You are warned, this post is going to be a long one. But by the end of it I promise that you will come to understand how the eurozone found itself one step before a financial implosion. You will understand how the common currency lead to a humongous misallocation of capital and how eventually Germany and the other rich countries of the eurozone were bailed out, contrary to anything that the mainstream media broadcast in their daily exposé of idiocy.
Tired of the daily nonsense on TV? Read through…
After WWII the European countries followed different economic models and different paths to prosperity. Some of them were more successful and became more competitive in international trade. Others were less successful and saw their international competitiveness deteriorate. The differences would be smoothed by diverging currency exchange rates. The Deutschmark, the Guilder and the Schilling for example slowly appreciated against their laggard peers, the Lira, the Peseta, the Drachma and the Escudo. Europe at some point decided that this was not good for anyone:
-The exporters of the surplus countries found it increasingly difficult to find a market for their products, since the appreciating domestic currency made their products more expensive abroad.
-The investors in the surplus countries also had a problem because investment returns domestically were declining as their economies matured and the markets got saturated. They could be investing abroad, but as the domestic currency appreciated, the returns on foreign investments would lose value in domestic currency terms.
On the other hand the deficit countries had the opposite problem:
-The depreciating currency did not encourage investment in the domestic economy, neither from domestic nor from foreign investors. The deficit countries had to offer rates of return substantially higher in order to offset the drag of the depreciating currency on investment returns.
-Without investment, the deficit countries could not increase their competitiveness which would put the currency exchange rate in a more stable path. They were caught in a vicious circle of low competitiveness > depreciating currency > lack of investment > lower competitiveness.
Fixing the currency rates among the European countries by means of a common currency was the way to address these problems. The common currency was thought to give a new boost to the stagnating European economy and also to solidify political stability in the continent. It was a great idea, truly. But the implementation was bad and the idea soon turned sour for both the surplus and the deficit countries.
I will try to explain what went wrong with a number of diagrams of communicating vessels and using Greece and Germany as an example. It is important to note that any and all of the deficit countries could take the place of Greece in this example, and any and all of the surplus country the place of Germany. The differences between these two countries are though the starkest.
The diagrams show the flows of money within the eurozone since the currency’s introduction. In the diagram above the blue liquid is the money supply which is (very) broadly speaking the amount of money that an economy uses.
Greece and Germany are represented with a vessel. The width of each vessel represents the potential GDP of each country, which is the amount of goods that an economy can produce if working at full capacity. With the volume of the liquid representing the amount of money in the economy, it follows that the height of the liquid in the vessel represents the ratio of the money supply over the potential GDP. It shows, intuitively, how much money there is in the economy for the purchase of the total goods the economy can produce. If the ratio increases, then more money chases fewer products causing inflation. The opposite happens when the ratio decreases with deflation as a consequence. At the time the euro was adopted we can assume that this ratio was at roughly the same level among all eurozone countries as each member had to bring inflation down to the same low level.
The two vessels are connected with two pipes: the current account and the capital account. The current account shows the flow of money for the purchase of goods and services and the capital account shows the flow of money for investments (the purchase of assets). By the time the euro was introduced, the eurozone members had small surpluses or deficits in the two accounts which for the sake of illustration we can assume they were close to zero. The needs of consumers and businesses for goods in both countries control the flow of money in the current account, investment returns command the flow in the capital account. Black arrows show the flow of money between the two countries and within them.
Enter ECB into the illustration. The ECB’s primary role is to control the money supply of the eurozone. It is not of the essence to discuss here how the ECB is doing that but we can say for now that the ECB can increase or decrease the amount of money in the currency block. Two things are important for that matter: first, that the ECB can theoretically inject infinite amounts of money in the system, although it would impose some limits on itself in order not to undermine the credibility of the euro; second, the ECB cannot control in which vessel the money flows, which is only determined by the two flow controllers in the bottom of the diagram.
Let’s see now how the economic model of the eurozone developed after the euro was introduced. As described above, investors in the saturated, surplus countries found new investment opportunities in the undeveloped new euro markets. With foreign exchange risk eliminated and without facing any appreciating impact on their investment flows they moved their investment and money away from their domestic market. German investors for example could now invest in Greece without causing the drachma to appreciate in the process and without the fear of currency losses in their investments. This happened through the capital account:
The money invested in Greece to some extent increased the potential GDP of the country (something not reflected in the diagram for the sake of simplicity) but for the most part caused inflation to rise. The Greek economy slowly readjusted itself by pulling back from export activities (since exports were becoming more difficult due to inflation and consequent labor cost increases) and entering into activities that would satisfy the increased domestic demand. The gradual appreciation of the euro against foreign currencies further contributed to this shift. The nominal increase of Greek income then gave a boost to the German exports since Greeks found it now cheaper to buy German products. The exact opposite thing happened in Germany, where German companies refocused their production into more export related activities, taking advantage of the increased inflow of money through the current account. The game had already started to turn bad:
Investment flows to Greece from Germany at some point started to slow down. At the same time, the Greek current account deficit was increasing. The amount of money in each country was already off-balance and a painful reversal commenced. On the side of Germany things still semt to be going great. Returns on foreign investments had been so far robust and exports were flourishing. But the flows were already unsustainable. Germany’s production model required that the current account deficit of Greece or any other deficit country was financed by a capital account surplus. If the capital account of Greece was not balancing her current account deficit, Greece’s current account deficit would be unsustainable, and so would Germany’s current account surplus.
This would inevitably happen once the risk adjusted returns on capital would equalize among the two countries, which would approximately coincide with the moment the growth rates of the two countries would approach the same level. Eventually, an exogenous shock raised sharply the risk on the Greek investments and made the risk-adjusted returns on Germany higher. That shock was of course the 2007-8 subprime mortgage crisis in the US. Things turned very ugly at that point because both the current and the capital account would turn negative for Greece:
Like in any time of crisis, investors rebalance their portfolios by moving their money into safer, less risky investments, usually government bonds or cash. In the case of the eurozone, there are no euro-wide safe haven investments. National governments issue their own bonds and banks are only supported by their local government. The safe haven for the whole of eurozone is only Germany and to some degree the other surplus countries, which are however smaller and cannot accommodate enough liquidity.
Therefore, when the crisis struck, risk aversion turned the flow through the capital account towards Germany, in the beginning only slightly because the Greek government accelerated its borrowings. But investors could spot already the weakness of Greece to face the crisis. They had seen what had already happened in Ireland and Spain when the housing markets blew up. They had realized that the eurozone countries could in fact run out of money. That’s when panic took over and everyone rushed for the exit. Money was literally flushed out of the country and Greece found itself in a freefall. Other countries with weak finances had or will have the same fate. Ireland and Spain were there first, then came Greece and Portugal. Italy now joins them in the same painful path. The other weaker countries of the eurozone that media do not pay much attention to will not avoid the downfall either.
But enough said for Greece. A lot has been written and a lot has been said about the series of mistakes the Greek economy fell into. The question is, what about Germany? Every news channel, every commentator and every economist still praise Germany for its open, competitive economy and its sound public finances. Its economy has recently soared despite the global macroeconomic “challenges”. How can Germany do so well?
The answer is simple. It cannot.
Germany completely messed up its business model exactly for the same reasons that Greece messed up hers. You see, there are two types of investments, let’s call them the “good” and the “bad”. The good ones increase an economy’s potential GDP. The bad ones do not increase its potential GDP but simply constitute a claim on its future production coming from the existing production factors. An example of “good” investment is to build a factory; a “bad” investment is to buy an existing factory. Most of Germany’s investments abroad were bad. Either directly or indirectly, German money was invested in activities which were supposed to earn higher returns from money that foreign investors were injecting into Greece. At the same time, German manufacturers tried to do the same thing by trying to export their production into the country which had now extra money to spend. And they were successful of course because the Greek supply of goods could not meet demand anymore.
That’s why Germany lost it, just like Greece. Germany thought that it is actually possible to inject, say, 100 euros into a country, get it back through exports and then get it back again with interest as an investment return, without having increased the ability of this country to produce the extra 100 euros. Utter dumbness! If Germany’s investments had been “good”, then the investments would perform well but the exports would not, because then Greeks would either be consuming their own stuff or, more likely, the two countries would trade more increasing both German exports and imports. If exports were good then investments would be bad.
Yet at this moment, Germany still tries to get its 100 euros back from both sides. It was not possible from the beginning, it is even less possible now. Even if Greece starts selling off any asset it has left, these “investments” (from the side of Germany) will still be “bad” and will not make Germany’s exports sustainable. The way that the eurozone has addressed the problem so far is to actually suck as much money as possible from Greece, destroying its potential GDP in the process and undermining the sustainability of the export-dependent German economy in the long run. No wonder why the euro crisis becomes worse by the day!
And here is the one more thing that makes the euro situation so absurd. In the above, I described how the model of both Greece and Germany was flawed, or how the eurozone’s model as a whole was flawed. This should be bad for each and every country. Yet which one got the money? Well, not the one which needed it the most and neither the one which was in good shape, because none is really. The one which is in the least worst shape did: Germany. It is Germany which is now using the money supply from Greece and the other troubled countries and at the same time moans about having to “bail” them out. Look at this diagram to see how the bail-out works:
The special purpose vehicle called EFSF (short for European Financial Stability Facility) injects money into Greece by refinancing the maturing Greek bonds and Greek government deficits. The money provided to EFSF comes from taxpayers in the eurozone and around the world through the IMF; the ECB prints its own money and therefore does not take any money from Germany. So, does Greece’s own money supply increase with this financial contraption? No, on the contrary, Germany’s money supply increases. As long as the current account and the capital account are deep into the red on the Greek side, money will flow out of Greece and into Germany. And the two accounts do not show any sign of changing at the moment.
More specifically, the current account will stay negative for as long as Greeks are rich enough (or more correctly not poor enough) to afford their imports, since there is no sign of Greece increasing its exports any time sooner. The capital account will stay negative for as long as i) uncertainty keeps required returns on investments in Greece elevated (and EFSF actually contributes to this uncertainty since it is not a committed facility and finances itself also from other troubled countries) and ii) the money supply does not increase in Greece to guarantee that money will be there to provide a return on invested capital. It is simply a vicious circle of uncertainty > capital outflows > lack of money to generate investment return > capital outflows and even higher uncertainty.
In the end, the EFSF sole purpose is to satisfy the short-term interests of Germany into getting its 100 euros back twice. Over the long run though it will only manage to shrink Greece’s potential GDP and with it also the potential GDP of Germany. Those in control of the demolition of the European economy know this very well, but by the time this eventually happens they will all be gone, richer perhaps, but hated and disregarded. They surely won’t be missed.
I guess I can close this post here, it was indeed a long one and still requires an addendum because some points are overly simplified and some others are not covered at all. To make the long story short, putting the blame of the current crisis on one or another country is futile. It was the euro itself and the markets’ false expectations that lead to this misallocation of capital, a misallocation which is evidently very difficult to correct given its magnitude. The one-sided treatment of the crisis by politicians, unelected officials and the media makes it even more difficult. The richer countries’ inability and/or unwillingness to admit what went wrong and share part of the losses will make perhaps long term solutions unattainable.