Wednesday, June 1, 2011

European Choices Continue to Narrow

On May 24, my post stated that debt ultimately leaves you with no good options. (

Martin Wolf in the Financial Times reduces the choices now available to the European Union to two: “The eurozone confronts a choice between two intolerable options: either default and partial dissolution or open-ended official support.  The existence of this choice proves that an enduring union will at the very least need deeper financial integration and greater fiscal support than was originally envisaged.” (See “Intolerable choices for the eurozone,”

The “original” design of the union, Wolf contends, is for all purposes, dead.  That could only be achieved by removing some of the countries now in the union.

To achieve the second of the two choices he mentions above is going to require a contortionist.  First, Wolf argues, European banks cannot remain national.  Whoa!  Second, he argues that the current system of European System of Central Banks (ESCB) must be eclipsed by a “sufficiently large public fund” that manage “cross-border” financial crisis.  Double Whoa!  And, third, the finance of the “weak countries” must be taken out of the market for years, “even a decade.”  Whoa! Whoa! Whoa!  What would result would be something Wolf calls a “support union.”

This certainly is “deeper financial integration and greater fiscal support than was originally envisaged” by the creators of the European Union. 

The question is, “could this ‘support union’ ever be achieved short of all countries in the eurozone coming under a common government. 

But, even so, I do not see that this “solution” reflects any change in the underlying economic philosophy of the current leaders of Europe concerning the propagation of the credit inflation that the leaders of Europe have perpetrated for the last fifty years or so.  With no basic change in philosophy, I cannot see how this second choice achieves anything except the postponement of the “day of reckoning” in which the range of options available to the European Union drops to one. 

Does this mean that the European Union will eventually be providing investors with a “sure-fire”, riskless investment similar to the one given George Soros by the British government in 1992?

It seems to me to be a real possibility.

John Plender, who also writes for the Financial Times, argues that the European Union can “Muddle along for now; but a Greek default is inevitable.” (
Plender writes that the burden of the policies imposed upon the Greek government by the IMF will only produce “great demands on the population” which is already enduring a deep recession.  Greek workers will have to ‘endure wage deflation” so as to restore the competitiveness of the Greek economy and the privatization program being discussed will put the transfer of Greek assets in the hands of an external agent. 

However, the other option, debt restructuring, is not currently acceptable to Plender, either.

He sees it as the only real choice for the time being: “If a package is agreed in June, which seems probable, the challenge will be to bring Greece to a primary budget surplus...” and “at that point, it would be sensible for Greece to bow out of the monetary union and take advantage of currency devaluation.” 

He goes on, “For that to work, though, European banks would need in the interim to have bolstered their capital.  And the execution risks are phenomenal.  This is policymaking on a wing and a prayer.”

The leaders of the United States need to absorb this lesson.  No matter that the United States is richer and deeper in resources than Europe.  No matter that the United States is bigger.  No matter that the United States has the reserve currency of the world.  The debt burden catches up with you.  As, as the debt burden is catching up with you…your options become fewer in number and they become less and less desirable.

The United States is not exempt from this outcome…unless it changes course before all the options go away. 

In all financial crises, the initial response of the central bank and the government must be to provide sufficient liquidity to keep the banks open and to avoid cumulative downturns in companies and the economy.  Bailouts and quantitative easing may be appropriate…for the short run.

But, there is a difference I have written about many times, between a “liquidity” crisis and a “solvency” crisis.  A liquidity crisis is a short-run phenomenon, which gets an economy over the short-run shock of a financial event. 

The longer-run problem is the solvency problem.  And, solvency is tied up with debt…debt loads that must be worked off.  And, working off debt loads takes time…lots of time.  And, working off debt loads cannot really be achieved by flooding the financial markets with more credit and more liquidity.  This is a “postponing” strategy.

To solve the “debt” problem and to prevent it occurring again in the future, leaders must change their basic economic philosophy about the creation of debt.  Credit inflation always leads to debt problems, and further credit inflation aimed at solving debt problems only leads to diminishing options and eventual collapse.  Insolvency cannot be solved by more debt. 

It should be obvious that more debt is not the solution to a problem if the options one has decline in number and the desirability of the options also declines.  To continue to pile on more and more debt is like the person in the hole, digging the hole deeper and deeper in an effort to get out of the hole. 

Europe is finding this out.  It, apparently, must be the case that the United States will have to learn this lesson as well.

If anything is going to give the emerging countries of the world the chance to close the gap on the developed countries it is a continuance of the credit inflation policies of Europe and America.  The ironic thing is that the shoe used to be on the other foot…the developed countries had control over their credit inflation whereas the emerging nations were reliant on excessive amounts of credit inflation.  This relative performance was given as an important reason why the developing countries could not hope to catch up with the developed world. 

China is catching up with the west faster than most analysts believed it would.  So with India…and Brazil….  If the European Union…and the United States…continue to push the edge of debt creation and continue to shrink their options, the tipping point  to this emerging world might occur sooner than most of us imagine.     

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