Some things to consider if Spain leaves the euro

It might seem almost churlish to wonder what would happen if Spain were to leave the euro. The official European position is that the battle of the euro has been pretty much won, order and anyone who argues otherwise will be accused of being a euro hater, cialis an Anglo-Saxon or, purchase even worse, a writer for the Financial Times.

But there is more than one “battle” around the euro. While the battle of liquidity seems to have been won, the solvency and the unemployment battles (the latter of which is really a battle of unbalanced demand) have not even been addressed. Every sovereign debt crisis in modern history has been preceded by assurances that it was only a liquidity crisis, but as I see it there were three separate problems that erupted in the 2008-09 euro crisis:

  1. A liquidity crisis. After the US subprime crisis set off a more general financial crisis in the US, investors were spooked. As they looked around to see who else was vulnerable, they began to wonder about peripheral Europe and, even worse, they wondered if everyone else was wondering. Once that process begins, it is just a question of time before credit dries up for at-risk borrowers. Suddenly heavily-indebted European sovereign borrowers found themselves unable to roll over their debt.
  1. A solvency crisis. Wondering about the sustainability of peripheral European debt was not irrational. In fact debt levels for many countries had soared, even before it was obvious that these countries were on the hook for an explosion in contingent liabilities generated by bad debts in the banking system. It is not at all clear that even at current levels these countries can repay their debts without imposing tremendous pain on an electorate that might (rightly in my opinion) refuse to accept it.
  1. A demand imbalance. Policies in Germany around 2000 aimed at improving Germany’s international competiveness did so by forcing down wage growth and, with it, household consumption growth. For reasons about which I am not sure it seems that investment growth also slowed dramatically, compounding the problem of weak household consumption growth. As German domestic demand fell relative to its total production of goods and services, instead of seeing unemployment rise as German producers cut back on capacity, Germany was able to resolve its domestic demand deficiency in the form of a rising trade surplus, as excess German savings poured into peripheral Europe. These ignited an asset boom that, by making peripheral Europeans feel richer than ever, ignited a consumption boom. Germany’s domestic demand deficiency, in other words, was matched by excessive demand in peripheral Europe, but this could go on only as long as the asset boom continued on the back of rising debt. Once it ended it could only be resolved by a rise in unemployment.

Have Europe’s problems been resolved? The ECB’s resolve to do “whatever it takes” has resolved the first of these three problems, at least temporarily. The ECB has promised to supply unlimited liquidity to roll over European sovereign debts, and as long as this promise is credible, private investors are happy to step in and roll the debt over themselves. Plentiful global savings have encouraged an urgent search for yield, and the ECB’s very credible commitment did the rest. But has Europe resolved the other two crises?

Clearly the second problem, the solvency crisis, hasn’t been resolved. Debt has grown much faster than GDP in all of the heavily indebted countries of Europe, making the debt burden worse than ever, and the visible debt is almost certainly understated by contingent liabilities that might arise within the banking systems of the afflicted countries.

For now low interest rates make the debt burden seem manageable, but if debt continues to grow faster than GDP (and even if Europe is able to achieve the optimistic GDP growth targets promised by the various governments, debt will still grow faster than GDP for many more years), at some point debt levels will seem so high that further unlimited promises by the ECB will simply not seem credible. At that point investors will flee the government bonds issued by peripheral European governments.

But we probably won’t need to wait even that long. If the ECB were ever to hint at an end to low interest rates, or an end to the promise of indefinite rollovers, the debt level would quickly become unmanageable as the cost of rolling over the debt soared. Like in Japan today, high debt levels are made manageable because of low interest rates, and the hope is that at some point a resurgent economy will allow the countries like Spain to grow their way out of their debt burdens.

But here is the dilemma. Interest rates are low mainly because growth is non-existent. Should Europe start to grow, interest rates would be forced up and, depending on the maturity structure of the debt when this occurs, higher interest rates could cause financial distress costs to rise quickly enough to stifle growth. We are likely, in other words, to relearn the lesson of nearly every previous debt crisis in history –the debt burden itself prevents the kind of economic resurgence that allows highly indebted countries to grow their way out of debt. It is only when the debt has been written down to some manageable levels that afflicted countries ever begin again to grow.

The third problem, the demand imbalance, hasn’t been resolved either. In Germany there is talk of raising wages to rebalance demand. There continues to be, however, reluctance to do so because of the fear that higher wages will undermine Germany’s international competitiveness and force its economy to rely on productivity growth, of which there has been precious little in the past twenty years.

If German consumption doesn’t rise, then in principle the domestic imbalance can be resolved by a rise in German investment, but it isn’t clear how this could happen. The German private sector – not surprisingly given excess global capacity and weak global demand – seems reluctant to embark upon a domestic investment boom.

The German government also seems reluctant to invest because this would require a rise in government debt, and were perceptions of German credit to weaken, it would undermine the credibility of implicit German support for the weaker European sovereign borrowers. What makes the whole process maddeningly complex is that Germany’s creditworthiness is itself vulnerable to any perceived deterioration in the creditworthiness of peripheral European governments because German banks, who were among the main conduits for the export of German savings to peripheral Europe, are too heavily exposed to peripheral Europe.

Until we see higher German consumption or higher German investment, however, German businesses must continue to rely indirectly on demand from the rest of Europe, which must consequently continue to absorb weak German demand in the form of higher domestic unemployment.

A quick digression on bilateral trade balances

Many analysts have trouble understanding how Germany’s demand deficiency has been absorbed by peripheral Europe when much of Germany’s exports go elsewhere, to China for example. Quite a few analysts besides me – Martin Wolf, for example, or Heiner Flassbeck – have pointed out that distortions that forced up German savings relative to investment after around 2000 (and so caused Germany to swing from large trade deficits in the 1990s to among the largest trade surpluses in the world in the 2000s and through to today) were directly responsible for the collapse in savings relative to investment in peripheral Europe.

Germany’s trade surplus, in other words, required – and probably caused – the trade deficits of the rest of peripheral Europe (many of whom ran large surpluses in the 1990s). Some analysts find this hard to understand because, they point out, Germany does not run bilateral surpluses with peripheral Europe, or not anywhere near the extent of aggregate German surpluses and aggregate peripheral European deficits. This proves, they argue, that the deficits of a country like Spain, for example, have nothing to do with German surpluses, and were caused by domestic failures within those countries.

It proves no such thing. The reason has to do with the nature of global trade. Imbalances have to settle on an aggregate basis and do not need to settle bilaterally. In fact they rarely do. The key is to focus on capital flows. Remember that if Germany is a net capital exporter, it must run a trade surplus. If its capital exports cause other countries in Europe to become net importers of capital, they must run the trade deficits that correspond to Germany’s trade surplus (I am glossing over the differences between the trade and current accounts, but this does not affect the argument).

It isn’t necessary, in other words, that German run a trade surplus bilaterally with other European countries in order that German demand deficiency be resolved by the rest of Europe. The trade surpluses and deficits can occur bilaterally, but it is actually unlikely that they will. Perhaps it is easier to think in terms of the currency. Without a common currency Germany’s currency should have risen, and the currencies of other European countries dropped, given their respective trade account balances. The common currency prevented this, however, so that Germany benefitted from a weak euro while other European countries suffered from a strong euro.

In my book, The Great Rebalancing, I create a very simply four-country model (I call them the US, China, Mexico, and Brazil) in which China exports capital to the US, with Brazil and Mexico in balance, and show that China must consequently run a trade surplus, the US must run a trade deficit, but not necessarily bilaterally. There doesn’t even have to be direct trade between the two. Even if they can each trade only with Brazil and Mexico, China will still have a surplus and the US a deficit.

This confuses a lot of people who think the causes and consequences of trade imbalances must show up in bilateral trade balances, but even simple trade theory recognizes that bilateral balances almost never matter. It is the direction of capital flows that will direct the trade imbalances. This is why Germany’s net capital exports, mainly in the form of bank loans, to peripheral Europe had to result in German trade surpluses and peripheral European trade deficits, whether or not these countries even traded with each other, let alone ran trade balances that matched the capital balances.

Back to the problem of debt

How much longer is the rest of Europe willing to maintain high unemployment in order to support the German economy? On May 26 we will discover, I suspect, that at least some parts of the rest of Europe have little interest in continuing to maintain the euro if that simply means that they must suffer unemployment in order to protect Germany from its unwillingness to pay workers more.

For now the policy-making elite in peripheral Europe continues to insist that there will be absolutely no flexibility on the matter of the euro. But in the 1920s the British policy-making elite, who insisted then that there would be absolutely no flexibility on the matter of free trade, was forced to abandon its principles as high unemployment and voter revolt forced it into devaluing sterling and setting up tariffs. There is huge controversy on the sequence and causality (not surprisingly), but there is little doubt that after these occurred the British economy improved significantly and unemployment dropped. Meanwhile it was trade-surplus America that suffered mightily from the rise of global protection, not trade-deficit England.

What does this mean for the survival of the euro? Perhaps that when the policy-making elite is determined to act “responsibly” and maintain its highest principles (protect the bankers), but mainly at the expense of the working and middle classes, policymakers are eventually forced into retreat by an angry electorate. And perhaps it also means that the electorate isn’t quite as stupid about economic policymaking as the elite might think.

There are at least two things I would suggest we should consider in thinking about the future of the euro:

  1. Peripheral Europe has so far been remarkably tolerant of high unemployment, but of course the longer this goes on the lower the tolerance. If at some point opposition to the euro, or opposition to servicing the debt, becomes an obvious way to gain political support, we may see the debate about the euro move from the radical and occasionally lunatic fringe to a more respectable part of the political spectrum, in which case financial distress costs will intensify and the process of unraveling the euro will intensify.
  1. My model argues that the German imbalances are forced onto the peripheral countries in the aggregate, who together have to absorb the shortfall in German demand by increasing their unemployment. This suggests that if any country were to leave the euro, the total imbalances would rise (every time a weak country leaves the euro, the euro will strengthen) and would furthermore be concentrated among a smaller group of countries, which would then face additional pressure and weaker credibility. No matter how determined any individual country is to stay in the euro, in other words, its ability to stay may well be determined by the weakest “link”.

The May 26 votes might end up reminding us that the euro crisis isn’t over. The longer unemployment and hopelessness drag on, the greater the erosion of support for the establishment and the stronger the support for the radicals who want to abandon the euro.

By refusing to allow the introduction of any flexibility into the discussion of the long-term outlook for the euro, Brussels is forcing Europeans to choose among two absolutes: stay in the euro as it is, or break the currency union permanently. This is risky, because over time the second option becomes increasingly viable, and any movement toward to second option is self-reinforcing – which means that as long as opposition to the euro is low, the growth of opposition to the euro will be slow, but when we reach the point at which opposition to the euro is large enough to be taken seriously, the growth in opposition will accelerate.

Policymakers who think, in other words, that we do not need to discuss alternatives to the hard euro position until much later, when there is a real threat to the hard euro, are taking a huge gamble. Once we have reached that point, the risk is that we get the intellectual and institutional equivalent of a “bank run”, and policymakers will be shocked by the speed with which things fall apart. It will then be too late to introduce a more flexible position on the euro.

By the way those who advocate more flexibility on the euro are usually painted as enemies of Europe and the euro, but this is nonsense of course. In my opinion the world is better off with a united Europe (more united than now) and with a common currency, but it might very well be that the only way to achieve both is to introduce flexibility into the current system, which means, among other things, the possibility of a temporary withdrawal. Otherwise any break will be permanent.

What does withdrawal look like?

Along those lines I have been thinking about what would happen if Spain were to leave the euro. I confess I know very little about the legal and political implications about a euro exit, and although I have heard often enough that it is impossible to leave the euro, I don’t think anything such thing can be true about a sovereign nation. It may be difficult, it may be messy, and it certainly will be unpleasant, but it can happen.

But aside from legal issues, there are a number of economic and financial considerations that I base on my fifteen years of trading the sovereign debt of defaulted and restructured countries and my addiction to financial history. Here are the things I considered as being relevant to any breakup.

  1. First and most obviously if Spain leaves the euro its debt burden will soar. If Spain left the euro and returned to the peseta, the peseta will immediately fall, and as it does the peseta value of the euro-denominated debt will rise commensurately. Let us assume that when this happens Spanish external debt is 110% of GDP. In that case a 20% decline in the value of the peseta will immediately raise the debt to 137.5% of GDP and a 50% devaluation of the peseta will raise the debt to 220% of GDP.
  1. By how much will the peseta devalue? You might think this is a question about how “overvalued” the Spanish euro is (15%? 20%?), but in fact the debt burden itself determines the amount of the depreciation because of the way it forces certain types of investor behavior. In the end the amount of depreciation will have nothing to do with economists’ estimate of the amount of peseta overvaluation.

Why? Because a devaluation will the lock the country into a self-reinforcing cycle in which a devaluing currency forces up debt, which forces Spanish businesses and households to hedge by buying euros and selling pesetas, which forces down the peseta further, which causes even more hedging, and so on, so that the peseta will drop down unrestrainedly until investors believe Spanish assets are cheap enough that they begin to counteract peseta hedging by buying pesetas to acquire Spanish assets. The structure of the balance sheet, in other words, is what determines the amount of the devaluation, and countries with a great deal of external debt are likely to see their currencies fall far below any “rational” level.

If Spain were a developing country, I would argue that given its debt level the peseta would fall at least 50-70% (and so its debt burden would triple), but because it has a credible legal structure (I am assuming no radical party wins the election before a euro exit), a decline of 30-40% might be enough to set off foreign buying. My guess, in other words, is that if Spain left the euro with a center-right or center-left administration, the peseta would likely drop no more than 30-40%. This still will cause an already unbearable debt burden to become impossible, especially because interest rates will immediately rise.

  1. This, by the way highlights the importance of the political process and the speed with which Spain decides on its strategy. The longer it takes for Spain to arrive at a decision to abandon the euro, and the more bitter the fight to get there, the greater the likelihood of a radical right or left party taking power, in which case the euro might not stabilize at a 30-40% discount.
  1. There might be a way to limit the drop further. Over the longer term I think a more tightly organized Europe, with a single currency and a real fiscal center, is good for Europe and the world, and a euro exit might even be just the way to achieve this. If Spain were credibly (this means with full German support) to commit to returning to the euro within, say, five years, at a predetermined level – for example one implying a 20% depreciation over five years – Spain might be able to get most of the competitive benefits of a depreciation without giving up the benefits of monetary and economic integration. It would be a “stable” departure from and reentry to the euro.
  1. However much the devaluation, whether it is catastrophic or orderly, debt would surge. There is a foolish belief that as long as we can find a way to roll over the debt the debt burden itself does not matter, but of course it does for two reasons. First, resources must be appropriated from some part of the economy to service the debt, and second, debt creates financial distress costs that can far exceed the actual cost of the debt.

Spain must restructure its debt burden to a “reasonable” level, which means a level at which the mechanisms that create financial distress are minimal. High levels of debt, remember, force creditors, businesses, household savers, household consumers, and policymakers all to act in ways that increase balance sheet fragility and reduce growth, not because they are evil but because they are rational. For this reason countries that are perceived as having too much debt never grow until the debt burden has been resolved. It is in everyone’s interest that Spain immediately receive a significant debt haircut or else it will not return to growth and the devaluation will have been wasted. I would argue that Spanish external debt should be reduced to 60% of GDP and payments stretched out between 10-30 years.

  1. Significant debt forgiveness doesn’t mean equally significant losses for creditors. Financial distress costs are triggered by the perception of a high probability of default. Spain’s creditors, of course, will hate to see their claims on Spain sharply reduced, but this is almost certainly going to happen anyway (I don’t think Spain has much chance of “growing” its way out of its debt burden without debt forgiveness), and if done in an orderly way, it is possible to compensate creditors for at least part of the debt reduction without incurring financial distress costs.

Spain can replace debt claims with a different set of claims whose payment schedule is positively correlated with economic performance. Instruments that pay according to GDP growth, the performance of the stock market, or land prices, for example, are the right way to line up the interests of the Spanish economy with those of the creditors. These are not unprecedented – Argentina provided GDP warrants on its defaulted 2001 debt – but they are used far too little. If a devaluation plus a sharp cut in Spanish debt causes Spain’s economy to come roaring back, as it most certainly will, creditors will be paid on the basis of how well the economy does, and can eventually recover a substantial part of the value of their original claims.

This is a very important point that few understand. High fixed claims will continue to drag down the economy because they increase the probability of default, and an increase in the probability of default sets off the self-reinforcing process of financial distress, in which agents behave in ways that worsen the debt burden, and worse debt burdens create pressure for agents to exacerbate their adverse behavior. But this doesn’t happen with high variable claims that are correlated with how well the economy does (like equity in a company, which cannot create financial distress costs). These claims are high when Spain can pay and low when Spain cannot, so they do not increase default probabilities at all. For this reason they will create absolutely no financial distress costs.

  1. If Spain were to eliminate financial distress costs and lower its domestic costs by 20% with a devaluation, the economy, at least part of whose poor legal structure has been reformed under Rajoy, would almost certainly soar, clocking in growth rates of 5% or more for several years. Spain has not completely wasted the crisis. It has implemented very serious reforms, especially labor reforms, but these reforms were aimed at old distortions in the Spanish economy and had nothing to do with the current crisis, which is caused by excess debt and an uncompetitive exchange rate.

I go to Spain often to see my family (I will go there this Thursday, for example). It is incredibly frustrating to see how terribly Spaniards are suffering, especially in the south, where my family lives. To add insult to injury, Spanish suffering is being blamed on old stereotypes – their fiscal irresponsibility and their laziness – when in fact Spain was among the most fiscally responsible countries in Europe before the crisis and Spanish workers worked more hours every year than did the Germans.

Spain clearly has a lot of serious policy problems, and way too much corruption, but these problems pre-date the crisis and pre-date Spain’s joining the euro. They have nothing to do with the current crisis, which was primarily the result of a demand imbalance in Germany. As I argue in my last blog entry, both the explosion in Spanish consumption before 2008 and the surge in Spanish unemployment after are automatic consequence of a savings glut for which Spain bears no responsibility.

Spain, in other words, cannot resolve its crisis on its own. It requires concerted action by Europe, and especially by Germany, in order to bring down unemployment. Germany cannot play its role because this must involve debt forgiveness, and Germany will not be prepared to acknowledge the need for debt forgiveness until German banks are sufficiently capitalized to recognize the obvious. There are no winners here, Europe’s demand deficiency means that there will be high unemployment somewhere, but Spain can decide how to distribute the cost of adjustment by deciding whether or not to remain inflexibly within the euro.


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 Add your comment
  1. I agree 100% to the prescription, debt should have been written down years ago. German wages could rise (they are rising above average but very slowly), but you seem to ignore that a nominal wage reduction in southern Europe is the other side of the coin. Let’s not forget that German wages are high on absolute terms already, so real innovation / productivity in Germany cannot be totally sub-par. It might not be so easiy to further improve. I now nominal cuts are as painful as it gets, but if a 40% devaluation is the alternative, rationally it migh make more sense.

    Is Europe as a whole overly competetive? If not, a balanced approach might be the correct approach.

    • Yes, JE, but wage reduction in the rest of Europe makes Europe competitive at the expense of even lower consumption and lower investment in productive facilities aimed at serving that consumption. In other words it means the global imbalances get worse. If the US, Japan and China are willing to absorb lower European demand (probably in the form of higher unemployment) this strategy works for Europe, but I don’t see that happening, especially as a rising trade surplus in Europe will push up the value of the euro.

  2. What puzzles me is that the current account of peripheral Europe has come back into a surplus, yet the german current account is still in an upward trend. Who eats the surplus? Partly the US, partly France but I doubt this explains the phenomenon. For Spain, the positive current account (if it stays positive, the last two month were strongly negative) should mean that a new currency must not necessarily come under so much pressure. I think on that front much progress has been made albeit at the expense of high unemployment. If the peripheral populace perceives this change as progress, maybe they continue to vote for the euro

    • I think you are right, Pigeon, and I don’t see this as sustainable. The US is certainly recovering, but the recovery is weak and it can be derailed by Europe.

  3. External debt will not overshoot, because all debts in euros will be legally converted to debts in pesetas (re-denomination). The only foreign debt that will increase would be that nominated in dollars, pounds, etc (i,e, non euro foreign debt, actually a very small percentage of total external debt). Same as Uk leaving the gold standard. The funny thing is that the biggest creditor of Spain would be the ECB, which would be bankrupted instantaneously (eh, they deserved it) so, it will have to require much more capital from the remaining members (that, is , if the euro survives)

    • I am not sure Spanish debt to, say, a German bank can be converted so automatically into pesetas. Much of Spanish debt qualifies as external debt. of course if Spain were able to convert its debt into pesetas, a depreciating peseta would mean that German, French and other foreign banks would immediately take the loss, which frankly would be a good thing.

      • In fact,it is the only way to exit the euro. Public debt (bonds and so) as well as private debt denominated in euros and held by the spanish financial entities (despite the nationality of the creditor that originally lent to the spanish finantial institution) shoud be renamed in pesetas. There is no other way to do the exchange. Only debt directly held by institutions in other euro countries should remain denominated in euros. You cannot exit the euro just by changing salaries form euros to pesetas.

  4. João P. Bragança

    Why do people have trouble understanding that if someone runs a surplus someone else must run a deficit? Can every country have a trade surplus? Obviously that’s impossible.

  5. Visiting Spain at the moment. Banks still give out here mortgages without any collateral or own savings at all. They don’t just give the amount of the house/appartment but 110 % of the price of it so one can buy the furniture too. Totally blown away. Nothing has changed. I wonder how much bad debt there is hidden in those banks.

  6. Given the “surprising” results of today’s election, I thought I would copy below my article last month for ABC, a Spanish daily, which was reposted on the Carnegie Europe website (

    The war between workers and bankers

    The European elections in May could turn out to be very important for Marine Le Pen and for her allies throughout Europe. It will signal the growing disaffection the working classes feel towards the policies that have driven Europe into crisis and have kept unemployment high and wages from growing.

    For nearly two centuries the resolution of any financial crisis has always involved a fight between workers and bankers, each of whom proposes to resolve the crisis in different ways. Bankers want stability above all, which to them includes maintaining the value of debts. Workers need growth, even if that comes at the expense of the monetary system and of creditors.

    The euro crisis is part of the long line of battles between the two. Bankers insist that countries like Spain must act “responsibly”, which to them means that they must remain within the euro and service their debt burdens, no matter how painful it is for the economy and for workers. If any country were to leave the euro and to restructure the debt they owe directly or indirectly to Germany, they warn, the economy will fall into chaos.

    But their advice comes with a steep price. Germany initiated policies nearly fifteen years ago to force down the wages of German workers so that German workers could compete abroad. These policies have caused net European demand to collapse, especially now that other countries are forced to do the same. As long as Spain remains within the euro and debt levels remain high, the Spanish economy must accept for many more years an excessive share of the resulting unemployment.

    To save Europe, Germany must boost domestic demand by boosting the income of German workers. This will allow the rest of Europe to do the same. But because Germany’s bankers are mainly concerned with the country’s debt and its banking system, Germany will not take the necessary steps to support its workers.

    It is important to understand Germany’s objectives. In the 1980s American banks were too weak to accept that Latin America was insolvent. It wasn’t until 1988-89, after they had rebuilt their capital base sufficiently to absorb the losses, that American banks recognized the reality, and in 1990 the region began to receive partial debt forgiveness. And only then did Latin America begin to emerge from the horrible economic crisis that brought with it political instability and social collapse.

    Like the US in the 1980s, Germany today cannot accept that European debts are unsustainable. Until its banks recapitalize, which will take many years, Germany will demand full repayment. And like Latin America in the 1980s, Europe will not recover until it regains monetary flexibility and partial debt forgiveness.

    This war between bankers and workers has been fought many other times. In the United States after high gold prices in the late 19th Century put unbearable economic pressure on American workers, William Jennings Bryan, a radical progressive politician famously demanded in 1896 that New York bankers not “crucify” the American working class on “a cross of gold”. He nearly won the American presidency. It was only the lucky discovery of massive amounts of gold in South Africa that brought relief to American workers and ended his career.

    On the other end of the political spectrum Adolf Hitler rose to power in a Germany whose workers struggled to repay the country’s enormous war debts. It has always been clear that whether the right or the left gains workers’ support during a crisis depends on who struck out most strongly for the workers and against the interest of the bankers.

    This is why Marine Le Pen matters. She has taken the lead in attacking the monetary straightjacket imposed on the French economy and has demanded that France exit from the euro. It is for this, as well as for her anti-immigrant beliefs, that much of the French elite abhor her, but there is no question that in working and lower middle-class communities away from the capital her message on the euro has garnered tremendous support.

    In the end Europe’s crisis will have to be resolved, and if the parties of the left and the center allow the extreme right to dominate the discussion, it will be the extreme right that resolves the problem in the ways it chooses. As long as mainstream politicians refuse to recognize that remaining within the euro and rolling over the debt will condemn Europe to many, many more years of economic pain they will become increasingly marginal to the debate.

    On this point history is very clear. Watch Marine Le Pen and her allies carefully. If mainstream politicians are too frightened to face reality, she will have the workers on her side, and her ability to influence the debate about the euro will only grow.

    • Could you explain the mechanics between a high gold price and the conflict between bankers and workers?

      • The monetary system at the time was the gold standard, which means that the price of the currency is tied to the price of gold. If the price of gold increased, the price of the currency increases automatically since there’s convertibility between the two. If there’s a rise in the price of the currency, the economy is at risk of undergoing deflationary pressure.

        • Exactly right, and what’s more the US was functionally bimetallic at the time with a large part of the country, especially the West, on a silver basis, so that as sliver prices fell relative to gold, incomes dropped in gold terms but debts did not.

          By the way sorry for the late responses to these and other comments, but I just came back from a very hectic two-week trip to eight cities in Europe.

  7. Hi Michael

    Excellent article! However, would a Spanish Euro exit, with its consequent debt re-domination, blow up European banks such as Deutsche and Unicredit though? The 30% to 40% drop in mark to market value from currency depreciation seems to be very steep, which would most probably blow a hole in the balance sheets of these banks. This might then create a full fledged banking crisis, similar to ’08. Maybe that’s why no one is entertaining such a step?

    • It absolutely would, Kurtz, which explains why creditor countries would hate it but not debtor countries. There are precedents. The LDC debt crisis of the 1980s dragged on far too long mainly because US banks were not sufficiently capitalized to take the losses until 1989. I am convinced this made the crisis much worse than it needed to be for Latin America, which was not able to grow until after it finally received debt forgiveness.

  8. Excellent article. Your best one even I would say.
    I am not so versed in economics (I find it incredible interesting though), so please excuse if I have a stupid question, but what prevents Spain from simply defaulting on its debt even though it remains in the Euro? As a soverign state it could simply renegate on its obligations and declare that they will follow your advice (e.g. 40% debt reduction over 30 years), thereby pushing the problem over to Germany and France and their banks.

    Thanks for your valuable contributions and honest opinions in these difficult and contentious times.

    • Legally nothing prevents it. Sovereign nations cannot be sued and their assets liquidated (with a few minor exceptions) and we are long past the days when US or European gunboats could “encourage” debt repayment. There are at least two reasons why sovereigns don’t like to default. First, it can cause a great deal of chaos in the domestic economy as well undermine respect for contracts, although with unemployment in Spain officially at 25% (unofficially I would guess 18-20%), some unkind people might ask whether we aren’t already there and how could it get worse.

      Second, it is widely believed that countries that default on their debt lose access to future funding, and will never again be allowed to borrow except at punitive rates. There isn’t much evidence to support this claim, however, because investors seem to lend on the basis of expectations of future growth, not past behavior. Greece and Argentina, for example, have the worst records for serial defaults, but in the mid to late 1990s Argentina was one of the darlings of emerging market borrowers and in the decade before the euro crisis lenders fought each other for the right to lend to Greece. For those who are interested I discuss in my book, The Volatility Machine, the history of sovereign lending and why lending to developing countries is only marginally affected by default history or even by the type and nature of domestic reforms.

  9. Excellent article. Your best one even I would say.
    I am not so versed in economics (I find it incredible interesting though), so please excuse if I have a stupid question, but what prevents Spain from simply defaulting on its debt even though it remains in the Euro? As a soverign state it could simply renegate on its obligations and declare that they will follow your advice (e.g. 40% debt reduction over 30 years), thereby pushing the problem over to Germany and France and their banks.

    Thanks for your valuable contributions and honest opinions in these difficult and contentious times.

    • Exactly that should have happened in 2008, but it is not sufficient to prevent the same development starting over again. South Europe needs to gain relative competiveness. And we need a better monetary system that makes it MORE difficult to develop an unsustainable credit driven boom. In my own opinion the latter is the key ingredient, but today that’s a fringe position.

    • Because a lot of the debt is also Spanish. Life insurance, banks, pension funds like to invest in their homeland. If for example Japan will default, it will default on its people, aka taxing the rich Japanese. I still wonder, why they give their government so much savings for so little return anyway. So also Spain would been hit by heavy losses. But maybe the other Spain.

      The solution now is, that savers (aka the sucking creditors) are paying up the bill – every month a little – with no return on their savings, getting next to nothing for a lot of risk, and the banks making free lunches with cheap federal reserve money to fatten their bellies.

      A massive Spanish haircut would trigger much more to follow, even a French one maybe. That could be the end of the world as we know it. 🙂 The cost of credit for all the others would rise unfathomable. Credit dry up, the government would put house owners a mandatory credit and take it as a tax. Real riots on the streets, the police not able to safe the day, not that little happenings like in Athens. The kiss of death for the known monetary system and the start of dark ages for Europe.

      Ok. That was just a bad dream speaking. The truth is: Spain would get some nice growth rates and getting out of its trouble in no time. As with loosing some debt, just some saving would evaporate and a lot of leveraging will turn out to be just some electrons anyway. Just a little puff and the sun will shine again. Its magic.

  10. Professor Pettis, thank you for another interesting post.

    I’m a little surprised that you favor a prescription for the Spanish debt which includes eventually reentering the Euro. I would like to know why. In the future will a common currency with Germany be any more suitable than it is today? Even if German and Spanish policies are more aligned than they are today, and Spain qualifies to rejoin the common currency, would rejoining be better than sticking with the Peseta next time around?

    Related to that, let’s say Spain does pursue a policy of rejoining the common currency. Is the idea of Spain rejoining the Euro at a predetermined level credible? That seems to involve a lot of guarantees for policies and outcomes that might be impacted by political change or external shocks over the 5 year period. Wouldn’t you be worried that a fixed target is too rigid?

    Finally, on a somewhat different topic, I wonder about the interesting statement, “countries that are perceived as having too much debt never grow until the debt burden has been resolved” and how it applies to China. Do you think China is still growing simply because its debt (or the perception of it) still has not reached that level?

    • It’s really a political point, Mileto, and not an economic one. Clearly Europe is not an optimal currency zone, and if Spain were to rejoin the euro and Europe had not reformed and centralized, you are right, and we would simply be preparing the next disaster.

      But if you believe, as I do, that a United Sates of Europe is a better outcome than a weakly federalized Europe, as we have today, then perhaps the act of leaving and rejoining at a future date would be part of a larger set of reforms in which national governments were weakened in favor of the European government and, most importantly, Europe engaged in some kind of fiscal centralization. Some parliamentary body, located perhaps in rotating capitals, would have to be responsible for the vast bulk of tax collection and fiscal expenditures. I am not sure how we can ever arrive at labor mobility because of heavy frictional costs like language barriers, different legal and educational requirements, etc., but I do agree with those who say that either Europe must move forward towards greater integration or we should just give up on the whole idea.

      Where are Europe’s Alexander Hamilton and George Washington?

  11. Interesting high level thoughts, but the implications for Spanish, European and global banks is very complicated. Santander and bbva would likely be bankrupt and what would happen to their foreign subs. I suspect countries like the uk and us, who are enforcing higher national capital ratios for international banks would have a field day. If all of their foreign sub balance sheets are matched id be very surprised as the banks are still large holders of Spanish govt debt at the consolidated level. But even bigger is the problem of association in financial markets. Italy or Portugal would surely be next and see their debt sold hard. The ECb would need to do QE. And all financial markets would likely drop 15-20%. I agree it makes lots of sense for Spain to exit but the panic in financial markets may not be worth it. And plus any serious discussion of this will take months of quiet preparation, which at some point will likely be leaked to the markets and perhaps start a crisis before leaders can work out the details. The speed at whic markets work and EU officials is opposite, it’s not the 1930s anymore and world wide central banks policy of asset inflation would surely be compromised by such a crisis.

    But hey stranger things have happened.

    • “Santander and bbva would likely be bankrupt.” Yes, but maybe this has already happened and is simply not being recognized, or will happen anyway as the economy continues to struggle and debt continue to rise relative to GDP.

      By the way if the peripheral countries, plus France, were to exit, it need not happen in a discrete and uncoordinated way. The could leave together and perhaps even create a new currency union, along the lines of the Latin Union in the 19th Century. This might reduce the risk of a currency collapse, allow coordinated negotiations on the future of the union, while retaining some of the economic benefits of the euro. There may even be a way to do this that reduces some of the problems of currency union, who knows?

  12. The issue of excess debt and the impossibility to normalize monetary policy if one wants the debt to keep rolling over is not specific to Europe. The same is true in the US, UK, Japan and several other countries. And the list is growing, not shrinking. (As an aside, nobody realistically expects this debt to ever be repaid, so let’s not even pretend, it’s enough to assume that hopefully there would be another buyer down the road so that this debt can be repaid by the issuance of a new one, and so on so forth). And when there is no more genuine buyer because the mispricing of the risks is too flagrant, just direct the supposedly independent central bank to itself buy the debt with freshly printed money.

    What is specific to Europe – or to the Eurozone to be more precise – is that it is one currency, so no freedom over monetary policy and no possibility for exchange rate devaluation, hence all the weight of the adjustment falls on internal devaluation.

    It is one single currency but 17 different economic policies (labor market policies, fiscal policies, etc).

    The major institutional mistake from the architects of the Euro was to believe that economic convergence will automatically happen if countries would only comply with two arbitrary norms: no more than 3% budget deficit and no more than 60% Government debt to GDP.

    As so often happen these days, reality has been somewhat different than the political promises. It now seems clear that – if the Euro is to survive – there is a need for a Chancellor of the Eurozone to coordinate economic policies inside the Eurozone to avoid intra-zone divergence (Germany can’t increase the legal age of retirement while France lowers it, in other words German and French competitiveness can’t diverge while they share the same currency, just to take one example). This unified economic policy requires a new Treaty and a new ratification by all the people of Eurozone member States as it is a further transfer of national sovereignty to the supranational level. Obviously, such ratification by the people is now very difficult to obtain thanks to the previous economic mismanagement and the accumulated badwill. There is also a need to have the ECB officially in charge of the management of the external exchange value of the Euro. If there is a currency war right, left and center, it is not possible to leave the ECB with no weapon and no ammunition so that the Euro becomes de facto the adjustment variable for all the other supposedly “freely” floating currencies until the situation is so desperate that capital will flee the zone and take down the currency. Member States have given up this prerogative of managing the exchange rate but the supranational level has not inherited it. It is another mistake in the institutional set-up of the Eurozone. As the country with the most economic credibility, Germany should take the lead in pushing for these changes in the economic governance of the Eurozone, subject – let’s not forget – to the democratic wishes of the people. In fact, a smaller but more coherent Eurozone would probably be much better as integrating 17 economies against the wishes of some of the people concerned is neither desirable nor likely to succeed. Failure from Germany to allow for these changes and insisting on full repayment within the existing set-up would be a mistake quite similar to France misplaced insistence that “Germany should pay” after World War I. Back then, “The economic consequences of the peace” turned out to be a disaster of gigantic proportions. Let’s hope the “economic consequences of the Euro” don’t turn out the same with Germany and France having changed seat at the table.

    Your suggestion of a common currency but with built-in flexibility to deal in a timely, intelligent and pragmatic manner with any imbalance threatening to grow too large also sounds valid for the world (cf. Bretton Woods). Indeed, as fixed exchange rates result in imbalances correcting the hard way by deflation and unemployment, floating exchange rates result in imbalances never correcting and being indefinitely rolled over. A system of managed fixed but adjustable exchange rates with the explicit purpose of preventing large and persistent trade imbalances seem the most adequate.

    • I think your comments on co-ordinating economic policy, and the ECB integrating an exchange rate policy are spot on.

      However, your last paragraph, I believe, negates your point. The solution has to be what you have proposed above. If you allow an alternative solution of ‘built-in flxibility’ then the pressure is off to co-ordinate economic policy and having an active monetary policy.

      Also, once investors and depositors realise that the euro is a flexible structure, then bank runs and bond runs will be frequent and devastating, forcing exits and devaluations at the first sign of a crisis – even crises that are imported through contagion, and do not require a devaluation.

      • You are right, we should be more precise and distinguish a common currency area (eg. the Euro) and a regime of fixed but adjustable exchange rates around a reference unit (eg. the ERM before the Euro).

        At the end of the day, a common currency fungible across all 17 eurozone members requires federalism in economic policy, including labor market policies and taxation. Otherwise, uncoordinated national policies within a common currency zone with free movement of capital leads to the kind of imbalances that we have seen in recent years, which moreover can only be corrected by deflation and unemployment in the “weaker” countries, which destroys political support for the Euro. In short, the current system of federal currency with no federal economic policy doesn’t work. The politicians who constructed this edifice might have wanted to avoid confronting the issue head on but i think it is now time to be clear and to decide: either federalism and the Euro, or no federalism and no Euro. It is up to the people of the 17 countries to decide. It would be preferable to avoid a European “secession war” over the issue of the currency.

        If a federal Europe with the Euro as single currency is not deemed desirable by the people concerned, it would still be in the interest of the countries being important regional trade partners to have a monetary system which cooperatively tries to prevent the accumulation of imbalances settled by debt, which triggers the double credit spiral identified by Jacques Rueff and that FrParlentAuxFr has mentionned (the claim of the surplus country enters the money supply of the surplus country while at the same time also staying in the money supply of the deficit country where it is recycled), which propels global debt to unbearable level relative to income and worsens cyclical slowdowns into nasty recessions / depressions. Such monetary system could be one of fixed but adjustable exchange rates around a reference unit that could still be called the Euro (or which could be called the Bancor or whatever on a global basis). In other words, the German Mark, the French Franc, the Spanish Peseta, the Italian Lira, etc would have fixed parities among themselves but will not be exactly fungible. If an imbalance can’t be corrected early on and were to develop beyond a certain point, a negotiated reajustment might be decided with the budens and the incentives appropriately shared. This will not be a mecanistic system but a code of good practices among trading partners with the specific goal of preventing the accumulaltion of imbalances.

        In a recent speech, Paul Volcker has alluded to such a system on a global basis as a way to encourage needed balance of payments equilibrium. See link below:

      • There have been modern cases of economies, even centralized states, with multiple currencies functioning reasonably well. Obviously multiple currencies increase frictional trading costs, but a European Union that allows some monetary flexibility on national lines while it eventually centralizes fiscal power and, more slowly, monetary policy can work, as it did in both the US in the 19th Century and China in the late 19th and early 20th centuries. This all gets pretty unorthodox, especially by modern standards, but if Europe is to become truly united over the next several decades a certain amount of monetary unorthodoxy, if it allows the flexibility needed to keep the system advancing, should not be beyond consideration.

  13. A problem with regular excellence is that merely acknowledging it sounds perfunctory: but in a world of misinformation and “technicism”, it is almost a duty to do so. Carl Schmitt wrote famously about how the neoclassical transformation of political economy into “technical analysis” has led to “the neutralisation and depoliticisation of the State”. The whole enterprise of European Monetary Union was a very audacious attempt to bring about European political union “from above” – that is to say, by forcing the “convergence” of European “policy” (politique, in French, politica in Italian) in all disparate avenues of social life. And by so doing, the clever designers of EMU – from Jacques Delors to Padoa-Schioppa – were hoping to force their political counterparts to lengthen their horizons to ensure lasting political stability in Europe.
    The problems and technical issues that Michael teases out with admirable intuition all point to the failure of European political elites – the German first and most culpably foremost. And there is a certain complicity of the Left in that European social-democratic governments, as is always the case, are brought in to repair the “technical” damage caused by irresponsible bourgeois policies, for which they must take the blame just as surely as European governments have had to socialise the losses of private banks by turning it into public debt. The result is that left-wing governments are “compromised” and this opens the door to craven right-wing opportunism which, in any case, can always count on the support of the most ferocious strata of the bourgeoisie. The fact that we are now with our backs to the wall, having to raise once more – but quite legitimately, Michael – the whole shebang of “Optimal Currency Areas” is just disconcerting. But opening our eyes to this interaction of technical economic discussion with direct political outcomes is why this blog is so valuable – or should I say, invaluable.

    • Ah yes. And speaking of invaluable, what day could possibly be complete without exposure to a full weighing in of BelBruno. Bravo and cheers.

      Basically, my theory is any deal is renegotiated and renegotiated until after discovery of what the other side is getting, both sides continue the deal just because they’re used to dealing with their interlocutors. No side is getting an exceptional deal after some period of time.

      And so wither the Euro(zone?) and Schengrin. Basically the deal was made to a war weary Europe, many years ago when aversion of inter-european war was paramount on the collective mind of Europa.

      Fast forward to now. Yes, there is no war but at what price? The free movement across borders of goods, labor(a loaded term encompassing people, families, consumers, voters etc) and capital benefited who the most or in retrospect, at all?

      I invite to re investigate your position and come to a conclusion that is more beneficial to our mutually shared humanity.

      Ciao Mein.

      • Point taken, Blorch. You can lead a horse to water, but you cannot make it drink. As DvD points out above, given the catastrophic obstinacy of the German political and industrial-financial elites, it ma y be that Europe needs to be saved from the euro now! The difficulty with what DvD suggests is that if we wait for economies “to converge” until monetary and fiscal union is achieved may amount to waiting for kingdom come – because all other instances of “federalism” do not start with economic convergence but rather with the “political will” to unite! Imbalances within countries or “areas” will always exist: the question is whether there is the political will to override these imbalances to ensure unity and leadership – which a Europhile like me (and I suspect Pettis as well) will always treat as an article of cultural and political faith. But again you are right: this “political will” is nowhere to be found in Europe. Cheers.

  14. Prof. Pettis,

    “Imbalances have to settle on an aggregate basis and do not need to settle bilaterally”

    Than why does it have to be Germany? Can’t it be any other surplus country or a combination of more than one country? Would China Re-balancing be enough by itself? The imbalance would remain but it might not be in Europe it could be somewhere else (more likely in weaker countries).

    Also, surely not just Germany or European banks will be damaged, it will take with it many other economies on the brink such as China as you wrote, Japan, probably Brazil etc. Demand would crash and that won’t help. I think they will do whatever they can to delay it until the banks are capitalized. The ECB can ease and cause a temporary growth and reduction in unemployment, and again, with China at least mini-re-balancing it does what Germany should be doing (would, then, China gets politically annoyed at Germany and pushes Germany to re-balance itself? Which makes sense, why should China take all the pain while Germany keeps basking in the spring sun. Reality is so complex, isn’t it, that’s why these things can last for years or decades….

    • Chinese excess savings flow mostly, through the PBoC, to the US (although in recent times increasingly to Europe, which might be bad news for a European export-led recovery) while German excess savings flowed mostly, through the banking system, to peripheral Europe. A point that too many economists miss is that trade flows can respond to capital flows, and seem to have in the past few decades, which is why bilateral trade is much less relevant in understanding trade imbalances than capital flows.

  15. Great article. However, given that a Spanish Euro exit will with certainty entail the re-denomination of local deposits, loans and contracts under Spanish law it is difficult to imagine that it would not extend to public sector debt unless explicitly governed by laws in another jurisdiction. It may not always be easy to draw a fine line as to what is local and not but with the non-international government bonds it will be pretty clear. That Spain would leave the euro with all the short term pain that would entail and still undertake to pay its debts in Euros for the benefit of the ECB, German banks etc will be politically impossible. The ability to shift some pain of re-denomination abroad will simply be too great an attraction, especially given Spain now has no current account deficit in need of external funding (and with a much cheaper currency that will in time become a generous surplus). I suppose there is always the fear of becoming a international capital market pariah a la Argentina but I would argue that 1) Argentina has had to work hard to earn its poor reputation in this forgiving era of yield hunger 2) Markets have a short memory as Greece has shown 3) It would be clear that Spain would not be able to service its debts if still in Euro anyway so I think creditors would be realistic 4) As the article makes clear there would probably be others jostling at the exit too……

  16. Surely the best thing is for Germany to leave the euro (and perhaps rejoin at a higher rate sometime years in the future as you suggest for Spain) This would avoid the increase in debt due to devaluation for Spain and bail out the other troubled countries too.
    Which countries would want to join the new DM? That would be an interesting disucsion for the Netherlands, Austria and Finland…

    • I agree with you. Germany has pursued policies that enabled it to achieve truly impressive “internal to the EU” and “external to the EU” export success without the customary nuisance of an appreciating currency. In normal circumstances that appreciation would have curtailed its success and forced a rebalancing of the German economy. Since Germany doesn’t wish to do anything to relieve the strains caused by its policies and its unbalanced economy, it occurs to me also that it might be more appropriate for Germany to leave the Euro rather than Spain.

    • Germany’s leaving is certainly one possibility, and perhaps the least chaotic, but German banks would still lose. Remember that their foreign loans are denominated in euros while their deposits would be redenominated in the new DM. If Germany left, in other words, its new currency would almost certainly rise relative to the euro, so that the DM value of its assets would drop relative to its DM liabilities.

  17. Spain’s external debt and international financial position are enormous at €1.6 tr and €1tr respectively

    I don’t see much of way out for Spain due to compounding and the fact that they can’t print consistent current account surpluses under the Euro. At the same time I am not sure you can handle this through an open default: Italy and France would be dragged in immediately. The numbers are just mind boogling

    • Yes, but the question is not necessarily whether Spain should do it or not. The question might be whether they will have to do it anyway if things don’t improve dramatically and quickly, in which case we are left with deciding on the best timing, which is usually sooner rather than later.

  18. If Spain leaves the euro, it leaves the EU. If Spain leaves the EU, Catalonia leaves Spain. You know, this post is why some of us think Anglo-Saxons are really really stupid.

    • You would help your case if you weren’t equally dumb, Dax. Do you really believe that Spain’s joining the euro is about keeping Catalonia? And do you really believe that Catalonians only want to leave Spain because they think it will leave the euro? They will probably leave one way or the other, and if Spain insists on keeping unemployment high for ten years they will definitely leave. And by the way, I don’t think the fact that Pettis is half French and born in Spain qualifies him as an anglosaxon.

      • Dax may raise his/her point in brief, but the point is reasonable.

        If Spain leaves the euro, it is quite likely the euro falls apart. The newly-devalued and ultra competitive Spain, will be far too much pressure for a euro-Portugal and euro-Greece. If Portugal and Greece leaves, then the euro will rise, and the pressure will turn to Italy and France. Only a small group of countries can withstand a strong German-centered euro.

        If the euro breaks up, then certainly questions will be raised about the EU. Why be subject to european law, european competition rulings, regulations etc, if the project of monetary (and finally political) union is no longer available?

        Also you maybe right that staying in the euro does not necessarily mean that Catalonia stays in Spain, but I do see the point that if Spain leaves the euro, it will cause Catalonia to break away in reaction for certain.

        In short Dax raises a valid point, that leaving euro has wider repercussions (which some Anglo-Saxons fail to take into account, which is why many predicted the downfall euro by 2011). If it was a decision simply based on ecomomics, I believe Greece, Spain, Portugal, Italy, would have already exited the euro.

        • But Alex I think that actually weakens the argument. You are right that if any one of these countries leaves, the whole thing will almost certainly break, but this only means that each country has to decide not whether it will pay the price for a decision it can make to stay in the euro but rather whether it will pay the price for a decision every other country also must make. In other words if there is some probability that Portugal, France, Spain, the Netherlands, etc. might leave, Spain will anyway pay the full price of staying without getting the full expected benefit, which now requires that every country make the same decision.

  19. Very stimulating article. I think you still under-estimate the political will not to “fall out of Europe” (= leave Euro) for peoples such as the Spanish who have experienced and escaped dictatorships, but we shall see..

    Like @Pigeon, I am curious to understand how the Eurozone and most previously deficit states have moved to current account surplus for several months, in terms of your analysis of the Germany/periphery economic interaction You state:

    “Germany’s trade surplus, in other words, required – and probably caused – the trade deficits of the rest of peripheral Europe”.

    It has been the consistent argument of BuBa’s Jens Weidmann that all the burden of EZ “adjustment” should fall on the (c/a) deficit countries, and none on the surplus states. I greatly disliked his argument, whose outcome of course is ongoing mega-high unemployment in the affected states. But he has so far achieved this result, without a change in German policy, and with falls in real and sometimes nominal wages and devaluation in most parts of the “periphery”. (The German trade surplus is now quite close to the sum of the trade deficits of France + UK, interestingly.)

    But does all this mean that your statement about German policy “requiring” deficits in peripheral EZ states was really conditional – i.e. “on the basis that the deficit states were not willing to cut real wages by a large amount and embrace high unemployment again”?

    • There has been a policy of internal devaluation in peripheral countries (minimum wages and pensions reductions, wages falling as unemployment rises etc). This has led to a drop in imports and a rise in exports, like in any normal devaluation. Nothing strange about it…

      • And of course high unemployment always reduce your trade deficit because it usually causes investment to collapse and employed workers to save even more. Remember that during the crisis of the 1980s Brazil ran the second biggest trade surplus in the world — as a sign of extreme sickness and not of ruddy good health.

        One way of thinking about it is figuring out the capital flows. If foreigners stop lending to Spain and Spanish business owners disinvest and take their money out of the country, by definition Spain will run a current account surplus, but this comes as a consequence of a deteriorating economy, not an improving one.

  20. Michael – When you contemplate German investment slowing after 2000 I think you refer to domestic investment. I also think you’ll find that German FDI outflows were substantial at the time, particularly to China, and that investment took the wind from Germany’s domestic investment sail. Interestingly, as BRIC FDI outflows increased and the price of investment assets grew globally, German FDI outflows slowed. This is relevant not only because it may answer your question concerning why German investment fell around 2000, but also because it reinforces the need for capital exporters (eg. Germany) to recognize losses, allow assets to reprice, and thus permit a new cycle of foreign direct investment to emerge.

    • Thanks, Rusros. At some future date I will graph the savings and investment patterns in Germany during the past two decades. These will show that after 2000 savings rose and investment declined, the balance between the two explaining fully the rising current account surplus.

      By the way one of the standard criticisms of Spain is that they deserve the blame for the crisis because they did not invest the inflows productively. But these inflows were the consequence of Germany’s higher savings which, instead of being invested productively in Germany, were matched by an actual decline in German investment. Spain, in other words, is to blame because they were not able to do with rising German savings what the Germans themselves were not able to do either. This criticism seems a tad unfair.

  21. There is a crisis of pain. It’s inflicted on people who didn’t benefit from the economy. Therefore the government is illegitimate. Illegitimacy has consequences.

    One ramification that gets rammed down is the shadow economy. In this economy, economic transactions are hidden from the government so that they won’t get taxes.

    One way for the government to fight back is legalize it: pot, prostitution, gambling etc. Legalize it and tax it. We already see this in Colorado where canabis sativa is now both recently legal and taxed.

    Another approach is to count illegal, black market activities when measuring GDP. Italy now counts smuggling and other foul commerce when computing its measure of Gross DP. In doing so, they provide visibility on a way forward for nations struggling with the consequences of the poor decisions their elected leaders made in the past.

    • On the issue of illegitimacy, it is true that with 43% participation in last week-end European Parliamentary elections (and therefore 57% abstention, like in 2009), it is not a representative parliament anymore. Representative democracy which is no longer representative is simply no longer democratic (not purely a European problem by the way). Ask any European you know these two questions: What were the 3 key measures of the last European legislature? What are the 3 key proposed measures of the upcoming European legislature? Nobody knows. Nobody. If it is just to simulate democracy, why bother? So 57% of European people don’t bother voting and a growing proportion of those who bother are expressing their discontent with the current functioning of the European Union. That’s not a totally negligible issue because, in the current set-up, European law (voted by unrepresentative parliament) has the last word over national laws voted by domestic parliaments (which might not themselves be so representative but probably still a bit more than the European Parliament). Effectively, democracy is dead in Europe. Not purely a European problem by the way. Repression is not only financial, as we gently discuss on this forum. The conclusion one could draw from the price of financial assets that these political, economic and financial issues make the world safer and more prosperous might be a tad on the optimistic side. For sure, financial markets everywhere have policymakers on their side. But, as and when they stop obsessing with whether Bernanke has shaved or whether Draghi will “whatever it takes” again and put their “risk management” hat back on, financial markets should be aware that it’s nothing that can’t be changed in a matter of weeks. Current conditions in many countries are entirely compatible with the street sweeping public order in no time. Indeed, illegitimacy could have consequences (one of the nicknames of President Hollande in France is Louis XVI… he must be relieved he has the best of both worlds: he’s not President for life but only for the next 3 years and so likely gets to keep his head but he will still receive a life pension for services not rendered… but that’s a different story for another time perhaps).

      Having said all that, it looks to me that – although super painful and to a large extent un-necessary, Spain is now in the process of completing its adjustment. For instance, across Lafarge’s global footprint of 160 cement plants worldwide, the most efficient one is in Spain. Car makers are adding production capacity in Spain (though that’s largely a mirror of capacity closures elsewhere in Europe). The residential market is bottoming out: the number of new mortgage approvals is stabilising at 15% of its 2006 peak in volume terms. Since Spanish house price have dropped by -40% over the period, it means new residential investment has dropped by -91% since 2006. These are all the classic signs of an economy that has exhausted its decline and of asset markets that have exhausted their selling. That’s why I’m less concerned than Laika on Spanish banks, at least those that are still around after the storm. The time to be blown away was 8 years ago, which was precisely when everybody was so bullish (sorry for being tautologic here, it always sounds so obvious in retrospect but it never is at the time, see the US right now). For sure, it will take time to recognize the full amount of NPLs but asset prices typically bottom many years before the last NPL has finally been recognized. To deploy a little bit of capital now in Spanish real estate is not crazy, although obviously not risk free, the main risk for foreign investors being indeed currency redenomination. But, it is not difficult currently to find many investments with a far worse risk / reward profile than Spanish real estate. Actually, some of the best investors in the world are bargain hunting in Spanish property right now. Real estate being the most debt intensive sector of the economy, it is clear from the shape of the overall balance sheet of the Spanish economy that there is little room (and actually little appetite) for another residential investment boom (we also see evidence of that in the US housing market, QE notwithstanding). That’s not incompatible with prices stabilising and eventually firming up, in fact quite the opposite. Worst case, it’s a rather nice and inexpensive place where to live. Much better than a basement flat in London or a shoe box in NY or HK. Hasta la vista

      • Part of representative democracy is the choice not to vote, Maybe this is because there’s no good choices, or maybe it’s simply because people don’t like waiting in line. Turnout numbers can be skewed for hundreds of reasons.

        • The European parliament was elected with 43% participation and the parties broadly in agreement with the current set-up and functioning of the European Union got ~ 73% of the votes. So, in effect, the new Parliament got the green light from 31% (43% * 73%) of the people to vote what it will vote in the next 5 years. It is an interesting debate of political philosophy how low this number (31%) could drop while maintaining the claim that the regime is representative. But that is not the purpose here. In practise, you are right that it makes at first no difference. Parliament will vote the same laws that it would have voted had it received the support of say 69% of the people.

          It would however be a mistake to dismiss or minimize the message from a majority of people disengaging or protesting. The message is one of discredit. For, representative democracy is not a discrete event every 5 years or so. Despite what many politicians might think, the hardest bit is not done on election night when they are elected. The hardest part starts the next day when it’s time to start delivering. That’s the crucial point, illegitimate governments (by that, i mean not sanctioned by a majority of the people) are condemned to succeed. If they fail (as determined by a majority of the people), things have the potential to quickly become unstable.

          This question of political legitimacy is entirely relevant to the difficulty of achieving “the great rebalancing”. As less and less representative governments feel the pressure to succeed from a more and more disenchanted electorate (or people when there is no elections), the resulting crispation leads to less and less cooperative economic policies globaly. It would not take much for the international trade and monetary system to break down, as it has done in the early 1930’s for largely the same reasons. Illegitimacy makes it harder to achieve “the great rebalancing” in an orderly fashion.

  22. Oh god! Long story short, the south of Europe is utterly corrupt and so if its in the interest of the north to keep the south in the zone, things of value will be exchanged and voila!

  23. I still cannot get it why the excess public debt is a problem if the growth picks up. In theory the CB can always manage to either monetize the government or hold the interest rates low enough to keep the debt servicing cost manageable. In practice / empirically a higher growth has rather (IMO) solved the debt problem. What am I missing?

    • The government cannot control the exchange rate and the rate of interest at the same time. If the central bank pegs the yield curve, it has no control over the exchange rate. What happens when you hold the 10 year at 1% while NGDP is growing at 10%? People just borrow at 1% to buy anything that yields NGDP, which is basically anything. This pushes the NGDP growth rate higher and you create a feedback loop. Pushing interest rates up is the only solution, but it forces a default when debt/GDP ratios are high. Trying to do what you’re suggesting would cause a currency collapse.

      Also note that the currency is an asset; it’s an asset in international trade. Therefore, the (indexed) value of the currency is the net present value of the returns on holding the currency: the real interest rate. The rate of return for holding the currency today is the short term interest rate (carry trade). Ergo, the value of the currency depends on the fluctuation of the expectation of the future real short term money rate of interest. All you need is a shift in the expectations of future real interest rates to cause a fall in the value of the currency. If Spain were to leave the Euro, there would certainly be a shift in the expectation of the future short term interest rate.

      • So you are saying that keeping the rates low will cause growth to accelerate and/or currency to depreciate. I agree. But once the growth picks up the tax revenues soars and the internal debt is easier to pay back, isn’t it? Also when the economic is doing well the taxes can be raised.

        I guess the part I struggle is better here

        “On the other hand if, in order to make its debt burden manageable Tokyo represses interest rates to well below the nominal GDP growth rate, it is effectively transferring a significant share of GDP from the household sector to the government in the form of the hidden financial repression tax. This is what Japan was doing in the 1980s, with all of the now-obvious consequences.”

        The government will need to tax (always) enough to get the real resources for its own (public) use but not more than that. The word “Repression” seems to imply here something unfair or not proper. But that is not the case: the government (for the people), hasn’t promised a certain real yield. The government papers always redistributes wealth, one way or the other. But both ways are equally fair and called upon by certain economic situations.

        I think it is easier to think public debt as a form of private debt (through government), some people own the papers we all are promised to pay back. But as with the private debt, only principal is promised to be paid back, and in nominal terms. From that point of view it comes easier to understand that the amount of debt while important is not a solvency issue.

        And for me it is not now-obvious: in the 1980s Japan debt level was normal (~50 %), CBs are always blamed for bubbles but then again for none of them has a official prevent bubble as a policy target.

        • It depends on the initial conditions. You must remember that the central bank cannot control real rates. It’s also a mistake to think the central bank can control the long end of the yield curve; it can only control the short end. For example, QE pushed long end rates up and steepened the yield curve. It was only after QE was discontinued that long end rates went down. Remember that tax revenues move linearly to inflation while debt servicing costs do not move linearly to shifts in interest rates.

          Also remember that every time debt is taken on by any sector, real resources must be transferred. The key question is productivity. If there’s no increase in productivity, the servicing cost of the debt will drag on growth. You use Japan as an example, but look at Japanese growth. Japan isn’t growing even though Japan’s deficit is 10% of GDP. It’s a mistake to think some guy sitting in some office in DC knows how to direct real resources; I find it extremely naive to believe that. There’s way too much complexity in an economy for that to be the case.

          Also note that government debt and central banks popped up to fund imperial expansions and wars. A history of central banking is a history of war finance. Centralization in government was designed for war (things like infrastructure are a major national defense issue). Personally, I think government debts should largely be used for war. With regards to taxation, there’s a point where an increase in taxes doesn’t result in an increase in revenue. There’s limits to how much a government can tax and too much taxation will cause capital flight, along with other problems.

          • Japan’s growth has been okay in per capita basis (

            It’s a mistake to believe that everything should be taken care by private sector. It’s not black and white.

          • When did I ever say everything is taken care of by the private sector? I specifically said the opposite. Also note that I never said government should be small; I’m saying centralization in government should be small. There’s a world of difference between the two.

            With regards to Japan, Japan imports all of its food and energy and has 10% budget deficits leading to okay GDP growth (which really isn’t a good measure of living standards anyways). The idea that we need to target GDP growth is stupid and scary. In many places, we had <1-1.5% growth during the Industrial Revolution; it's the kind of growth you have that really matters in the long run.

          • Note: Centralized government is necessary; it’s designed for war. Things like proper infrastructure and trade between the empire, republic, nation-state, or w/e is a key part of why centralization in government exists. Don’t distort what I’m saying to say that everything needs to be done by the private sector because I’m saying the exact opposite: governments are necessary, but they’re dangerous when they escape their primary purpose.

    • First of all, it depends on how much of the debt is external. In the case of Spain, all of the debt is in a currency that the country cannot control. Secondly, you must remember that the currency is an asset; it’s an asset in international trade. The gain from holding the currency overnight is the real short term money rate of interest, which is set by the central bank. Therefore, the (indexed) value of the currency today is the net present value of all the expected future real short term interest rates. Thirdly, a central bank cannot control both the interest rate and the exchange rate. If you try to hold the 10 year at 1% while NGDP is growing at 10%, people will just borrow at 1% to buy anything which has a return of NGDP (basically everything). That behavior pushes NGDP higher and exacerbates the initial problem. When the central bank is forced to peg its yield curve, it becomes screwed.

    • What happens to the FX rate of the currency if the central bank pegs the yield curve? Remember that the currency is an asset in international trade, which means that the (indexed) value of the currency today is the net present value of all the expected future real overnight interest rate–since the gain of holding the currency is the short term money rate of interest in terms of FX.

  24. Why just stop at the national level, why not introduce seperate currencies at the regional level, municipal level or event on a enterprise or individual level? Surely an enemployed individual in Seville could better his competitive position vis a vis his Hamburg competitor and reduce his debts by devaluing his personal currency and redenominating his mortage and credit card debt. He could then rejoin Hamburg currency in 5 years after he has reajusted. Why should not every individual not have a balanced current account? An alternative could be the good old COMECON bilateral balanced barter system of trade,no current account problems there and stable currencies too! Just allocate bilateral trade quotas between German and Spain and problem solved, it worked even for capitalist Finland in its trade with the socalist USSR, so obviously internal economic policies do not need to matter! The conceit of academic economists such as Mr Pettis is that they beleive that they can alter the fundamental ongoing productivity imbalances (income side) between Germany and Spain with a cleverly disguised one off wealth redistribution (balance sheet side) adjustment via a convoluted manipulation of accounting identities (currency and debt renomination). If anything, this just resets the disequilibrium at a different starting point and postpones the day that the Spanish have to make the hard structural choices necessary to compete on a productive basis with the Germans. If this strategy had merit, the Italians would be wealthy world economic leaders today. Just face it, unless they really want to change, the Spanish will remain relatively poorer than the Germans and continue to fall behind them because it is their fundamental economic lifestyle choice, not the fault of an abstract accounting unit known as the Euro.

    • The principle you state is correct: productivity growth (a result of state efficiency, investment in technology, education, social capital etc) needs to be comparable over the medium-term between the states sharing the euro, otherwise the euro does not work. There is no magical solution.

      However, Prof Pettis’ point is that German competitiveness was not borne out of productivity growth. He actually writes: “there has been precious little [productivity growth] in the past twenty years” in Germany.

      His argument is that “policies in Germany around 2000 aimed at improving Germany’s international competiveness did so by forcing down wage growth and, with it, household consumption growth”. Ie Germany improved competitiveness not by hard-earned productivity growth (which you claim Spain must follow to keep-up with Germany), but by simply keeping wages and consumption low (eg by reducing pension entitlements). After reducing domestic consumption, the Germans were left with increased savings (the difference of domestic consumption to excess production) which they invested in Spain, creating a boom in Spain that allowed Spain to over-consume and thus fill the consumption gap the Germans created.

      If this is true, then it is only natural that the Germans will lose this investment made over the years, by taking losses on the spanish assets they acquired (eg spanish government bonds). And even more inevitable is that Spain will stop-over consuming and the Germans need to either find another country to fill the gap, or they need to increase their own consumption, if they are to avoid a recession.

      I actually think the answer is somewhere in the middle. Both Germany has become competitive mostly by restraining wages and consumption, but also Spain and other peripheral countries need to work harder in improving their productivity. However, to date it is only peripheral countries that have been asked to take hard measures to improve productivity and became cheaper (through internal devaluation), whereas Germany has done precious little. If Germany keeps the same mentelity, then even if peripheral countries succeed in becoming more competitive (more productive and cheaper) this time, then Germany would just restrain internal wages once more, to maintain its precious ‘competitiveness’ and trade surplus, leading once more to a crisis, until peripheral countries decide to break with the euro.

      There is no one-sided solution, both parties share they blame, and hence should take part in its solution. In this I agree with Prof Pettis.

  25. Hi Michael

    Pls excuse my ignorance but could you kindly explain more your comment above “every time a weak country leaves the euro, the euro will strengthen”? ..

    If spain indeed exited, wouldn’t there be concern that the other peripheral countries would also exit and this would see the euro weaken due to capital exiting the euro entirely?

    • Yes but if all weak peripheral countries leave it will just leave Germany and pals and the Euro will be super strong.

    • And it also depends where the money goes. Typically money fleeing Spanish and Greek banks end up in German banks, or in the banks of countries for whom a euro-exit is perceived as unlikely. In that case there would be no net effect on supply of or demand for the euro.

  26. Even though the diagnosis is correct – the unsustainable debt, the north-south demand imbalances – the prescription ignores one very important fact.

    Having a flexible euro, one that countries can temporarily exit and re-enter at a pre-agreed rate later on does not work. An exit will mean not only losses for bondholders, but also depositors (as both will turn into pesetas – bonds can also turn into pesetas given that they are subject to local law, which of course the spanish government defines, as happened in the Greek restructuring).

    If bondholders and depositors know that there is a flexible euro, in which it is normal that a country facing trouble exists, then bond and bank runs will occur at the first sight of trouble. Why have your euros in a Spanish bank and risk a loss? When these bank runs start, they will make an exit inevitable.

    Ultimately those arguing for a flexible euro, will also argue for capital controls to be ‘flexibly’ put in place, to protect against perceived crisis, which however do not require an exit (such as contagion fear from a crisis elsewhere in the world). But then of course there is no point to the euro in the first place.

    You either should have a euro countries cannot exit, or no euro at all. There is no middle ground. If you want a euro, then the only solution is prevention. Tighter political and fiscal union, which allows fiscal transfers and at the same time policy co-ordination and policing, which does not allow individual countries to create large imbalances.

    • In this monetary system, the losses for the depositors are losses for the government since we have deposit insurance. It just means an increase in the debt of the governments whose banks hold the public debt of the companies, which are European banks. The entire European banking system is completely bust. The total bank assets of Europe are around 3 times European GDP and the European banking system is undercapitalized relative to the American banking system. The German banking system has a bank assets/GDP ratio of around 3.5 and the banking system is more levered as well. If the PIIGS wrote down their debts or left the Euro, the German economy would implode while German public debt would explode. Germany would get hit very hard along with the French banks

      • I was commenting on Prof Pettis’ proposal for a flexible euro, one that countries can temporarily exit, devalue and then re-enter.

        In this scenario of exit & devaluation, government bonds and deposits are re-priced in the new local currency (eg peseta) and hence devalued with respect to the euro. There is no losses as such, that would be covered by depositor issurance (the nominal value of deposits remains the same, albeit in pesetas now).

        The problem with a flexible euro structure, is that spanish depositors will move their money from spanish banks to other euro-area bank to avoid a possibly conversion into pesetas, creating bank runs at the first sign of trouble. The flexible euro structure is thus a very unstable one.

        The only solution to avoid bank runs, would be to introduce temporary capital restictions, which forbid spanish depositors moving their money abroad. Clearly though this just dismantling the euro one step at a time.

        As I said – either a country is willing to take the pain to stay in the euro, or else it has to exit the euro altogether. There is no middle ground – or flexible euro approach – – as Prof Pettis suggests

        • But the option doesn’t have to be only between a forever-firm euro (if that is even possible) or a forever-flexible euro (which, by the way, sounds a bit like Europe under Bretton-Woods, which was hardly a bad time for Europe). We can introduce temporary flexibility while Europe irons out the distortions that make a forever-firm euro all but impossible. And the distortions that need to be ironed out are not impossible to figure out. We all more or less know what needs to be done. We just doubt the political will to do it.

  27. In short, no investor or saver will trust a ‘spanish’ euro (ie one invested in a spanish bond, or deposited in a spanish bank) if they believe Spain and the other euro countries will not go through pain to defend it, when a crisis arrives. And should they?

    • Why not? They did with the peseta. All they need is an interest rate high enough to compensate them for the expected depreciation. Does this mean interest rates will not converge? Yes,and that’s probably a good thing. The convergence of interest rates in the eurozone during 2000-07 bears a large share of the blame for the asset bubbles and the trade imbalances.

      • That is exactly my point. A flexible euro is a peseta. There is no benefit for Spain having a strong euro AND sustaining high rates. The only reason to live with a strong euro, is to benefit from low rates, which only comes if markets believe its a euro no-one can exit.

        If you hint to the market that the euro is flexible, then at any sign of crisis, they will push Spain to a temporary exit/devaluation. Spain may as well keep the peseta, and avoid the hassle.

        Having read your other comments, I can accept this point. Maybe its better to break the euro apart now, build the fiscal/political union closer, and then re-introduce euro2 (for good). The euro founders, thought that if they first introduced the euro that would force countries into a closer fiscal cooperation. That has indeed happened as a response to the crisis, but at heavy cost to the legitimacy/populatity of the EU/euro.

        It is still unclear which route is best, or indeed if nationalism can be overcome at all during this age.

  28. An Anglo-Saxon here. Suppose something happened in France, an event out of nowhere where people took to the streets, the govt fell, new elections were held and Marine Le Pen found herself the President of France.

    How could growth be restarted and unemployment driven down? The French currency must get cheaper or tariffs to make import substitution possible must be put into effect. Exactly as per the 1920s British example. For the currency to get cheaper the eurozone must reflate. Either that or France must exit the eurozone, or Germany must exit the eurozone, or the eurozone must divide into two blocks.

    Or France becomes a permanent vassal province of Berlin. Is that likely?. Looking back at the history of Europe I wouldn’t have thought so.

    Perhaps all the Germans are waiting for is for someone to actually say (and mean) we will leave unless you allow reflation. Hollande lost his nerve and backed down, this election is in a way a sign that if the socialists don’t find some backbone they will be swept away as the Greek old left wing were.

  29. It is difficult to exaggerate Pettis importance now. I just wish he would publish much more during these times. The Euro crisis is “white hot” still, not in the least abating as the so called “recovery” is about to fall away and the depth of the problem comes to the forefront. Identity based analysis provides such power and clarity it is near impossible to refute the current status. But because the dynamics are multidimensional it is not useful in coming up with a useful prediction but for removing from the table those remedies and analysis which simply are not even on the right playing field. That is alot.

    I challenge Michael to come to scenarios that are appropriate for the illustrations he uses from history. “Hitler” means “Franco” is not far behind and Le Pen and company bring to mind the French “Croix de Feu” and the German Freikorps and the Spanish “Caudillo”. In other words war is just around the corner.

    In fact I cannot see how Spain leaving the Euro would not result in at least civil war and likely trans- European war, once again. The irony is it is almost the same, but for certain pervasive social safety nets now in place, as the late 1920s and the 1930s in Europe. Then once the safety nets are rendered, which will happen without transfer payments, then all goes to hell and violence.

    It is time to drop the obvious economic analysis, though so many resist the obvious, and drive into the political problem, the constitutional problem that is Europe.

    First one must understand why the EU and the EZ and the Euro exist. That is with now doubt almost soley the bones and blood of 40 million or so dead from WW II. Until one digs into that and really faces it and then relies on that motive for defining remedy, then Europe and the peace is doomed.

    Therefore is it an impossibility for Spain to leave the Euro, just as it is an impossibility for Germany to maintain this fiction that this is a financial problem. The problem is whether or not Germany abrogates the treaty that ended WW II which demands the political support by Germany of all of Europe. The sense they have room to bargain and time to stretch out the recapitalization of German banks is based on the US providing security for Europe and thereby “infantalizing” Europe, and Germany, into a fantasy realm.

    The essence of EZ and Europe being the main clauses in the peace of Europe for WWII must be re-tabled.

    But as one looks at this as a constitutional and political problem and not one of credit and finance – the ease of total remedy delivered suddenly and immediately become obvious.

    The remedy for Europe, and the only remedy, is to convert the framing of the sovereign debt of the entire EZ from that of a “trade league” or a confederacy into a federation. Given a constitution, Europe can easily convert all EZ sovereign debt at par into the new “Europa” sovereign debt overnight. There is rich precedent for this from German unification in the 1800s and the recent German re-unification. And of course the USA in the early 1790s. Overnight the Hamiltonian solution is provided and along with that EZ becomes ‘Europa”, a sovereign massive federal republic.

    And as a state in a union of states, Germany subsumes to the equal under federal debt to Greece. Just as Hamilton’s purchase of Rhode Island debt, worth pennies on the dollar in the 1790s, and paying par at the time with new USA “full faith and credit” debt was done on the same terms as North Carolina trading at par and receiving par for their debt in the conversion.

    After this conversion all EZ states must have equalization payments, transfer payments which after those payments imbalances are made up by labor mobility.

    To those who scoff at this idea, tell me how exactly Spain pulls out of the Euro without mayhem as Greece insists on terms and Ireland rebels and Germany attempts to find recourse and collateral for debt? Then after financial mayhem, for the last 1000 years in Europe, the tanks follow and blood spills.

    Perhaps the most dangerous aspect of this crisis is how all assume – even Pettis – that war is not a possible outcome which results in a near fantasy of consideration.

    There really is no other way out.

    • So you’re telling me that countries who have been fighting against each other for centuries are gonna come and hold hands and go joint and severally liable. Yea right. The great thing now is that the European powers no longer rule the world, which makes the consequences of wars between European powers less costly to the rest of the world.

      I also don’t think world war is likely. I think it’s much more likely to see disputes between regional powers in a Cold War style. I think you’re seeing the US taking a containment policy against China by uniting Japan, Taiwan, the ASEAN nations, and maybe India while the US also tries to contain the Russians in a similar manner with Azerbaijan, Georgia, and the old Soviet satellites like Poland.

      Also note that a expansionist Russia may be enough to unite Europe. I also don’t think Prof. Pettis is saying war isn’t a possibility.

    • Is the creation of a federal debt ‘Europa’ necessary. The problems of the EZ are internal: surely the ECB could achieve the same effect through OMT?

      As an aside, your mentioning of German unification in the 19th century as a model is interesting from the point of view that the strongest and most dominant state (Prussia) and its Junker class was ultimately consumed (sacrificed?) by Germany at large and finally dismembered. I doubt a portend of things to come, but an interesting parallel nevertheless.

      • JamesPF
        The symptom of the EZ problem is being confused with being the problem, even Pettis – and I think it clear the extremely high regard I hold him in – makes this mistake. The symptom are chronic imbalances which absent a currency mechanism forces re balance via labor. The problem is that a confederation structure, especially a weak trade treaty bloc that the EZ represents itself as being, can never find any other solution but through the labor readjustment. Transfer payments or debt forgiveness is another route to take in combination with labor adjustment, but that is simply not going to happen in a confederate structure, especially one where governance is more often than not provided by “competencies” in conjunction with the European Council. So a federation must take place with a constitutional direct representation to provide oversight of greatly empowered central bank, treasury and judiciary.
        The peripheral states leaving will not happen as Pettis is right, it throws the Euro towards a 2.00 value and will decimate all export for the Northern Bloc, especially Germany and the Netherlands. Germany goes back to the state it had pre-EZ – the “sick man” of Europe.
        And I deliberately used German unification for the reason you gave – the subsuming of the most powerful into a state that in aggregate is far more powerful than the “seed”. Germany must subsume into Europa allowing it to be administered from time to time a popularly elected Greek, Spaniard,
        What Pettis does not face square and all who I read on Europe – but with interest Merkel cites this form time to time – is the EZ structure and the Euro are basically a peace treaty.
        Therefore if the peace treaty is abrogated and not strengthened it is just common sense that what it was keeping at bay will reappear.


    • Thnaks, George, but my only real contribution is to figure out balance sheet dynamics. I leave the geopolitical implications to others.

  30. There are as usual great points in Mr. Pettis’ work, however there is a great fallacy that needs to be redressed about the ~automatic equation~. This has been pointed by Jacques Rueff.

    The equation of ~exporting savings/capital~ as an automatic entry against exports of goods and services is a fallacy perpetuated. This is the entire cause of our predicament and imbalance not a ~universally true equation~. The great Jacques Rueff explains the problem with absolute clarity. Let us expose that this fallacy has nothing unescapable. Let us take the example of Holland exporting corn (wheat) in Great Britain, and Great Britain experiencing a trade deficit against Holland in the XIX, as it was famously explain Henry Thornton. In the XIX century when a country would see its credit overheat and would be in temporary overconsumption with trade deficit, the Bullion price of Gold would start to trade above the mint parity. Automatically what people would do is to convert their BoE note for Bullion ship this bullion overseas. This would have the result of contracting M0 and forcing interest rates up. This would in turn wipe off bad credit (the central bank would still provide liquidity at a punitive rates but only against good credit – see Thornton, later copied by Bagehot–). Prices would go down for a while, savers (in coins) would be rewarded, trade would be forced to be balanced and at some point the prices would be low enough so that capital (Gold) would come from overseas again and push interest rates lower and prices higher at the end of the cycle. Holland in our exmaple who was exporting to UK would first receive an inflow of Gold against its trade. It would have the effect of lower interest rates, and create some overheating and higher prices and in turn reduce the export advantage of Holland automatically. So in now way Holland would ~export~ capital against it initial trade surplus, it would actually increase in Gold bullion and M0 would UK would be reduced. Where is this false equation of automatic export of capital against trade surplus coming from?
    From a geopolitical hat trick perpetrated since 1921 to force exports to accept IOUs. Before this period it was never allowed for central bank to accumulate foreign currency ~assets~ (IOUs in reality), the assets would be only in its own domestic currency and some Gold settled for its trade (which is not a liability of anyone else).

    What happens today when the US has a trade deficit? It pays with its own currency. This USD asset lands on the Chinese Central bank, some Yuan are created against this asset but the USD are not ~withdrawn~ from the US money market. In other words those USD are recycled on US money market, they are double counted, there is no shrinkage of M0 in the US with this trickery, there is no forcing interest rates up, and forcing the US to balance its trade. This system is the source of permanent inflation and imbalance. Before 1921, there would have been a sacrifice, some Gold would have left M0, there was no automatic lending for the trade deficit, there would have been a hike in rates, a fall in price, lower price and a balancing of trade. The consensus tries to portray this period as ~horrible~, however the depression and high unemployment would not be so protracted because the imbalance of excess debt, excess trade surplus, abnormally low rates would not be possible.
    As for the case that devaluation hurts the banker, it is wrong, it hurts the creditor but not the bankers if both assets and liabilities are devalued (of course if the a Spanish bank can not re-denominate its debt from Euros to Pesetas they go bust). If all assets and liabilities are devalued, a devaluation actually helps the bankers avoid bankruptcies which would have been inevitable in XIX century, and with no gov bail-out.
    Other than that great points as usual, but it is time to redress this ~equation~ fallacy. Before 1921, an export would not ~lend~ to its client, it would be settled in bullion and the importer would see an immediate effect in interest rates of its imbalances and could not force the largesse of its creditors by stuffing them with paper USD slips which would be doubled counted in PBoC as an asset backing Yuan creation and at the same time those USD recycled in the money markets in the US.
    This is the core of fraud, and the core of the problem.

    As for everyone saying that the Gold standard was responsible for 1929, it was not, in fact the 1921 system of allowing foreign IOUs enabled an accumulation of those way beyond where it should have been, increasing debt in the system. The key problem of this accumulation is that there was still left the capacity in fine to convert. So large accumulation of debt (IOUs) allowed by letting foreign currency swaps accumulate in central banks yet a conversion feature at 20 USD per once which resulting in the catastrophe (worst of both wolrd). The Currenty system is not as bad as there is accumulation but there is no redemption feature (we had the same predicament in the 1960s which forced the suspension of conversion by Nixon). The best system would be a system where the trade is settle for something (Gold, bitcoin, any token which is not a liability in foreign currency). This would force a balancing a trade, and would prevent the automatic vendors financing that China is forced to do and would stop those imbalances. Let us not beat around the bush, this monetary system, and this equation IS THE CAUSE OF THE IMBALANCES.

    • I am not sure, FrParlentAuxFr, that the rebalancing mechanism under gold is something to which we should aspire. First, the much larger role today of governments in the economy means that imbalances can be far greater than they otherwise would have in the 19th Century. Look for example at China, which has the highest savings rate in history not because of household thrift but because of an overwhelming state sector that forced household income to the lowest share of GDP ever recorded (think also of Japan, which although nominally a free market was heavily controlled by the MoF in the 1980s also with a very low household income share of GDP). Or look at the extent of US military spending abroad. These factors are as likely to be the culprit behind the great imbalances of the post-War period as the much maligned fiat currency.

      Second, no one should believe that financial crises under the gold standard were trivial. They were not, and in fact could be just as brutal as our modern crises. In fact they often led to revolution.

      The difference with today, as Barry Eichengreen pointed out, is that under the gold standard (or any fixed currency regime, like the euro), rebalancing always came at the expense of the working class, and as long as they were effectively disenfranchised (and, not incidentally, the adjustment mechanism was not fully understood) the adjustment could seem relatively “painless” to the ones who mattered politically.

      In a liberal democracy, however, where workers have the right to vote, we shouldn’t be surprised, or disapproving, if they express with their votes their unhappiness at being the ones who must bear the brunt of the adjustment costs, especially as they were not the ones who received the brunt of the benefits when the imbalances were being created. In France Marine Le Pen seems to be eager to show exactly why Eichengreen made that claim.

  31. After reading the post and some of the comments, my position is as follows:

    I believe that one way or another, Spain will have to re-structure its external debt. I agree that Germany is neither in a position to consider debt forgiveness (and remember that Germany suffered the same kind of creditor intransigence after WWI), nor prone to favor the policies that would reduce the imbalances.

    As for the trigger of the next crisis, I am afraid that when interest rates increase in the US in a meaningful way, the love affair with peripheral assets will be over. Just as it happened to Germany in 1928. When that happens we will see what the real determination of the ECB is and if Germany has the stomach to share the burden. I would be not surprised to find a second version of the Emminger letter.

    • For 5 years now, there is this idea that US interest rates will at some stage increase in a meaningful way, a sort of “back to normal” scenario as per previous cycles, after the painful but temporary 2008-2009 episode. As and when it comes, this normalization of US interest rates, while benign for the US economy, is assumed to be painful for emerging markets and peripheral Europe (which it will). But, this rosy scenario, while appealing, is not very likely at all. At least, it is very unlikely that US interest rates go up as a result of a deliberate intention of the Fed. This is because the US economy is now engaged in another phase of releveraging, which makes it impossible for the Fed to normalize interest rates.

      Between Q2 2010 when economic growth normalized and Q1 2014, annualized nominal GDP grew by $2.2 Tr while total non-financial debt grew by $6.2 Tr. In other words, it took 2.77 of incremental debt to produce 1 of incremental GDP. Consequently, total non-financial debt is increasing again faster than income and reached 249% of nominal GDP in Q1 2014, a new all-time high and largely above the problematic level of 2007. For all the rejoicing about the US economic recovery, and how Bernanke miraculously avoided another great depression, the simple truth is that the US economy is just growing into the new – higher – debt / income limit allowed by lower interest rates. Said differently, the US economy is following scenario 3b and 4a outlined by Michael Pettis in Economic Consequences of Income Inequality. This strongly suggests that the root causes of the debt accumulation have not been addressed and are still active.

      With non-financial debt at 249% of nominal GDP, and assuming a 7 year average amortization period (shorter for consumer debt, longer for mortgage debt, probably about 5 year for corporate and State debt and probably about 7 year for Federal debt) and 3.6% average interest cost on the entire debt (again, different interest rates according to maturity and different credit spreads according to quality and surety), it means debt service (principal + interest) absorbs ~41% of nominal GDP. Remember, debt service has first priority over other spending, as per the legal system. The smallest increase in interest rates and other spending will likely contract, sending the economy into recession. Say interest rates increase by 150bps back to a “normal” level. Debt service will increase by 2.3pts of GDP, enough to send the economy into recession, which in itself will be enough to push credit spreads wider and the whole dynamic can quickly become a vicious circle as per the 2008 template. Effectively, the layer of ice between the joy of debt-financed growth and the pain of balance sheet recession is very, very slim.

      It means the Fed, by treating the symptoms but not the causes, has put itself into an uncomfortable corner. If it hikes interest rates back to normal, it risks sending the economy into recession. So it probably won’t. Look at Japan, it has effectively 0% policy rates since 1995, almost 20 years and it doesn’t look about to normalize anytime soon. But, if it doesn’t hike interest rates, the Fed risks allowing speculative excesses to degenerate to levels making a financial crash inevitable, with its negative feedback loop on the real economy. Already, if you add up non-financial debt currently at 249% and listed equity market cap currently at 139% of nominal GDP, you get financial assets (thus defined) of 388% of GDP. Over the past 100 years, such a relative level of financial assets has only been seen briefly between Q4 1927 and Q3 1929, though the mix was different (arguably better) back then with less debt and more equity.

      For all the talk about Bernanke having avoided another great depression, both the sequence of events and the relative orders of magnitude are actually much more consistent with a different historical analogy: Bernanke has reacted to a 1921 type of crash exactly in the same way as his distant predecessors, thereby paving the way for a 1929 type of crash. This scenario is by no means not set in stone (not yet) but, when you look coldly at the data, it is more likely that the rosy scenario widely accepted and it becomes more likely as time passes and both debt and equity values keep outpacing income growth. If this scenario were to materialize, you could retitle Bernanke’s famous November 2002 speech: “Deflation, making sure it happens here”.

  32. The Euro is obviously a regional experiment of a Bancor-style supranational currency. If Euro fails then Bancor fails. And the central bank gold agreement is the thermonuclear option in the event that Euro fails

    • The most important purpose of a common unit of account around the world which is not also the domestic currency of a participating country – call it the Bancor or whichever other name – is the avoidance of large and persistent trade and current account imbalances among participating countries by setting exchange rates at the appropriate levels and, in case imbalances develop for a given set of countries, to negotiate and enforce early remedies that share the burdens and the incentives appropriately, which can take the form – but not necessarily or not exclusively – of a reajustment of certain parities.

      The Euro has not been that at all. It has been a system of irrevocably fixed exchange rates between different countries whose economic, tax, labor market policies have been left uncoordinated so that not only imbalances inevitably developped but also that their resolution was impossible other than by deflation in the deficit countries. In other words, the Euro has been the exact opposite of what an intelligent and cooperative system of managed exchange rates should be to prevent (at best) and resolve without too much pain (at worst) large and persistent trade imbalances that undermine the balance sheet of the global economy.

      A common federal currency can only take place in a federal country with a single economic policy and, in fact, a common culture and desire to live together. That is the historical lesson of the great difficulties facing the Euro and many of its participating countries. It is obviously out of the question and completely impracticable to have a world federal country and global common currency. Which is not at all the same as saying that we need a better functioning world trade and monetary system.

      In fact, i believe the opposite argument is true. Consider how floating exchange rates have been spectacularly unable for over 40 years to achieve anywhere near trade balance equilibrium. Contrast that with how during the preceding 25 years the Bretton Woods system of managed fixed but adjustable exchange rates has been much closer to achieving that goal. The conclusion from these past 70 years of accumulated experience under both systems is rather that floating exchange rates have failed or, at least, have performed less well than a system of cooperatively managed exchange rates.

      • I agree on your point about the Euro, but to pick up from the last paragraph – surely floating rates have only ‘failed’ because countries have intervened in their rates and what we have is in reality an uncoordinated managed system?

        • Could be. “Free” markets are not entirely – or perhaps not even mainly or at all – free. This is becoming quite obvious in many markets nowadays where the invisible hand is becoming all too visible.

          But not necessarily either. In fact, a necessary condition for floating exchange rates to work towards trade balance equilibrium is that financial flows in FX markets correspond to trade flows in the markets for goods and services. With financial flows 35x larger than real trade flows on a daily basis, this condition has never been met, far from it.

          From here, either State intervention and / or some herd mentality of speculative flows (ie. these financial positions that are not matched by real flows) are each more than enough to cause persistent and damaging out of equilibrium situations.

  33. You are a brilliant writer, but could you use some visuals, please? Visual learners comprise 60%+ of the population and visual learning takes place 60,000 times faster than just reading the article. I, for one, cannot follow your writing, but I can discern that you know a lot about what you write about.

  34. I agree on your point on net capital exporting as a signal of external imbalances. There’s a beautiful paper by Milesi – Ferretti and others on this issue, and it confirms your suggestions.

    That’s the full reference: Chen, R., Milesi‐Ferretti, G. M., & Tressel, T. (2013). External imbalances in the eurozone. Economic Policy, 28(73), 101-142.

  35. Thanks for “translating” to common language difficult numbers. However we need dates! When do you think that a no return point will be achieved? 2, 5, 10, 20 years?

  36. Spain has never been a fiscally responsible place by any stretch of the imagination. Same goes for Greece, Italy, Portugal and probably others.
    The problem with Spain is structural and dates back to times prior to European Union. Spanish government blames it to the crisis but it is only partially related to the crisis. It is structural.

    • Rubbish. The problem is not structural, The problems are due to the insistence on a fixed exchange rate and then entering the euro. This could only lead to high unemployment.

  37. As the Spanish elections are coming up I went back to this “old” post. If I may, I have a couple of questions: first on the debt issue. If I understand correctly because of the lex monetae any debt issue under domestic law will be converted in the new currency, in case of exit. This means that – I think – the almost totality of public debt would be re-denominated in pesetas and unless companies/households contracted debts in dollars or other currencies their debt too would be turned into pesetas. So the explosion of the debt burden may not occur, indeed the country could inflate its debt away. (This is by the way the reason why such possibility is precluded to Greece because after the bail out more than 80% of its public debt has been issued under English law, in case of exit therefore, the country can only default). Am I missing something?

    Second question: are you sure that a growing-at-5% Spain with its own currency would be willing to go back to the euro? Why should it? And besides, are you sure that Europe to work needs the Euro? Aren’t the political implications of a fully-fledge fiscal union that would make the Euro function too ambitious to ever be realistic?

    Thanks as usual for the illuminating posts.

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