Tuesday, May 15, 2012

Eurozone Meltdown (Redux) and the Failure of Austerity

Things in Europe recently deteriorated dramatically. Austerity failed miserably to resolve the Eurozone crisis. The chart at right, from Bloomberg, shows the added risk premium of Spanish government debt relative to safe haven German Bunds has reached a new high--the highest since the crisis over there started and the highest in Eurozone history. Thus, the prior peak, on November 22, 2011, reached 4.69 percent--meaning that Spain paid nearly five percent more to compensate bond investors for the additional risk of holding Spanish bonds for 10 years. Today, as shown above, the spread now stands at 4.88 percent. Given that German Bunds yield a near record low of under 1.5 percent, Spain bears more than four times the interest expense of Germany to borrow funds.

This record high risk premium arose from political chaos in Greece, which this blog first reported on in May of 2010. Essentially, the recent May 6 elections in Greece ushered in fringe groups that make an exit from the Eurozone more likely. The austerity imposed as a cost of EU bailouts drove unemployment to 21%--thus the European "rescue" of Greece failed economically as well as politically. New elections for mid-June appear necessary to form a new government and this vote will determine if Greece will abide by the outrageous austerity imposed by Berlin and others or throws in the towel on the Euro. This is why more and more mainstream voices recently shifted their focus to the rather grim reality of the economic consequences of a Greek exit from the Eurozone monetary union--or the consequences of a Grexit.

The bottom line here is "cascading defaults, banks runs and catastrophic risk," as this blog reported last fall. No firm or individual would want to hold any asset or deposit that is subject to being re-denominated in new Drachmas rather than Euros. So all Greeks would desperately pull all Euros out of the Greek banking system rather than wait for bank deposits to be shifted into Drachmas which would rapidly fall in value. Meanwhile no firm would want Drachma assets and would retain many Euro denominated obligations--threatening massive and unknown risks of insolvency. There already are reports from Greece that bank runs are brewing.

Soon Spanish, Irish, Italian and Portugese investors would fear that those countries too may exit the Euro and capital would flow to safe havens such as Germany, the UK, and the US. The chart above illustrates that very dynamic. Money is rushing toward Germany lowering the yields on German debt as investors bid up the price of Bunds. Germany would lose access to its major export markets as the soaring cost of capital throughout the Eurozone crushes buying power and investment. Unemployment, already at a record high, in the Eurozone would soar.

So, how does all this add up for the USA? Initially, expect the cost of debt for the US to plunge. But, ultimately our economy would suffer great harm and deep distress from at least four channels:

First, if Europe suffers a depression from this financial meltdown, demand for US exports will decline as will export-related jobs.

Second, who knows what derivatives exposure our megabanks have to Greek, Spanish, Italian, Irish and Italian sovereign debt. After all, MF Global went belly-up on Greek debt and JP Morgan recently showed how inept the megabanks are at managing derivatives exposure.  

Third, beyond sovereign debt, our megabanks no doubt have huge exposure to Eurozone megabanks, through derivatives and otherwise, and if the Eurozone descends into full-blown depression it is hard to fathom their grossly undercapitalized banks surviving in the absence of government support which is not likely in a sovereign debt crisis for most Eurozone nations.

Fourth, a crisis over there means massive asset fire sales over here. US equities, commodities, real estate, and anything that can be sold for quick cash would invariably be called back into Europe to meet massive liquidity needs over there.

All in all, if Greece exits the Eurozone, in my view it will have more negative consequences for ordinary Americans than the failure of Lehman Brothers in September of 2008.


  1. "Austerity is destroying Europe, we are told. In fact, this “anti-austerity” slogan was a big reason for the victory of newly elected socialist François Hollande to the presidency of France. Interviewed in The Economist a few weeks ago, Hollande’s campaign director said “We are not disciples of savage spending cuts.”

    But then, I look at the data and I am asking: What “savage” spending cuts? ... Graph of European Spending

    The most important point to keep in mind is that whenever cuts took place, they were always overwhelmed by large counterproductive tax increases. Unfortunately, that point is often overlooked. This approach to austerity — some spending cuts with large tax increases — is what President Obama has called the “balanced approach.”

    However, as I have mentioned previously, while this balanced approach may sound good and appeals to our sense of fairness and moderation, but it can be a recipe for disaster. That’s because it fails to stabilize the debt, and it is more likely to cause economic contractions. -- Veronique de Rugy, Mercatus Center, George Mason University

  2. Great Britain has been Paul Krugman's "poster boy" for his arguments against the supposed evils of austerity:

    "Let’s look at Britain, which just entered into a double dip recession because of, according to Paul Krugman, “the evident failure” of austerity policies. If we look at spending levels in the UK both in nominal and real terms, we can clearly see that despite the announcement of deep cuts, government spending continues to rise ... If we look at total government spending as a percentage of the economy, Britain reached a peak in 2009 at 51.5%, and that came down to 49.9% in 2011. Can anyone seriously argue that Britain is in a recession because of that tiny drop in spending as a share of the economy? ... the tax increases already took place (the VAT rate went up from 17.5% to 20%, for example). But as we can see, spending cuts haven’t taken place at all. Thus, austerity in Britain consists only of tax increases." -- The CATO Institute

    So, the absolute level of spending increased, while spending, as a percent of GDP, fell only marginally. How is that austerity? What has actually happened in the UK, as in other European countries, is that the government has raised taxes. So, in order to be accurate, your post should read that tax increases have "failed miserably to resolve the Eurozone crisis".

    I know that Krugman would probably argue that Greece is more representative of what he means with regard to the effect of austerity measures, but Greece is really evidence of the effects of spending beyond ones means for an extended period of time. Greece's profligacy has left it with no options. The size of it's accumulated debts has made it prohibitively expensive to borrow. Austerity is not a strategy, it's a necessity. The troubles that have ensued are not the result of spending less, they are the resulting of having spent too much in the past.

    No nation has ever spent its way out of a debt crisis. Ever.

  3. "We often hear that big cuts in government spending over a short time are a bad idea. The case against big cuts, typically made by Keynesian economists, is twofold. First, large cuts in government spending, with no offsetting tax cuts, would lead to a large drop in aggregate demand for goods and services, thus causing a recession or even a depression. Second, with a major shift in demand (fewer government goods and services and more private ones), the economy will experience a wrenching readjustment, during which people will be unemployed and the economy will slow."

    "Yet, this scenario has already occurred in the United States, and the result was an astonishing boom. In the four years from peak World War II spending in 1944 to 1948, the U.S. government cut spending by $72 billion—a 75-percent reduction.It brought federal spending down from a peak of 44 percent of gross national product (GNP) in 1944 to only 8.9 percent in 1948, a drop of over 35 percentage points of GNP." -- David R. Henderson, Stanford University, Mercatus Center Publishing

    1. First, there is no question that fiscal contraction in boom times, within reason, can be sensible. We should have balanced the budget after the recession of 2001, not enacted historically low levels of tax, particularly during wartime.

      Second, during the Eisenhower administration the nation spent money on the Marshall Plan, the GI Bill, the Interstate Highway System, unprecedented high levels of peacetime defense, and the first foray into federal funding for secondary education. Yet, debt/gdp went from 100% to 60% in eight years. Eight years!

      How? 91% top marginal tax rates.