Mammon or Messiah research: Mike Whitney: Europe Chooses Depression

Europe Chooses Depression

June 07, 2010 | Information Clearing House

Forget about a smooth recovery. Finance ministers and central bank governors of the G-20, met this weekend in Busan, South Korea and decided to abandon "tried and true" expansionary fiscal policies for their own strange brew of belt-tightening policies and austerity measures. The EU members are eager to restore the illusory "confidence of the markets", something that will surely be lost when the eurozone slides back into recession and the hobbled banking sector begins hemorrhaging red ink. Trimming deficits while the economy is still on the mend will weaken demand and force businesses to lay off more workers. That will decrease economic activity and slow growth. It's a prescription for disaster.

Here's an excerpt from Paul Krugman's blog: "Slashing spending while the economy is still deeply depressed is both an extremely costly and quite ineffective way to reduce future debt. Costly, because it depresses the economy further; ineffective, because by depressing the economy, fiscal contraction now reduces tax receipts....

The right thing, overwhelmingly, is to do things that will reduce spending and/or raise revenue after the economy has recovered — specifically, wait until after the economy is strong enough that monetary policy can offset the contractionary effects of fiscal austerity. But no: the deficit hawks want their cuts while unemployment rates are still at near-record highs and monetary policy is still hard up against the zero bound." ("lost Decade, Here We Come", Paul Krugman, New York Times)

Europe is marching headlong into a depression. The attachment to stone age economics is shocking. It is as if John Maynard Keynes never lived. When GDP shrinks--as it inevitably will--the deficits will grow and bond yields will widen making it more expensive to fund business. Public confidence will wane, relations between member states will sour, and cities will fill with angry demonstrators. Fiscal consolidation will rip the 16-state EU apart and trigger a crisis bigger than Lehman Bros. The ECB needs to support demand by encouraging government spending while households patch their tattered balance sheets and regulators take over underwater banks. Any deviation from this plan will only exacerbate the problems.

How sick is the EU banking system? Here's an excerpt from the New York Times:

"It's a $2.6 trillion mystery. That’s the amount that foreign banks and other financial companies have lent to public and private institutions in Greece, Spain and Portugal, three countries so mired in economic troubles that analysts and investors assume that a significant portion of that mountain of debt may never be repaid.

The problem is, alas, that no one — not investors, not regulators, not even bankers themselves — knows exactly which banks are sitting on the biggest stockpiles of rotting loans within that pile. And doubt, as it always does during economic crises, has made Europe’s already vulnerable financial system occasionally appear to seize up. Early last month, in an indication of just how dangerous the situation had become, European banks — which appear to hold more than half of that $2.6 trillion in debt — nearly stopped lending money to one another...."

Analysts at the Royal Bank of Scotland estimate that of the 2.2 trillion euros that European banks and other institutions outside Greece, Spain and Portugal may have lent to those countries, about 567 billion euros is government debt, about 534 billion euros are loans to nonbanking companies in the private sector, and about 1 trillion euros are loans to other banks. While the crisis originated in Greece, much more was borrowed by Spain and its private sector — 1.5 trillion euros, compared with Greece’s 338 billion. ("Debtors’ Prism: Who Has Europe’s Loans?", Jack Ewing, New York Times)

This proves that the real problem is the banks, not "sovereign debt". (which is only 567 billion of the 2.2 trillion euros total) The EU is faced with the same problem as the US; either take over insolvent banks and restructure their debt--making bondholders and equity holders take a haircut--or endure years of hellish subpar economic performance with high unemployment, dwindling investment, grinding deflation and social unrest. The EU has chosen the latter, and for reasons which may not be that clear at first glance. A cheaper euro makes EU exports more competitive, which will keep the EU's most powerful member (Germany) happy. Also, deflationary policies protect the interests of bondholders who are heavily invested in financial institutions whose asset values are grossly inflated by cheap money and massive leverage. Finally, austerity measures transfer the losses from banks and shadow banks onto the backs of workers, consumers and retirees. Screwing workers to enrich bondholders and bankers is a political calculation. It makes no economic sense.

Belt-tightening in the EU means that the world will (again) have to rely on the US consumer to bounce back, shrug off his historic burden of personal debt, and resume spending like a madman. With unemployment hovering at 10%, credit lines being slashed by the day, and retirement just around the corner (for many baby boomers); that looks like an unlikely prospect.

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