Is the Euro zone crisis by design?

March 15, 2012

A few months ago, I started writing an analysis of our global economic situation that I wanted to present in the form of an optimistic thought experiment. That article has become so long and complicated that it has essentially turned into an economics PhD dissertation. I have shelved it for a while pending a major culling, simplification and rewrite. I still hope to publish it in the coming months.

While doing research for the section on the Euro zone crisis, I came across an article I helped write for Niall Ferguson in 2003 where I argued that the European Union was far from an “optimal currency area” with broadly homogeneous conditions. Moreover, the lack of a fiscal union, cross country labor mobility and the fiscal straightjacket of the Growth and Stability Pact would lead to a crisis.

I wondered if such a crisis was not by design. The European Union project had reached the limit of its democratic mandate. The Maastricht Treaty of 1992 which led to the creation of the euro and created the pillar structure of the European Union had proved extremely hard to get approved. In Denmark they had to hold two referendums to get the treaty through and in France it barely passed with 51.05% of the vote. Similarly, the Treaty of Nice in 2001 was initially rejected by Irish voters until they gave the “right” answer in the second referendum. Similar difficulties ensued with the treaty of Lisbon in 2007 though it was eventually approved and passed into law in 2009. It seemed clear there was no public appetite for further integration.

Knowing that they did not have broad public support for more power seeping from the individual nation states to the European Union, I still suspect the “eurocrats” made do with an imperfect system that, given its limitations, they knew would lead to a crisis. They probably thought that in the face of such a crisis, when faced with the extraordinary costs of a breakup, Euro zone countries would opt for further political and economic integration – even if they lacked the democratic mandate for it.

The recent takeover of Italy by an unelected technocratic caretaker government of bureaucrats led by Mario Monti, and the reforms imposed upon Greece, seem to lend credence to the idea. As far as conspiracy theory goes, this one is far from being “hidden” given that the European Commission president himself at the time, Romano Prodi said that sooner or later “there will be a crisis.”

I am including excerpts from the 2003 article below for your reading pleasure.

    “By joining EMU countries relinquished the power to set their own monetary policy, control interest rates and let their economies adapt through foreign exchange rate adjustments. Instead, the power to decide the monetary policy for the EMU countries was handed over to an independent central bank, the European Central Bank (ECB) with a mandate of price stability. The bank sets one rate that applies to all EMU countries.

    However, the EU is not what economists call an “optimal currency area” with broadly homogenous conditions. Some countries, such as Italy or Ireland, are unsynchronized with the economic cycles of others like France or Germany. As a result, one monetary policy with one type of interest rates may prove inadequate.

    For instance the current short term interest rates of 2.5% are probably too high for France and Germany which are both on the verge of recession and too low for Ireland which has been growing much more rapidly and where inflation is hedging upwards.

    This is all the more problematic that, contrarily to the United States, there is very little labor mobility between countries and no systematic mechanism for fiscal transfers to countries and regions that might lose out. Even in the United States where regions suffer asymmetric shocks because of local concentration of particular industries, labor movements, while more fluid than in Europe, are far from costless.

    This would be alleviated if countries could use fiscal policy to smoothen the business cycle. However, the very ability to do that is threatened by the Growth and Stability Pact that prevents individual countries from running deficits above 3% of GDP with strong economic penalties in case of breach (as high as 0.5% of GDP). This was driven by the German desire to impose tough conditions for entry to countries such as Italy, Spain and Portugal. Ironically, it is now hurting Germany the most.

    Budget deficits naturally increase during recessions. Tax revenues fall as corporate profits decline and national employment declines. Expenses increase as unemployment rosters and thus unemployment benefit outlays increase. Traditional economic policy suggests loosening fiscal policy even more during recessions to “prime the pump” and getting the economy started again. If countries were to follow the Growth and Stability Pact they would increase taxes to avoid breaching the deficit limit. Increasing taxes during recessions is economic folly.

    In recent years, in order to avoid breaching the limit both Germany and France have been privatizing companies and counting the proceeds as income. In 1997 France relied on a one-off payment from France Telecom worth 0.5% of GDP to keep it below the limit. So far these one off sales have saved them from the disgrace of breaching the limit. Moreover, both countries have kept tighter fiscal policies than they should have imposing significant costs on their economies.

    In 2003 and 2004 with their economies on the verge of recession both France and Germany are set to breach the 3% limit of budget deficit. Ironically, this may actually end up being beneficial. Rather than commit economic suicide both countries have wisely decided to ignore the rules set by the stability pact. The European Commission is unlikely to sanction the two countries that have done most for European integration and may even abandon the Growth and Stability Pact. Ironically, this could allow less disciplined southern countries to also flaunt the rules that were meant to keep them in line to begin with, thus planting the seeds of a future crisis.

    Historically the European Union has proven practical and will probably adapt accordingly. However, even the removal of such ill-conceived policies as the Growth and Stability Pact still leaves the European Union at risk from a strong asymmetric shock which will test the Union to the limit. The European Commission’s president himself, Romani Prodi, said recently that sooner or later “there will be a crisis.”

    Also, it’s unknown what will happen if a country decides to exit the EMU or the members decide a disobedient country ought to leave. The costs of exit are likely to be very high leaving the most likely outcome as further political and economic integration with mechanism for fiscal transfers between countries.”

It’s remarkable how the situation has changed since I wrote the article. At the time it was Portugal and Ireland that were growing too rapidly and France and Germany that were in recession. In fact, the first two countries that broke the rules of the Growth and Stability Pact were Germany and France in 2004. They were not punished for exceeding the budget deficit limits. The lack of rule enforcement set the stage for the southern countries to brazenly flaunt their budget deficit limits until their excesses led to the current European sovereign debt crisis. It will most likely lead to further political and economic integration, as I predicted in 2003. The ultimate irony would be if the crisis that the eurocrats caused to promote integration actually became so big that it led to the euro’s disintegration instead!

  1. yendi
    March 16th, 2012 | 10:23 am

    In 1996 as I was working on the launching of the euro, we were dealing with all these questions, hoping with no grounds that the next step will be a fiscal harmonization, leading to a stronger political union. I had in my hands from the European commission the Greek data in total chaos and contradiction, obviously manipulated. Everybody knew and decided to go ahead, No surprise now. Just a characteristic of human nature: Inch’allah.

  2. Fab
    March 18th, 2012 | 3:38 am

    Hi Fabrice,

    to have a Big Picture, it’s necessary the origin of a matter and as far as Greece yendi is right 100% and furthermore Mr Prodi knew very well that that the situation of Italian public finance wasn’t fit at all to get into the Euro, hence, they also tricked the Italian public counts through derivates and once they’ve made it , all the Italian establishment kept silence to hide the truth!!

    Here is an interesting article:

    Wall St. Helped to Mask Debt Fueling Europe’s Crisis :

    http://www.nytimes.com/2010/02/14/business/global/14debt.html?pagewanted=1&hp

    Euro crisis is just anothor poisoned fruit of the financial speculation through which American and European banks, mutual funds and hedge funds have made money in different ways, here is an example:

    http://www.dailymail.co.uk/news/article-1253791/Is-man-broke-Bank-England-George-Soros-centre-hedge-funds-betting-crisis-hit-euro.html

    How can they do all this disaster?

    Here is the main explanation:

    The Devil’s Derivatives…

    http://www.amazon.com/The-Devils-Derivatives-Traders-Regulators/dp/1422177815/ref=sr_1_1?ie=UTF8&qid=1332059221&sr=8-1

  3. Fab
    March 18th, 2012 | 3:39 am
  4. Fab
    March 18th, 2012 | 4:10 am

    Other strange coincidences:

    a) Guess Which Country Has Debt Of Nearly 1000% Of GDP…

    http://www.businessinsider.com/g10-countries-by-total-debt-to-gdp-2011-12

    b) “America Is Using Tricks To Hide A Debt Crisis Worse Than Greece” by Bruce Krasting, former hedge fund manager:

    http://www.businessinsider.com/us-debt-worse-than-greece-2012-3

    Is it just a case that London and New York are the two most important financial markets of the world??

    I don’t think so!!

  5. Fab
    March 18th, 2012 | 4:24 am

    Obviously, Italy and Italians can’t blame financial speculation for their own faults because:

    “If the army is confused and disjointed, neighboring rulers will have easy ground to create disturbances. This is the meaning of the saying: an undisciplined army, it leads to another victory ” by Sun Tzu in “The Art of War”

    http://www.amazon.com/The-Art-War-Sun-Tzu/dp/1936041758/ref=sr_1_4?ie=UTF8&qid=1332062528&sr=8-4

  6. Fab
    March 18th, 2012 | 4:40 am

    In conclusion:

    1)The massive use of derivates only leads to financial disasters and a huge and deep reform is compulsory at least!!

    2) The failure of the business model “Universal Bank” is very clear and a huge and deep reform that divide retail banks from investment banks is compulsory. At the same time, all the sector of hedge funds must be deeply reformed!!

    3) There must be fair, few and clear ( for all western countries ) rules to compute public debts of the western nations, hence, new international agreements are compulsory!!

    And that’s all from me!

    All the best!

    Fab, greetings from Italy.

  7. Fab
    March 18th, 2012 | 6:02 am

    As far as the fact that Italy made false papers to get into the Euro:

    ““It was a well-kept secret,” Piga, the Italian economist who exposed the derivatives deals at considerable risk to his career, said in an interview in 2010. He cautioned that many governments, such as Sweden’s and Denmark’s, have used derivatives “in a proper way in public debt management,” but that troubled economies such as Italy and Greece were sometimes operating according to different standards. “It was a mortal embrace that started between governments and banks. Both know they have entered into something that enters this gray area. Thus they both become blackmailable.”

    Source:

    http://www.nationaljournal.com/economy/-government-sachs-italian-style-20111110

    His paper ( in English ) “Derivatives and Public Debt Management” can be downloaded at:

    http://www.gustavopiga.it/publications/

    All the best!

    Fab

  8. FreemonSandlewould
    March 18th, 2012 | 7:27 pm

    EU seems to be pretty heavy bureaucracy. Seems to want to stifle freedom. Its all going to be better if it comes unglued.

  9. Stacie
    March 20th, 2012 | 10:21 pm

    Interesting post Fabrice. I actually have some insight into the situation as well. When I was working for Professor Michael Porter at Harvard Business School, we used to teach a case on the European Union as part of his Microeconomics of Competitiveness class. (as you can imagine, the class was geared towards non-macro explanations of economic outcomes) As part of the class, we had the privilege both years I was there of having Romano Prodi come in as a guest speaker as well as joining us for a more intimate lunch. For your blog readers who may be unfamiliar, in addition to being the EC President from 1999 – 2004, he was also formerly the Prime Minister of Italy – somehow without owning a single TV station!

    So Prodi definitely has a unique perspective on the crisis. As per your quote above, he notes that everyone in the EU was quite aware at the time that there were some shortcomings in the financial aspect of the union. In fact, he claims that the number one problem with the union is, as you also mention, the fact that there is no exit mechanism. But he emphasizes that the main point of the union was always keeping the countries tied together enough to prevent a Third World War. So it was really always more politically than economically motivated. In fact, as he pointed out just as the crisis was beginning and Greece was the main culprit, the entire Greek economy is less than a quarter of the GDP of a the single German province Nordrhein-Westfalen. So a smidge economically but causing a lot of political tension. It’s possible that the current leaders see the purpose of the union differently, and have purposely engineered this game of brinkmanship now that they are stuck with the economic consequences. But it seems unlikely that the original leaders, with political unity in mind, would have consciously engineered this kind of political tension, with riots and unrest just waiting for a charismatic despot to place the blame elsewhere and flare up old tensions.

    Also, keep in mind, as you mentioned in your original article, it was the big guys who were the first to break the rules (Prodi tells the story of calling up the French Finance Minister and informing him that he was outside of his limits, and the Minister responding “So?” – obviously Prodi, being Italian, tells it much better). At the time, France and Germany were probably the most likely to be punished through economic crisis, something I can’t imagine they would have allowed given their influence . . .

  10. Fab
    March 21st, 2012 | 4:18 am

    Hi Stacie,

    as far as:

    “So Prodi definitely has a unique perspective on the crisis.”

    It’s not true at all!!

    Because I repeat that Mr Prodi (obviously not the only one!Just few other names: Ciampi, Barucci, Dini, Amato,Tremonti, Berlusconi, Draghi, Grilli, D’Alema, ,Fazio and son on!!) knew very well that that the situation of Italian public finance wasn’t fit at all to get into the Euro, hence, they cooked the Italian public accounts through derivates and once they’ve made it ,all the Italian establishment kept silence to hide the truth!!

    The Council on Foreign Relations launched a serious warning several years ago!!

    Here is an interesting article:

    1) “Enron and Italy: Parallels between Rome’s efforts to qualify for euro entry and the financial chicanery in Texas”

    http://www.cfr.org/italy/enron-italy-parallels-between-romes-efforts-qualify-euro-entry-financial-chicanery-texas/p4455

    2)Another interesting article:

    http://www.zerohedge.com/article/step-aside-greece-how-gustavo-piga-exposed-europes-enron-2001-focusing-italys-libor-minus-16

    Anyway, I’ve already pointed out the paper of Gustavo Piga at the end of my last post!!

  11. Fab
    March 21st, 2012 | 4:19 am

    Recent news about the issue:

    a) http://www.bloomberg.com/news/2012-03-16/italy-said-to-pay-morgan-stanley-3-4-billion-to-exit-derivative.html

    b) http://www.businessweek.com/news/2012-03-19/italy-holds-derivatives-on-211-billion-of-debt

    In conclusion:

    1)Greece and Italy cooked the books through massive misuse of derivates to get into the euro.

    2)Modern financial markets are mainly dominated by speculation, levels of financial industry interconnectedness (first link within my post N 3 ) are mind-blowing and the importance of financial industry ( second link within my post N 3 )is totally disproportionate within western countries.

    Hence, Euro crisis is just a consequence!!

    All the best!

    Fab, greetings from Italy.

    PS Germany and France also cooked the book to get into the euro through some accounting tricks!!

    Obviously not through massive misuse of derivates like Greece and Italy!!

    small sins vs Big Sins!!

  12. Fab
    March 21st, 2012 | 6:53 am

    Meeting in Paris (Council of Europe Office)
    Monday, 29 November 2010

    “Derivatives in Public Management”

    GUSTAVO PIGA
    Director, Ph. D. in Money and Finance

    http://www.gustavopiga.it/wordpress/wp-content/uploads/2012/03/discussion.pdf

    This is a very short version but some important concepts can be found!

    All the best!

    Fab

  13. Fab
    March 21st, 2012 | 7:02 am

    The Official Document:

    Doc. 12556

    28 March 2011

    Over-indebtedness of states: a danger for democracy and human rights

    Report1

    Committee on Economic Affairs and Development

    Rapporteur: Mr Pieter OMTZIGT, The Netherlands, Group of the European People’s Party

    http://assembly.coe.int/Main.asp?link=/Documents/WorkingDocs/Doc11/EDOC12556.htm

    50. At the time, Gustavo Piga, a Doctor of Economics, published a book as part of this inquiry, Derivatives and public debt management,27 highlighting the dubious practices whereby states could minimise their short-term public deficit. These practices are typified by their lack of transparency and have grave repercussions on future and long-term state indebtedness. For instance, derivatives can be not only a very useful tool for state debt management but also help hide more public debt if they are misused.

    All the best!

    Fab

  14. N
    July 2nd, 2012 | 11:02 am

    On marche sur la tête en Europe: on assiste à une destruction massive d’emplois, et recours massif à des stagiaires pour tout et n’importe quoi.

    Dans les pays à bas cout de main d’oeuvre 100% des salariés sont payés. Au salaire local, mais ils sont payés. Et ils consomment à leur tour avec ce salaire.

    En France on assiste à une explosion du nombre de stages. Sans croissance, sans boom démographique ni départs massifs en retraite. Bref rien ne justifie ceci. 2005: 1 Million de stagiaires. 2011: + 2 million de stagiaires

    et ceux ci ne sont pas comptés dans les stats de demandeurs d’emplois car ils sont en stage.

    Pourquoi en France peut-on recourir à de la main d’oeuvre estudiantine, compétente, formée (bac +5), parfois pour des stages d’un an en entreprise payés 432.17 euros par mois en lieu et place de vrais contrats de travail au salaire légal.

    Si le stage fait moins de 2 mois l’entreprise n’est pas obligée de rémunérer le stagiaire. On voit des sociétés rechercher 6 stagiaires par an, un tous les deux mois sur un poste occupé par un salarié auparavant. Cout: zéro euro.

    En théorie le stagiaire ne doit pas remplacer un salarié, ni occuper un emploi saisonnier.

    Dans la pratique de nombreuses offres sont illégales. Comme un étudiant en stage de moins de 2 mois n’est pas payé, pourquoi les entreprises recruteraient elles ?

    Moins cher que gratuit cela n’existe PAS. Le pire étant ce recours devenu systématique au stage pour tout et n’importe quoi: chef de projet, développement C++, consultant, assistant chef de projet, auditeur etc. Voire même un stagiaire qui “recrute d’autres stagiaires en assistant le DRH”.

    Quel est dès lors l’avenir d’un pays qui forme des gens compétents qui s’expatrient faute d’emplois ? Ils entreprendront ailleurs et paieront leurs impots ailleurs.

    c’est un immense gachis de compétentes et d’idées. Et le pire de cette crise reste à venir avec un effet de dominos.

  15. N
    July 2nd, 2012 | 2:55 pm

    petit rappel sujet d’histoire économique année 1995 concours d’entrée à l’ESSEC:

    L’Europe sociale existe-t-elle ?

    (sujet de philo d’H.E.C: “l’oubli”)

    Quelques années plus tard, les mêmes problématiques ressurgissent