Europe’s internal adjustment

With all the talk of competitive currency devaluations and international currency wars, less attention is being paid on the arresting fact that some countries within the Eurozone are achieving what many thought they could not: an internal devaluation via wages and other production costs.

A consequence of this is that some Southern European economies are regaining shares in export markets, their products cheapened by a mixture of labour market reforms and downwards pressure on wages. The FT recently reported that in Portugal exports in 2012 rose by 5.8%, with exports to outside the EU rising 20% in this period. This was Portugal’s third consecutive year of plus 5% export growth. Writing about Spain, Tony Barber suggested that a similar phenomenon was occurring in the Spanish manufacturing sector. Car companies planning to reduce production in France and Belgium are boosting output in Spain. Nissan has committed 130 million Euros of extra investment into its Barcelona plant in order to raise annual production to 80,000 units. Ford, Renault and Volkswagen have all followed suit with their own investments. Barber explains that lying behind such decisions are changes in Spanish labour laws. A reform package last year introduced by the government has loosened up collective bargaining practices, making it easier for firms to negotiate favourable terms with workers.

The ability to boost export competitiveness by internally devaluing is not uniform across the Eurozone. France has enacted its own labour market reforms but labour costs remain significantly higher there than in Spain or Portugal. Monti in Italy has been less successful in pushing through labour market reforms. This unevenness has had the effect of exaggerating the competition between countries within the Eurozone. Unable to compete with one another via national currency manipulations, competition is realized via changes in the labour market. Accepting lower wages has become a matter of national duty in today’s Eurozone.

This development has various implications. The first is that it seems parts of the Eurozone are able to achieve what we thought was only possible in the olden days of the Gold Standard: internal adjustment where the burden falls upon societies, not currencies. This worked back then because there were far fewer public expectations about jobs and welfare to challenge the harsh assumptions of Gold Standard supporters. When such internal adjustment became intolerable, it collapsed. We might have expected something similar today. In fact, the quiescence of European labour has made internal adjustment possible. In some places, it has meant hollowing out national democracy in favour of more stable, technocratic alternatives, but the single currency remains. Differences between the constraints imposed by Eurozone membership and those of the Gold Standard help explain some of the stability of the former but not all. Much is also due to weak labour militancy.

Another implication dovetails with a previous post on falling productivity in the UK. In some Eurozone member states, productivity figures have improved. In Spain, productivity is has risen by 12% since mid-2008. However, such increases have not been achieved via any labour-saving investments. There have been no marked technological developments that explain rising productivity figures. Rather, gains have been made through labour itself. This tells us a great deal about European capitalism: it is far easier to claw back price competitiveness via assaults on labour than it is to boost productivity through capital investment in research, product development and technological improvement. Paradoxically, we can say that weak labour militancy results in low incentives for firms to channel capital into labour saving technology.

The kind of internal adjustment taking place within the Eurozone is thus hardly a victory for supporters of austerity. Competiveness is boosted in short-term ways, via downward pressure on wages. There is no longer term gain in productivity that might actually leave a socially useful legacy for societies as a whole. Recessions and social upheavals in the past had the same human cost in terms of wasted lives but they came with great labour-saving inventions and other gains. European leaders are so worried about currency wars precisely because Yen and Dollar devaluations threaten to wipe away the marginal gains in price competitiveness their businesses have made. And they know that were this to occur, there would be nothing much left. Only the waste.

Varieties of finance?

In a previous post, we looked at the structure of the European banking system. We asked whether there was a particular European story that can help explain the sorry state of the current European economy. It was noted that the size of the European banking sector, so much larger than in the United States, reflected the central role banks in Europe play in financing the private sector. In the US, there is more reliance on capital markets than on banks and so the assets to GDP ratio of US banks is much lower than in Europe.

Can we transform those differences into something more systematic? Do differences in financial markets point to deeper and broader differences between different types of societies? The question here is whether there exists the same kind of variety in financial sectors as there does in capitalist economies more generally. A popular way of classifying capitalist systems is according to type: liberal market economies, coordinated market economies and mixed market economies. This is the famous “varieties of capitalism” approach. Can we say that the financial sectors in Europe are shaped by these national institutional factors? One basic distinction, for instance, is between market-based and relationship-based borrowing and lending. In more liberal market economies like the UK, companies are expected to rely more on the open market as a source of finance. In a coordinated market economy, corporate financing is fed through bank-to-business relationships.

Finding out whether any of these patterns exist in the date on financial markets is not easy. Interest has tended to be in the ties between business and politics, not in the correspondence between differences in financial markets and broader varieties of capitalist production. But there is some data out there. In the Liikanen report on the European banking industry, we see little evidence for these kinds of patterns. In terms of the balance between stock market capitalization, total debt securities and bank assets, we do see differences between Europe and the US. But within Europe, a supposedly liberal market economy like the UK has bank assets that massively outstrip any other European country and offsets its larger stock market capitalisation (p119 of the Liikanen report). The data on financial institutions and markets collected by Thomas Beck, Ash Demirgüç-Kunt and Ross Devine (available here) is extensive but suggests that the biggest difference is between income levels, not between varieties of capitalism. Another way of thinking about the varieties of financial markets is whether it can help explain different national government responses to the current economic and financial crisis. One study of this by Beat Weber and Stefan Schmitz (available here) found that institutional factors did not in fact influence very much the rescue packages put together by European governments. They point instead to other factors. The degree of inequality in society, which they take as an indication of the fact that policymakers in those countries use access to credit as a substitute for higher wages (what Colin Crouch calls “privatized Keynesianism” – see here), is for them one element that explains the form the government bail-outs took. On the varieties of capitalism, they note that as an approach it is focused more on production and not on financial systems. It has therefore little to say about financialization as such.

National differences remain important and a feature of the current crisis is the difference in the national responses. Behind efforts to build a common European response are national bail-out packages that differ greatly in terms of size and in the strictness of their conditions. But financialization as such, and the boom of the late 2000s, was common to many high-income countries. By way of explaining the current crisis, Beck and his colleagues write that “the lower margins for traditional lines of business and the search for higher returns were possible only through high-risk taking” (p78 of this paper). The implication here is that the lack of profitability in the real economy drove the expansion of financial activity in the 2000s. This explanation isn’t perfect but it certainly helps us understand why it has been so difficult for governments to return to positive growth. If financialisation was itself more symptom than cause, then we are still left with the causes of the crisis today.

The Zombie Currency and the Fetters of Europe

Hobbes once said that money is the “Sanguification of the Commonwealth” Wherever it circulates, so it brings goods from those who produced them to those who need them, and in the process sustains the life of the body politic, the same way blood sustains the life of the body. If Hobbes was right, that is a bad sign for the euro. The euro was supposed to be the lifeblood of the European Union, circulating through and nourishing the political institutions of the Euro-Leviathan. Instead it is sucking the life out of it.

Part of the problem is that the euro was not just supposed to nourish existing institutions but conjure into being a set of institutions that had not yet been fully created. It was a political project through and through. It was supposed to compensate for the EU’s democratic deficit and confusion of powers: a kind of European version of post-Tiananmen China – economic vitality in the place of more democratic institutions. But, unlike China, the EU never went all the way to creating a highly coordinated, if undemocratic, Euro-Leviathan. What the euro promised was financial integration, macroeconomic stability, and technocratic peace. A common currency managed via European Central Bank monetary policy would bring borrowing costs down, given the implicit continental wide guarantee. This is exactly what happened at first. Sovereign debt yields converged rapidly, such that where Greek yields had been almost 25% in 1992 compared with German 7% yields, by the end of 2000, two years after the introduction of the euro, their yield were nearly the same. Credit flowed freely across borders, as did capital, consumer goods, and even labor.

But as we have seen over the past months, the background guarantee of supranational monetary support was not actually there, the Leviathan was a many-headed hydra, and the underlying economies diverged rather than converged. The ECB’s mandate is to control inflation not save banks or engage in fiscal transfers. There is no coordinated continental-wide fiscal policy. The responses to the recent crisis have been short-term, ad hoc moves, like the Long Term Refinancing Operations, in which the ECB loaned money to national banks to buy sovereign debt, in an attempt to keep yields low and increase liquidity.

The effect has been to extend the sclerotic features of the European political system into the economy, rather than to have that economy breathe life into the political institutions. Consider the following three facts, which together reveal just how rapidly the European economy has financially dis-integrated, even as the euro ghosts along preventing this dis-integration from becoming an economic reorganization:

1. First, as everyone has noticed, sovereign debt yields have radically diverged to reflect not the strength of a continental economy with a coordinated economic policy, but rather dramatic differences in national economic potentiality. Germany is safe, France moderate, the PIIGS increasingly risky. (Note both the convergence from 1999-2009, and the rapid divergence from 2009 onwards. Graph from the ECB)

2. Second, as Gillian Tett reported in May, cross-border private lending has seized up. An essential feature of eurozone financial integration had been the willingness of banks to make loans in one country backed by assets from another. Lending to Greek consumers were matched by German funds; lending to Spanish borrowers covered by French assets. Now, as Tett observes, “banks are increasingly reordering their European exposure along national lines…the fracture has already arrived for many banks’ risk management departments.”  Banks now demand that any loan to a particular country be backed by funding from that country. Where the economic strength of Germany thus facilitated borrowing, speanding and investment in weaker economies, it now subtracts from that same provision of credit. Given the economic contraction, Greece, Spain, Italy now have fewer good assets to put up against loans that now has to be backed nationally. This “asset-liability matching” is an indication that banks are already treating the european economies as breaking up, even if this break up is not registered at the level of different currencies able to register these different economic potentials. An April ECB report on financial disintegration notes that the standard deviation in interbank lending rates across countries has continued to grow and fluctuate wildly since 2009, and an August report confirms continuation of the trend in various financial markets: “the pricing of risk in the repo market…has become more dependent on the geographic origin of both the coutnerparty and the collateral, in particular when these stem from the same country.”

3. Recently, the Financial Times reported corporations have had to seek financing from the corporate bond market, because bank loans are in short supply, and that the yields on corporate bonds are nationally divergent. According to the FT, “Interest rates paid by companies in the eurozone’s weaker economies have surged, highlighting the bloc’s fragmentation as the European Central Bank loses control of borrowing costs.” Further, this particular instance of fragmentation heavily favors large businesses that can sell bonds on corporate bond markets, and some countries have many more corporations with access to these markets than others. Money is going into already established avenues for investment, not new growth areas. Once again, financial markets are reflecting the fragmentation of the European economy.

In sum, diverging national bond yields, diverging bank loan structures, diverging corporate borrowing costs. The blood is running through the arteries of a foreign host.

The ECB is not so much keeping the euro alive as keeping it from dying. Public funding by the ECB is replacing private funding at the cost of sinking more and more money into going concerns, suppressing new avenues for investment. Banks are not lending to companies, they are investing in their own sovereign debt or parking cash back at the central bank. Major companies are sitting on cash hoards rather than investing.

The Euro is a zombie currency – a monetary undead, wandering around feeding off the flesh of living economic entities. Of course, there is an alternative to trying to goad skittish banks and bearish companies into investing. One could sequester savings and force investment through a massive, European wide investment plan. But that would require decapitating the zombie, or however else one finally kills the walking dead. The fetters of the EU political structure weigh too heavily on the economic forces of the Eurozone to allow such a radical act. There may be a European solution to the continent’s economic malaise, but it won’t come from the EU.

France’s heterodox economists

Back in June, The Current Moment blogged about a manifesto written by a group of “dismayed economists” in France whose critique of free market orthodoxies was beginning to gain ground. This past weekend, a long interview with one of the original signatories of this manifesto, the French economist André Orléan, was published in Le Monde. Focusing on the role of financial markets in macro-economic policymaking, Orléan makes a number of excellent points.

He notes that historically, the role of specific economic interests, such as those of finance or of specific sectors of the real economy (export industries, domestic farming interests etc.) have been contained by the wider concerns of governments. The universality of the general interests holds sway against the particularities of individual groups. He makes the good point that this battle has often been fought through national central banks. They have been the main tool used by the executive power to pursue the interests of wider society. This gives us a rather different perspective on what is often assumed to be the narrow partisanship of politically-controlled central banks. In the mainstream economic literature, independent central banks are the guardians of the public interest; central banks directed by national executives are prisoners of political short-termism. This may be the conventional view today but Orléan reminds us that the historical record supports the opposite view: politically-controlled central banks were the vehicles for the articulation of the public interest. The primacy of politics over economics, as Orléan puts it, has had as one of its main tools the power of the central bank. This might shed a different light on the Orban government in Hungary: attacked for its anti-democratic ambitions, one of Orban’s proposed reforms was to curtail the independence of the Hungarian central bank. Rather than welcome this as an attempt to regain political control over macro-economic policy, Orban was criticized for his nascent authoritarianism. In fact, the more powerful assault on the democratic control of macro-economic policy has been waged over the years by the European Court of Justice, particularly its attack on the notion that national public sectors should be shielded from the competitive pressures of the private sector.

Orléan also has an interesting reflexion on the nature of finance. Contrasting it with the market for goods or services, he notes that finance has a “directly collective dimension”: it is concerned not just with individual sectors but with the economy as a whole. He gives the example of the infamous downgrading of France’s triple A rating by the agency, Standard & Poor’s. In its report, S&P referred to the EU’s new fiscal compact agreed upon in December 2011 (which the UK and the Czech Republic are today refusing to ratify), which it judged inadequate to meet the demands of the Eurozone debt crisis. Orléan notes that it is exactly this kind of very general judgement that is typical of the financial sector; and yet such generality does not pass through – as with democratic decision-making – a system by which a variety of different views are confronted via the freedom of the ballot box. This curious combination of its very narrow representative claim along with its interest in the economy as a whole can go some way of explaining the rise of technocratic governments in Europe today: they express the same peculiar combination, with individual technocratic leaders such as Italy’s Mario Monti having a history of very close relations to the world of finance.

Orléan’s views on the way out of the current crisis are based around a reassessment of the idea of value in the economy and of value creation. He argues for a much greater focus on the creation of value within the real economy, as this is ultimately where jobs and growth are created. He suggests that a new law should be introduced that firmly separates savings banks from investment banks, an argument included in the French Socialist Party’s programme. There is nothing radically new in Orléan’s arguments but his attack on conventional assumptions in economics is both powerful and welcome.

The EU’s six-pack

Tomorrow, finance ministers from all EU member states will meet to formally vote on a new set of proposals drafted by the European Commission. Entitled the ‘new economic governance package’, these proposals have been in preparation for many long months. They have been worked on by an army of national experts in the Council and civil servants within the Commission. Government representatives in Brussels have been making sure that any disagreements are ironed out before ministers meet tomorrow to stamp the package with their approval. The package was already all but finalized at the last meeting of EU finance ministers in Poland (see relevant statement by the Polish Presidency of the EU here).

The economic governance package contains six new legal instruments (see here for a summary), hence it’s nickname, the ‘six-pack’. Its main goal is to tighten supervision over national government budgets. The philosophy underpinning the package seems to be that the current European crisis is the result of excess spending by governments (for why this is only a partial account of the crisis, see here). The proposals are thus designed to “lock-in” prudent fiscal policy through an array of rules and a tightened sanctions regime. Governments running excessive deficits, for instance, will only be able to avoid a sanction from the European Commission if the Council musters in return a qualified majority of votes against the sanction (the so-called “reverse voting mechanism”). The Commission’s supervision of government spending will be expanded to include overall government debt in addition to its existing role in supervising deficits. The package also includes a new ‘excessive imbalance procedure’: an in-depth review of a country’s economic situation undertaken by the European Commission at the demand of the Council. Based on the results of this procedure, the country concerned would have to present to the Council a plan for how to resolve these ‘excessive imbalances’.

As a measure of what will be the consequences of the Eurozone crisis, this is a good start. More dramatic developments may ensue as governments struggle to contain the consequences of a likely Greek default. But as far as the day-to-day running of the Eurozone goes, the measures proposed by the Commission are likely to form the horizon for macro-economic policy in the EU for the years to come. Looking at the proposals, we see that nothing fundamentally different is being proposed. The modifications point to a tougher regime of regulation of national economic policy, particularly as regards government spending. The connection between national finance and economic ministries and pan-European institutions of control and supervision will become tighter. And the scope for pressuring countries with budgetary difficulties will increase. Being a member of the EU won’t change dramatically, but it will become a meaner and harder-edged place. And the presumption of the package is simple and is consistent with the philosophy of the EU as a whole: bad behaviour by national governments is to blame; greater supervision by external, non-partisan authorities is the solution.

Looking for growth

We have often argued at The Current Moment that what is missing in both the US and Europe is a real plan about how to make these economies grow. The political right points to the need for tax cuts; the left prefers state-funded jobs programmes. Neither addresses the problem of a languishing private sector, where firms are sitting on cash rather than reinvesting it. Central banks have tried to stimulate the economy by pushing down interest rates as way of stimulating private borrowing. As argued before (here), quantitative easing has not had the desired effect.

One response to the current problems is to point to the need to get consumers spending again. Firms are sitting on cash because they are gloomy about the future: without more buoyant demand, more investment will only mean the production of unsold goods. Critics of the austerity measures being pushed through across Europe often frame their opposition in terms of its effect on demand: how can European economies grow if the continent’s consumers are being hit with new taxes, cuts in welfare incomes and job losses?

This consumption-oriented view of growth is worth comparing with the growth experiences of the emerging markets. Growth does not just come from consumption. In fact, things look rather different if you look outside of the US and Western Europe. Take China. In its recent World Economy report, The Economist notes that the percentage of the gross national product that is consumed has fallen steadily in China since the 1970s.

If we were to map China’s annual growth figures on the graph, the relationship between consumption and growth would be an inverse one: a rise in the latter as the former has fallen. This makes sense if we look at how Chinese investment decisions are made. Capital is channelled via state-controlled banks into production. The percentage of the GDP that is reinvested is remarkably high in China: around 50% of GDP. It is on average half of that in OECD countries.

One way of looking at the contemporary slump in Western Europe and the US is through the lens of productive investment rather than that of consumption. The Chinese model has its own limitations, not least its reliance upon the demand for its exports in overseas markets. China is also at a different stage of its development, meaning that we are not comparing like with like. But it is nevertheless useful as a way of generating different sorts of questions. In what ways are investment decisions made? By whom and with what goals exactly? And crucially, how has the role of financial intermediaries changed over time and what impact have those changes had on investment? We don’t have answers to these questions yet but they are a good place to start when thinking about the growth problems in contemporary Europe and in the US.

Can the European Central Bank really save the Eurozone?

The Belgian economist, Paul de Grauwe, has been calling for some time for a comprehensive reform of the Eurozone’s institutions. Contagion, he argues, is inevitable in a currency union that lacks adequate political power. There is no way out of the Eurozone crisis other than more political union. It would appear de Grauwe has the ear of European Central Bank chief, Jean-Claude Trichet: over the weekend the ECB started buying up Spanish and Italian government bonds, at rates low than those being offered by the market. Another step towards the ECB acting as a lender of last resort.

De Grauwe’s account of the crisis is simple and compelling. He argues that government bond markets in a currency union like the Euro are “inherently fragile”. They are basically issuing debt in a currency the value of which they have no real control over. Greece, Spain, and Italy all issue their debt in Euros and yet they do not control the value of the Euro in the same way that the UK or Switzerland control the value of the Pound and the Swiss Franc. Governments in London and Bern can, in extremis, force their central banks to print more money. There will always, in theory, be enough money to pay back bondholders. In the Eurozone, there is no such guarantee as the ECB is not a lender of last resort. And this makes the Eurozone inherently fragile. In practice, the ECB has been buying bonds of crisis-struck member states but it has done so as an exception, not as the rule.

De Grauwe’s recommendation is then simply to give the ECB responsibility as lender of last resort in the government bond markets of Eurozone member states. This should put a stop to contagion, according to de Grauwe. But will it? Defaults have occurred in the past in countries that both issue their own currency and have control over their national central banks. Why should the Eurozone be any different?

De Grauwe’s analysis supposes that there is an institutional quick fix to the Eurozone’s problems. This is akin to suggestions made in the US, covered in the Current Moment, about resolving the debt burden via low interest rates and some easy money provided by the US Federal Reserve. Two problems stand out here. The first is that the problem the Eurozone faces is not an institutional one but it is the inability of some Eurozone member states to return to growth. Until national income in troubled Eurozone member states grows faster than state expenditure, or until a realistic prospect of this arrives onto the horizon, the debt crisis will continue. The European Central Bank, even as lender of last resort and notwithstanding the esteem with which central bankers are held today in macro-economic circles, cannot restore profitability to national economies of the Eurozone.

The second problem is a political one. De Grauwe has nothing to say about the political implications of transforming the ECB into a lender of last resort. Some are beginning to wonder about the democratic quality of these developments but generally it is considered an afterthought to a more pressing set of institutional questions. This repeats the patterns of the past: innovations at the EU level are subsequently presented to domestic populations as a fait accompli, to be given a stamp of approval by voters. Why this should work now, when previous efforts to do the same failed miserably, is anyone’s guess. The Eurozone’s debt crisis, if resolved, is likely to be followed by a political crisis as the EU scrambles to find legitimacy for its new powers.

Financialization European-style

It is often said that financialization exists mainly in the United States and the United Kingdom. Western European countries, with their higher savings rates and smaller financial sectors, enjoy a better balance between industrial and tertiary sector productivity and financial activity. When the global crisis first broke in 2008, this was the message from France’s then finance minister Christine Lagarde: France is insulated from the crisis because its recent growth has not been so driven by credit and borrowing.

Focusing on statistics such as savings rates can tell us something about the nature of financialization. But this only goes so far. As we have argued before on this blog, financialization points us towards something broader: a re-structuring of both the financial and non-financial economy. This development exists in Europe as much as it does elsewhere, though the manner in which it develops can be a little different. In a recent article, finance economist Harald Hau analyses the EU’s most recent bail-out plan for Greece. His conclusion fits with an earlier Current Moment post: European governments have relieved banks of much of their debt burdens in Greece, resulting in what Hau calls a “reverse wealth tax” from Eurozone and IMF taxpayers to the richest 5% in the world.

The mechanics of the transfer are worth noting. Overall, the supposed private sector contribution to the new plan is modest: 37 billion Euros out of an overall plan of 109 billions Euros (plus, don’t forget, the 110 billion Euros of the first bail-out plan). However, Hau notes that the market discount for Greek debt was already 50%. Private creditors were unsurprisingly willing to accept a 21% write-down on their loans – much better than what the market was offering them. What is also striking is that European governments have guaranteed the new Greek debt via the European Financial Stability Facility, the EFSF. If we consider the extent to which talk of a Greek default has become commonplace, with many saying it’s a question not of whether but of when, then it is again no surprise that private creditors have been happy to swap loans to Greece – tinged by the strong possibility of default – with guaranteed cash via the EFSF.

The real mystery is how all of this was possible politically. In the UK, the nationalization of some banks during the crisis was both controversial and has generated fierce discussion since then about the rights and wrongs of such a move. But compared to what the EU is doing, the UK government’s decision was far more in the interests of the taxpayer. In the case of taking up ownership of banks, there is a strong chance of getting one’s money back. As Hau notes, the EU could have pursued this route, providing direct bank support through recapitalization. Instead, it chose to guarantee sovereign debt, a move that directly transfers wealth from taxpayers to private creditors.

The answer has to be that regional integration of the kind seen in Europe has the political effect of distancing these kinds of decisions from the electoral constituencies directly affected by them. Sarkozy, Merkel and other national leaders are able to do things via the EU that they could not do nationally. Financialization is thus alive and well in Europe, with its bent towards technocratic justifications well-served in an EU equally interested in masking political choices behind the veneer of expertise.