This Time, Europe Really Is on the Brink - A Commentary by Niall Ferguson and Nouriel Roubini

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I Can't Hear Poors
This Time, Europe Really Is on the Brink

Der Spiegel

Niall Ferguson and Nouriel Roubini

June 12, 2012


The European Union was created to avoid repeating the disasters of the 1930s, but Germany, of all countries, has failed to learn from history. As the euro crisis escalates, Berlin should remember how the banking crisis of 1931 contributed to the breakdown of democracy across Europe. Action is urgently needed to stop history from repeating itself.

Is it one minute to midnight in Europe?

The failure of German public opinion to grasp the dire state of affairs in Europe today is inviting a repeat of precisely the crisis of the mid 20th century that European integration was designed to avoid.

With every increase in the probability of a disorderly Greek exit from the monetary union, the pressure on the Spanish banks increases and with it the danger of a Mediterranean-wide bank run so big that it would overwhelm the European Central Bank. Already there has been a substantial re-nationalization of the European financial system. This centrifugal process could easily continue to the point of complete disintegration.

We find it extraordinary that it should be Germany, of all countries, that is failing to learn from history. Fixated on the non-threat of inflation, today's Germans appear to attach more importance to the year 1923 (the year of hyperinflation) than to the year 1933 (the year democracy died). They would do well to remember how a European banking crisis two years before 1933 contributed directly to the breakdown of democracy not just in their own country but right across the European continent.

Astonishingly few Europeans (including bankers) seem to remember what happened in May 1931 when Creditanstalt, the biggest Austrian bank, had to be bailed out by a government that was itself on the brink of insolvency. The ensuing European bank crisis, which saw the failure of two of Germany's biggest banks, ushered in the second half of the Great Depression. If the first half had been dominated by the American stock market crash, the second was all about European banks going bust.

What happened next? The banking crisis was followed by President Hoover's one-year moratorium on payment of World War I war debts and reparations. Nearly all sovereign borrowers subsequently defaulted on all or part of their external debts, beginning with Germany. Unemployment in Europe reached an agonizing peak in 1932: In July of that year, 49 per cent of German trade union members were out of work.

The political consequences are well known. But the Nazis were only the worst of a large number of extremist movements to benefit politically from the crisis. "Anti-system" parties in Germany -- including Communists as well as fascists -- had won 13 percent of votes in 1928. By November 1932, they won nearly 60 percent. The far right also fared well in Austria, Belgium, Czechoslovakia, Hungary and Romania. Communists gained in Bulgaria, France and Greece.

The result was the death of democracy in much of Europe. While 24 European regimes had been democratic in 1920, the number was down to 11 in 1939. Even bankers know what happened that year.

Those of us who repeatedly warned in the 1990s that the experiment of monetary union would end badly would be gloating now -- if we were not so troubled by the prospect of history repeating itself.

Losing Faith
What is the situation today? Europe's periphery is in depression. According to the IMF, gross domestic product will contract this year by 4.7 percent in Greece and 3.3 percent in Portugal. Unemployment is 24 percent in Spain, 22 percent in Greece and 15 percent in Portugal. Public debt already exceeds 100 percent of GDP in Greece, Ireland, Italy and Portugal. These countries, along with Spain, are now effectively shut out of the bond market.

Now comes the banking crisis. We have warned for more than three years that continental Europe needed to clean up its banks' woeful balance sheets. Next to nothing was done. In the meanwhile, a silent run on the banks of the euro zone periphery has been underway for two years now: cross-border, interbank and wholesale funding has rolled off and been substituted with ECB financing; and "smart money" -- large uninsured deposits of high net worth individuals -- has quietly exited Greek and other "Club Med" banks.

But now the public is finally losing faith and the silent run may spread to smaller insured deposits. Indeed, if Greece were to exit, a deposit freeze would occur and euro deposits would be converted into new drachmas: so a euro in a Greek bank really is not equivalent to a euro in a German bank. Greeks have withdrawn more than €700 million ($875 million) from their banks in the past month.

More worryingly, there was also a surge of withdrawals from some Spanish banks last month. On a recent visit to Barcelona, one of us was repeatedly asked if it was safe to leave money in a Spanish bank. This kind of process is potentially explosive. What today is a leisurely "bank jog" could easily become a sprint for the exits. Indeed, a full run on other PIIGS banks would be impossible to avoid in the event of a Greek exit. Rational people would ask: Who is next?

In the meantime, the credit crunch in the euro-zone banks on the periphery remains severe as banks -- unable to achieve the new 9 percent capital targets by raising private capital -- are selling assets and contracting credit, thus making the euro-zone recession more severe. Fragmentation and balkanization of banking in the euro zone, together with domestication of public debt, is now well underway.

The process of political fragmentation is also speeding up. In the last Greek elections, seven in 10 voters cast their ballots for smaller parties opposed to the austerity program imposed on Greece in return for two EU-led bailouts. Established parties are also losing out to splinter parties in Italy, where the comedian Beppe Grillo's Five Star Movement has just won control of the city of Parma, and in Germany, where a maverick party called the Pirates is all the rage. Less frivolous populists now have substantial support in France, the Netherlands and Norway. This trend is ominous.

Reducing Moral Hazard
The way out of this crisis seems clear.

First, there needs to be a program of direct recapitalization -- via preferred non-voting shares -- of euro-zone banks both in the periphery and the core by the European Financial Stability Facility (EFSF) and its successor the European Stability Mechanism (ESM). The model should be the US's successful Troubled Asset Relief Program (TARP).

The current approach of recapping the banks by the sovereigns borrowing from domestic bond markets -- and/or the EFSF -- has been a disaster in Ireland and Greece. It has led to a surge of public debt and made the sovereign even more insolvent while making banks more risky as an increasing amount of the debt is in their hands.

Direct capital injections would bypass the sovereign and avoid the surge in public debt. In practice, the euro-zone taxpayer would become a shareholder in euro-zone banks and the current balkanization of banking would be partially reversed. This might also help overcome the political resistance to cross-border mergers and acquisitions in coddled domestic banking systems.

Of course, over time, sound banks that restore capital through earnings would be able to buy back the public preferred shares. So this partial nationalization would be temporary.

Second, to avoid a run on euro-zone banks -- a certainty in the case of a "Grexit" and likely in any case -- a EU-wide system of deposit insurance needs to be created.

To reduce moral hazard (and the equity and credit risk undertaken by euro-zone taxpayers through the recap and the deposit insurance scheme), several additional measures should also be implemented:

  • The deposit insurance scheme has to be funded by appropriate bank levies: This could be a financial transaction tax or, better, a levy on all bank liabilities -- both deposits and other debt claims.
  • To limit the potential losses for euro-zone taxpayers, there needs to be a bank resolution scheme in which unsecured creditors of banks -- both junior and senior -- would take a hit before taxpayer money is used to cover bank losses.
  • Measures to limit the size of banks to avoid the too-big-to-fail problem need to be undertaken. In the case of Bankia, the merger of seven smaller caixas merely created a bank that was too big to fail.
  • We also favor an EU-wide system of supervision and regulation. If the euro-zone taxpayer backstops the capital and deposits of euro-zone banks, then supervision and regulation cannot remain at the national level, where political distortions lead to less than optimal oversight of banks.
True, European-wide deposit insurance will not work if there is a continued risk of a country leaving the euro zone. Guaranteeing deposits in euros would be very expensive as the exiting country would need to convert all euro claims into a new national currency, which would swiftly depreciate against the euro. On the other side, if the deposit insurance holds only if a country doesn't exit, it will be incapable of stopping a bank run. So more needs to be done to reduce the probability of euro zone exits.

No Alternative to Debt Mutualization
Specifically, three actions are needed:

  • Fiscal austerity policies should not be excessively front-loaded while structural reforms that accelerate productivity growth should be sped up.
  • Economic growth needs to be jump-started in the euro zone. Without growth, the social and political backlash against austerity will be overwhelming. Repaying debt cannot be sustainable without growth.
  • The policies to achieve this include further monetary easing by the ECB, a weaker euro, some fiscal stimulus in the core, more bottleneck-reducing and supply-stimulating infrastructure spending in the periphery (preferably with some kind of "golden rule" for public investment), and wage increases above productivity in the core to boost income and consumption.
Finally, given the unsustainably high public debts and borrowing costs of certain member states, we see no alternative to some kind of debt mutualization.

There are currently a number of different proposals for euro bonds. Among them, the German Council of Economic Experts' proposal for a European Redemption Fund (ERF) is to be preferred -- not because it is the optimal one but rather because it is the only one that can assuage German concerns about taking on too much credit risk.

The ERF is a temporary program that does not lead to permanent euro bonds. It is supported by appropriate collateral and seniority for the fund and has strong conditionality. The main risk is that any proposal that is acceptable to Germany would imply such a loss of national fiscal policy sovereignty that it would be unacceptable to the euro-zone periphery, particularly Italy and Spain.

Giving up some sovereignty is inevitable. However, becoming subject to a "neo-colonial" submission of one's fiscal policy to Germany -- as a senior periphery leader put it to us at a recent meeting of the Nicolas Berggruen Institute (NBI) in Rome -- is not acceptable.

Not Optional
Until recently, the German position has been relentlessly negative on all such proposals. German officials have repeatedly opposed the direct recapitalization of troubled banks. Chancellor Merkel has consistently ruled out euro bonds. Some German spokesmen have made it sound as if they actually want a Greek exit from the euro zone. Others have been over-eager to impose the same fiscal regime on Spain as has already been imposed on Portugal.

We understand German concerns about moral hazard. Putting German taxpayers' money on the line will be hard to justify if meaningful reforms do not materialize on the periphery. But such reforms are bound to take time. Structural reform of the German labor market was hardly an overnight success. By contrast, the European banking crisis is a financial hazard that could escalate in a matter of days.

We have tried to come up with proposals that address German anxieties. But we want to emphasize that action is urgently needed. Germans must understand that bank recapitalization, European deposit insurance and debt mutualization are not optional. They are essential steps to avoid an irreversible disintegration of Europe's monetary union. If Germans are still not convinced, they must understand that the costs of a breakup of the euro zone would be astronomically high -- for themselves as much as for anyone.

After all, Germany's current prosperity is in large measure a consequence of monetary union. The euro has given German exporters a far more competitive exchange rate than the old deutsche mark would have. And the rest of the euro zone remains the destination for 42 percent of German exports. Plunging half of that market into a new Depression can hardly be good for Germany.

Ultimately, as Chancellor Merkel herself acknowledged last week, monetary union always implied further integration into a fiscal and political union.

But before Europe gets anywhere near taking this historical step, it must first of all show that it has learned the lessons of the past. The EU was created to avoid repeating the disasters of the 1930s. It is time Europe's leaders -- and especially Germany's -- understood how perilously close they are to doing just that.
I Can't Hear Poors

From a respected author and from an economist, this paper is idiot.

They don't realize that high gov't spending is financed by inflation and this creates fragility in the financial system. With emphasis on increasing consumer spending and government spending, how in the fucking hell are banks going to stay capitalized? Banks get recapitalized through savings, and savings is what we all keep fighting against.

President Camacho
Yes, the founding of the UN by pro-American managerial regimes represented some sort of "restoration" of 19th century personal liberty and electoral sovereignity. The Soviet Union's role is always conspicuously redacted from these 20th century historical myths.

The fact is that the age of popular democracy belongs to the period from the early 19th to the early 20th century.... ordinary people don't care about "democracy" anymore-- not Germans, not Greeks, not Spaniards. People are no longer moved by party slogans and ideas... we enter the age when individual leaders carve out movements funded by their own capital and driven by force of personality.

These academics are always wrestling paper tigers... the Germans can't "destroy democracy" with austerity programs because the EU isn't democratic to begin with.

do u think there'll be a war?

Team Zissou
I don't see the incentives for war between the European powers. The ahistorical wrinkle in all this is the presence of large numbers of non-European immigrants, most of whom are net tax consumers. They will not or can not pay enough taxes to keep the post-WW2 state afloat. What will they do? What will be done to them?
nuclear launch detected
It boggles the mind how the Euros don't understand that the minute you surrender your printing press you pretty much surrendered your sovereignty.

I mean the two biggest ways a government has control over the macro-economy is monetary policy and fiscal policy and the two usually need to "compliment" or "balance" one another for the economy to be humming. If inflation is suddenly sky high due to terrible monetary policy decisions you aggressively raise taxes and when your country is bankrupt due to terrible fiscal policy decisions you use the printing press to rescue you from complete oblivion. Now I'm not advocating that nations should rise taxes or print money every time they face a crisis but they are quick effective shot term solutions that alleviate the pain until serious changes are made.

So I have no idea what the PIIGS where thinking when they gave up control over the printing press to the Germans who could give a shit that they are now bankrupt because they thought giving retirees $5000 a month in government pensions was a good idea.
President Camacho
Yeah, that's a good point.

Woodrow Wilson has always been rightly regarded by reactionaries as the one president most responsible for driving the nail in the coffin of the Old Republic-- he presided over the creation of the Federal Reserve and kicked off America's foray into "humanitarian" global intervention.

But far less often discussed-- although arguably just as responsible for ushering in the managerial age-- were the 16th and 17th Amendments passed immediately before Wilson's tenure. The common theme between both of these amendments was the removal of a layer of control from the state level, creating a direct client-patron relationship between the Federal government and the populace that had never existed before.

The 16th Amendment gave the Feds license to essentially tax the populace at will... The 17th Amendment completely warped the election and reelection criteria for senators. Once contingent on a senator's perceived honor and integrity among members of the House-- now it became a contest of pandering directly to the electorate, with all of the low-ball tactics and idiotic slogans that had long since characterized presidential campaigns. Most importantly, private capital now gained a direct line to a branch of the legislature that had formerly served to check the executive as senators scrambled to build 'war chests'.

Mencken enjoyed lambasting the quality of US Congressmen, but the men of the Upper House prior to the 17th Amendment still had a modicum of honor and integrity; the rejection of Wilson's postwar plan was their last major victory. Compared to the likes of Kerry, McCain, and Ted Kennedy, they were veritable saints.

Once the natural allies of mob and high finance are linked-- and this was the combined effect of the Federal Reserve Act & the 16th & 17th Amendments-- the "Republic" is finished. A comparable event in Rome was the Gracchi's and Marius' successful collusion with the financial magnates to wipe out the old families or otherwise neutralize their role as guardians of the state.