! Remember what China is doing to the USA ? The Germans did exactly the same to their poorer neighbors. With all this strong growth in the German economy they have the worlds second largest current account surplus (net foreign assets) after China. German banks lent this out to the EU countries who borrowed beyond their means. Most of this was spent on German exports and to build infrastructure which they could not afford. The common currency helped by eliminating foreign exchange risks and a stable interest rate regime. For the banks it was like drinking water, they thought it could never harm them since there is no threat of devaluation of assets. Similar to the implicit guarantee that existed in the US housing market that the government would come to the rescue, the German banks assumed that they are lending to Euro zone member countries with no chance of default. The single currency also made it easier to borrow as the poorer countries got loans at much lower interest rates than they would have if they were not part of the Euro.
As it turned out, the cycle had to stop somewhere. With the collapse of the Irish economy and the revelations of unsustainable debts of Greece the European crisis is coming to a head. The PIGS should never have joined the single currency regime without first ensuring their economies were competitive enough to deal with it. The German and French banks should have been more cautious lending money to countries who could not afford it. While the German’s and the French may not have created the problem, they have benefited from the inconsistencies prevalent over the last decade since the formation of the single currency. They will be the biggest losers if the Euro collapses which means they will do what it takes to prevent it from collapsing.
As part of the deal, the banks have now agreed to write-off 50% of the Greek debt i.e. they will assume that this money is not going to comeback. But of course this is real money and needs to be made up. To help the banks deal with this write-off they will have to raise some capital equivalent to the money they are writing-off. The banks have 2 options to do this:
1. Sell some of their assets to raise money
2. Borrow this money
Guess what the banks are choosing to do, yes they will borrow and guess who is most likely to lend them? The country with the largest current account surplus in the world China !
Why would China do this ? We will leave that for some other time!
Let me know your thoughts in the comments section.
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