Tuesday, April 17, 2012

Mises Daily The Eurozone: A Moral-Hazard Morass

The Eurozone: A Moral-Hazard Morass

Mises Daily:Tuesday, April 17, 2012 by


European politicians are still trying to save the project of the euro. They design ever-greater bailout packages. Along with the bailouts, an economic government may be forthcoming. Countries may give up parts of their sovereignty. The character of the European Monetary Union (EMU), and even the European Union (EU), may change forever.

While it is still unclear where future developments will lead the EMU, the costs and risks of remaining within the system are already immense and rising.

The Misconstruction of the Euro

In the eurozone, there are fiscally independent sovereign governments coexisting with one (central) banking system. This is a unique construction as normally there is one government with its own banking system.

Governments can finance their deficits through the banking system and money creation. When governments spend more than they receive in tax revenues, they typically issue government bonds. The financial system buys an important part of these bonds by creating new money. Banks purchase these bonds because they can use them as collateral for new loans from the European Central Bank (more precisely the European System of Central Banks).

New money flows to governments that monetize their deficits indirectly. The cost of the indirect monetization is born by all users of the currency in the form of a reduced purchasing power, i.e., inflation. If there is one government per central-banking system, the whole nation bears the cost of the deficit monetization. However there are in the eurozone several governments running their own budgets.

Imagine that all governments but one have a balanced budget. The one deficit government can then externalize onto other nations part of the costs of its deficit in the form of higher prices. This monetary redistribution is the already-existing transfer union in the EU.

A government like the Greeks', with high deficits, prints government bonds bought and monetized by the banking system. As a consequence, there is a tendency for prices to rise throughout the monetary union. The higher the deficit of a government in relation to the deficits of other countries, the more effectively it can externalize the costs of a deficit. The incentives of this setup are explosive as governments benefit from deficits higher than those of their eurozone neighbors.

The Stability and Growth Pact designed to contain these incentives utterly failed because governments themselves judge whether sanctions are imposed on them.

One effect of this ill-fated setup is that it allows governments to maintain uncompetitive economic structures such as inflexible labor markets, huge welfare systems, and huge public sectors for a long time. Thereby the system causes the overindebtedness and uncompetitiveness typical for the recent sovereign-debt crisis. Multiple sovereign-debt crises have in turn triggered a tendency toward centralization of power in Brussels and the new rescue fund. In other words, the monetary-transfer union causes the general sovereign-debt crisis to bring us now ever closer to a more explicit transfer union. The possible European economic government or transfers through eurobonds are only the result of the underlying and dangerous monetary-transfer union implied in the institutional setup of the euro.

The Prebailout Redistribution: Interest Rate and Monetary Flows

An important cost of the Eurosystem consists in the redistribution implied in its setup. This redistribution brings benefits for some countries at the cost of others. The redistribution before the 2010 bailouts resulted mainly from interest-rate adjustments and money production.

More-fiscally-irresponsible governments benefited from the implicit guarantee by the more-fiscally-sound countries even before the euro was installed. Interest rates dropped to the level of Germany.

Figure 1
Three month interest rates in Germany, Greece, Spain, Ireland, Italy and Portugal (1987–1998)
Source: Eurostat

Another factor reducing interest rates in peripheral countries was a reduction of the inflation premium in interest rates. The inflation premium fell because inflationary expectations were reduced. The European Central Bank (ECB) was considered to act like the Bundesbank.

These lower interest rates allowed countries to run deficits and accumulate higher public debts. More debts could be accumulated than would have been possible without the implicit guarantee of countries such as Germany.

The lower interest rates coupled with an expansionary monetary policy by the ECB led to distortions in peripheral economies. The Greek government used the lower interest rate to build a public adventure park. Italy delayed necessary privatizations. Spain expanded the public sector and built a housing bubble. Ireland added to their housing bubble a financial bubble. These distortions were partially caused by the EMU interest-rate convergence and the expansionary policies of the ECB. Naturally, people related to the bubble activities in these countries — such as public employees and construction workers — benefited. However, the population in general took a loss through the extension of the public sector and reduction of the private sector, as well as through malinvestments in the construction industry.

While private and public debtors of the periphery enjoyed lower interest rates due to the euro, someone had to pay for it. The implicit bailout guarantees were given by more-productive countries such as Germany. Due to the guarantee the German government had to pay marginally higher interest rates than it would have paid otherwise.

In sum, in the EMU, with its assumed "solidarity," there is redistribution because interest rates converge. Irresponsible governments benefit at the cost of more-responsible governments.

More-irresponsible governments benefit in another way — through unequal money creation. A country as a whole can benefit if it runs higher public deficits than other countries. Its government prints government bonds that are bought by banks that may use them as collateral for ECB loans. The money supply increases. The first receivers of the new money benefit at the cost of later receivers. Take the Greek example: the ECB accepted Greek government bonds as collateral for their lending operations. European banks could buy Greek government bonds and use these bonds to gain a loan from the ECB at a lower interest rate.

The banks bought the Greek bonds because they knew that the ECB would accept these bonds as collateral for new loans. As the interest rate paid to the ECB was lower than the interest received from Greece, there was a demand for these Greek bonds. Without the acceptance of Greek bonds by the ECB as collateral for its loans, Greece would have paid much higher interest rates than it did. Greece was, therefore, bailed out or supported by the rest of the EMU for a long time.[1]

The costs were partially shifted to other EMU countries. New euros were effectively created by the ECB, accepting Greek government bonds as collateral. Greek debts were monetized, and the Greek government spent the money it received from the bonds to secure support among its population. As prices started to rise in Greece, money flew to other countries, bidding up prices throughout the EMU. Abroad, people saw their buying costs rise faster than their incomes. This was redistribution in favor of Greece. The Greek government was being bailed out by a constant transfer of purchasing power from the rest of Europe.

The Tendency for the Size of Government to Increase

The incentive for higher deficits has secondary effects. Governments that traditionally have been fiscally more irresponsible see in the Eurosystem a chance to profit from higher deficits. Running deficits, they can win votes and increase state power. Both lower interest rates and money creation work in favor of these states. Similarly, the incentives of the more responsible states are to spend more. Why reduce public spending in favor of the more irresponsible governments that run high deficits profiting from the monetary redistribution? As governments boost spending, the state's size increases.

By the increase in government spending, more resources are drawn from the private sector, where they compete in satisfying consumer wants, and put into the public sector, serving the ends of politicians. The increase in the state's size caused a loss in productivity and a lower standard of living than otherwise.

Open Bailouts, Subsidies, Transfers

The incentives and mechanisms of the Eurosystem lead to excessive deficits and rising debts. The financial crisis of 2008 led market participants to doubt the commitment of fiscally sounder governments and the ECB to bail out weaker governments. Due to bank bailouts and increased public spending, deficits and debts soared in 2008 and 2009. Would Germany really be capable of and willing to support peripheral governments?

The rising yields of peripheral government bonds, their unsustainable fiscal situation, and the unclear commitment led to the bailouts of Greece I (€110 billion) and II (€130 billion), Ireland (€85 billion), and Portugal (€78 billion). These bailouts total €413 billion. Eventual losses are born by taxpayers in the fiscally sounder countries.[2]

In addition to these bailouts, the EFSF has been installed. Its size is to be leveraged to over €1 trillion. Germany's part of the guarantees is €211 billion. When other countries that are guaranteeing this sum get into fiscal difficulties, the German part will rise.

Indeed, the size of the EFSF will not be enough. To effectively guarantee all peripheral debt, the fund has to be increased to €1.45 trillion.[3] As the guarantees of Italy and other peripheral countries are worthless, Germany will have to guarantee €790 billion or 32 percent of GDP according to a report from Bernstein. If France loses its AAA rating, the German share will rise to €1.385 trillion or 56 percent of the German GDP (almost €17,000 per capita).

In addition, taxpayers are also indirectly on the hook through the engagement of the International Monetary Fund (IMF). At the same time, taxpayers may suffer losses from the bailouts undertaken by the ECB. The ECB bought until the beginning of November 2011 more than €183 billion of peripheral government bonds at an increasing pace. For any losses, Germany's part is 27 percent.[4]

Moreover, the ECB has accepted government bonds of peripheral countries as collateral. If a government defaults, it will probably take down with it a great part of its banking system that had bought its government's bonds. The banking system in turn will be unable to repay ECB loans. The ECB will then be stuck with the collateral: government bonds in default. Raoul Ruparel and Mats Persson (2011) from the think tank OpenEurope calculated in June 2011 that a Greek default (restructuring of 50 percent) would cost the ECB between €44.5 and €65 billion. These sums have been rising since June 2011 and will rise in the future. Peripheral governments keep running (substantial) deficits, the ECB buys more bonds, and peripheral banks increase their refinancing with the ECB.[5]

Another support for peripheral countries works through the TARGET2 system. There are credit and debit accounts within the Eurosystem and its national central banks that are not netted. At the end of October 2010, the Bundesbank had claims of €326 billion while peripheral countries had liabilities of €335 billion (Sinn and Wollmershäuser 2011, p. 5). The Bundesbank claims have risen sharply to €616 billion in March 2012.

The TARGET2 system works the following way: imagine that a Greek depositor transfers his money from his Greek bank to a German bank. As a result, the German bank reduces its refinancing with the Bundesbank and the Greek bank increases its refinancing with the Bank of Greece.

The Bundesbank earns a claim against the Eurosystem, the Bank of Greece a liability. In theory these claims could be netted, for instance, by transferring assets such as gold from the Bank of Greece to the Bundesbank. Yet these claims are never paid in the Eurosystem, and the balances continuously build up. When the Greek bank finally defaults, the losses are shared by all central banks in the Eurosystem and ultimately affect taxpayers.

Tendency for Price Inflation

The Eurosystem is prone to price inflation to the detriment of all users of the currency. As we have seen, the Eurosystem incentivizes deficits and debt accumulation. At least part of these debts and deficits are very likely to be paid via money production. The ECB has been quite inflationary in order to support the project of the euro.

The following measures indicate the inflationary stand of the ECB:

  1. Since 2008, the ECB provides unlimited liquidity to banks. Whenever a bank provides a new Greek government bond as collateral the ECB provides more base money.

  2. The ECB has diluted collateral standards. Greek, Portuguese, and Irish bonds will be accepted as collateral even if rated as junk. The quality of assets that are backing the currency is diluted.[6]

  3. The ECB has bought government bonds outright in a sum of €220 billion.

  4. The ECB holds interest rates at artificially low levels to save the euro project. Higher interest rates could lead to defaults both private and public in the periphery. Even though price inflation is around 3 percent, and over the 2 percent self-set limit, the ECB lowered its historical low interest rates at the beginning of November and December 2011.

Prices in the eurozone are thus higher than they otherwise would have been. The bailout costs will probably not be paid entirely by higher taxes but also through money production. Imagine that Germany takes a loss from loans to the Greek government of €10 billion. Will the German government increase taxes by €10 billion or reduce expenditures by €10 billion? The answer is probably not. More likely, the German government will increase its debt financing through the banking system, thereby increasing the money supply. As debt mountains are increasing in all of the EMU, inflationary pressure is increasing as well. Within the EMU there is no way to escape.

Centralization and the Loss of Liberty

The EMU has a built-in bias toward centralization that can affect the whole European Union. As seen before, there is an incentive for deficits especially in the smaller countries that can expect to be bailed out. The accumulation of debts triggered a sovereign-debt crisis. This crisis, in turn, has been and may be used for centralization. The bailouts and rescue funds require new central institutions. In order to manage and prevent further debt crisis, some politicians ask for an economic government. Countries are expected to lose sovereignty in exchange for bailouts and in favor of an increase of power of European institutions.[7] In fact, Porter (2010, p. 13) argues that a solution to the current problems would be a harmonization of taxes, a "federal" tax, as well as a full merger of the ECB and national central banks in a step toward political union. Similarly, Deo, Donovan, and Hatheway (2011) regard some kind of "fiscal union" as the solution to the euro crisis.

The centralization of fiscal policies contains important risks for members of the eurozone. They lose part of their sovereignty. The centralization will imply some harmonization of fiscal policies. One may think that austerity measures will prevail in this harmonization. And this may be so in the beginning as the German influence remains dominant. However, the German influence will likely suffer the same fate it suffered within the ECB. The ECB was thought to be in favor of "hard money" and modeled after the Bundesbank. Similarly, the new economic government may be modeled after fiscally responsible Germany. But, like in the council of the ECB, Germany and its allies will find themselves in the minority.[8]

Already in the case of Ireland's bailout, important aspects of the European harmonization became apparent. European politicians such as Nikolas Sarkozy pressured Ireland to increasing its corporate tax. The deal was this: bailout for tax increase. In spite of the pressure, the Irish government resisted.

Lastly and most importantly, fiscal harmonization eliminates competition. In Europe there still exists tax competition to attract citizens, companies, and investments.[9] Countries cannot increase taxes too much, because people and capital can easily move to other EU countries. The possibility of voting by foot — exiting countries with higher tax burdens — is an important guarantee for individual liberty. The EMU drifts toward centralization and economic government thereby eliminating tax competition and making voting by foot more costly. Once harmonization is reached, taxes and regulations will probably increase. So staying with the EMU comes with this important risk for individual liberty — maybe the most important European value.

Threat of Conflicts between Nations

The EMU provokes conflicts between otherwise peacefully cooperating nations. Redistribution is always a potential cause of social stress. The monetary redistribution in the EMU was not understood by the bulk of the population and, thus, did not cause conflicts. The bailouts, the rescue fund, and the interventions of the ECB that were ultimately caused by the setup of the EMU have made the redistribution between countries more obvious.

Germans do not like maintaining the Greek welfare state. In the German media Greeks are called "liars" and "lazy." The Greek media, in turn, demanded reparations for World War II. While the Germans do not like paying for the periphery, people in peripheral countries blame Germans for austerity measures. They feel that the unpopular measures are imposed on them by foreign (German) pressure. Within the EMU, these clashes and conflicts will continue and probably increase. Remaining in the EMU implies living in such an atmosphere and the risk of escalation.

To make an understatement, the costs of the Eurosystem are high. They include an inflationary, self-destructing monetary system, a shot in the arm for governments, growing welfare states, falling competitiveness, bailouts, subsidies, transfers, moral hazard, conflicts between nations, centralization, and in general a loss of liberty. In addition, these costs and risks are rising day by day. Considering all this, the project of the euro is not worth saving. The sooner it ends, the better. Alternatives exists. A return to sound money such as the gold standard would boost responsibility, harmony, and wealth creation in Europe.


Rodrigo González Fernández
Diplomado en "Responsabilidad Social Empresarial" de la ONU
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