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Doomed to fail. Sovereign debt crisis in the Eurozone

Updated: Mar 22, 2021

The currency union is an endless recession machine for the Mediterranean Countries that will not unite Europe, but divide it.

Since 1973 the World has been using a fully "Fiat" currency system not linked anymore to Gold. Removing the link to Gold caused the birth of the free floating exchange rate mechanism where each National's currency was free to float and to find its true "dynamic" equilibrium in the marketplace. The fixed exchange rate of the previous monetary system (Bretton Woods) ended.

The World was changing and also changed the mainstream (Keynesian) idea that Fiscal policy was the main tool of the State for managing the economic affairs of the Nation. The Monetary policy became more important (Monetarism). The Market started to take over the State as the main economic Actor for allocating resources.

The basic idea of monetary policy is to smoothen the Business cycle. Contrary to popular opinion a Country with a booming economy goes hand in hand with higher interest rates because there is "Demand" for money and credit. Vice versa in a Country with a struggling economy, Interest rates decline because the "Demand" for money vanish.

The job of the Central Bank since when they became Independent from the Government is that of a wise manager that use a brake (rising Interest rates) when the boom is causing too much inflation, too much debt and financial speculation and kick-start the economy by lowered interest rates when the opposite happens (which cause high unemployment). But Central bankers make mistakes too..

For example interest rates were kept “too low for too long” in the 2000s, inflating the US housing bubble with cheap debt fooling people into borrowing money they couldn’t afford. In practice the FED financed the boom. When the Interest rates were raised everything came back to normal in US and mal-investment were cleared.

But not in the Eurozone. They took a road that had big consequences on the market and lives of people. The ECB created a one-size-fits-all monetary policy still in place.

There are at least 5 reasons why I still believe that the EU political project is doomed to fail.

1) EU is built on set of rules where no one is held accountable

Democracies are strong not because they avoid errors but because they learn and correct these errors. But EU is built on modern multilateralism so the System is not really focused on delivering solutions but political compromise. In this way crisis, when they happen, never get resolved but only delayed. A strong Government is the one who takes actions immediately to protect its citizen. A perfect example of what just said is the reaction to pandemic of British and US government

2) Public Debts of member States have never been consolidated into a single European federal debt .

This is the origin of all problems. They let member states to borrow from their own budgets. So when the Euro doubled in value from 2002 to 2007 against the Dollar that meant that Southern Europe saw their national debts doubling in real dollar terms. That matters because Italy, for example, being an exporting Country, suffers when the value of its Euro, a currency they can no longer manage, revalues against the Dollar (Exports decreases and Debt increases in real term).

3) One monetary policy for all those different EU Countries means the wrong interest rate applies everywhere which leads to economic instability and anti EU movement

The governor of ECB when deciding the appropriate level of Interest rates for the Eurozone does not look at the situation in Italy, Germany or any other Country but at the Euro area economic performance as a whole. The idea of setting a single level of Interest rates to heterogenous economies (Countries) that can experience at the same point in time a divergent economic cycle (expansion/ recession) is insane because asymmetries of course arise over time until economic realty will kicks in destroying the economic future of their citizen.

In fact, during the last decade Countries from the North of EU were experiencing an economic boom that needed a ECB’s loose policy while at the same time Mediterranean Countries were in an endless recession and needed the opposite monetary policy (lower interest rates - tightening monetary conditions ).The ECB decision was to average the numbers leaving all unsatisfied. In other words, instead of monetary policy smoothening the business cycle, it is worsening it

A lost decade for many of the indebted European Countries was the obvious consequence. Their industrial production base went back to levels of the 1980s. As always, in situations like this, the Creditor dictates what to do to the Debtors. Suddenly Spreads became important and were the weapon used by the first to impose their will to the others. Economic gaps widened even more.

This happened because this time around economic imbalances within and between Member Countries could not be re-balanced by the free floating Exchange rate mechanism (revaluation / devaluation of the national Currency).The Euro was born, a de facto a Fixed exchange rate mechanism. Fixed exchange have never worked through History causing economic pain, misery and bankrupting Countries. The key here is that there is no rebalancing mechanism. There can be no rally in the German exchange rate to bring the trade surplus back into line. The export boom will continue until some sort of crisis puts an end to it.

This is is in-fact the 3rd reason....

4)Exchange rates are a market correcting measure, rebalancing trade and thereby economic growth

“The stability which fixed [exchange] rates offered was a false one. It prevented currencies for adjusting gradually to market realities, and in the end it produced wild swings of instability. There’s nothing new about fixed exchange rates collapsing. What might be new is to finally learn the lesson that fixed rates don’t – and can’t – work in free markets.”

– Margaret Thatcher, 1992

A free floating exchange rate System has a huge influence on the economic performance of a Country. It is a cause of prosperity or poverty, This is because West developed Countries growth is manly based on External trade as we can see from the GDP components : GDP=C+I+G+(E-I)

The exchange rate can be a Government policy tool to try and improve economic growth. Nations can improve their economic performance by devaluing their currency, for example. This encourages exports and discourages imports, which supposedly improves economic growth.(Italy before entering the Euro)

But the Exchange Rate Mechanism could also be the cause of an Eternal Recession Machine. Having the wrong exchange rate is dangerous. It prevents struggling countries from recovering economically by devaluation – (Italy after entering the Euro)

So the point I am trying to make is that every Country in a particular moment of its History has the currency status its deserves based on the wealth, fertility's rate and productivity level it is able to achieve, year after year. If you remove the automatic market adjusting mechanism provided by the exchange rates and impose an artificial exchange rate (FIXED) instead, valid for all 27 Countries, some of them are doomed to go bankrupt along the road because, year after year, economic cycle after economic cycle, it makes the Companies in these Countries less competitive overseas.

The trend becomes more and more difficult to reverse until the day comes when the Country go bankrupt or has to restructure its debt or devalue it (by inflation)

5 Capital flights start when the confidence of the people in the System in place ends

Debt / GDP ratio is the core of the problem. When debt grows faster than GDP, year after year, the debt level becomes unmanageable. No way to escape this truth. It is also valid for all citizen. If your revenues growth slower than your debts you go bankrupt.

The day of reckoning comes and the Country defaults on its debt (sovereign debt crisis).That is the teaching of History. When and How will that occur?

The Eurozone's attempt to reduce the Italian Debt/GDP ratio by targeting the reduction of Public debt levels brought Austerity and Deflation making things worse. This policy failed as always does in History.

Now (coming soon) they will try with inflation which is the modern (less painful) way of defaulting on its own debts. Inflation devalues the nominal amount of the debt. When this happens and more and more people realize that their saving are evaporating ( losing purchasing power) they will start spending their money fast. It is People perception of the risk what matters the most. Markets move in anticipation of the event even if that is unjustified

What does usually happen under an inflation wave?

Savers will suffer the most because as inflation spreads in the System from the producer to the consumer :

1) the cost of production of goods and services rises. This cost is then passed on the consumers

2) Commodities' shortage will fuel and accelerate the commodity boom also because China is not going to be for longer the cheap manufacturing base of the World . some form of De-globalization is coming

3) a financial and house bubble will be the home of the new speculation as investors try to protect themselves

4) consumer inflation will make people poorer

But whatever the reasons all large inflations in History began with Government mismanagement/excess, deficits and debts, and that they ended much the same, with a currency reset of some kind along with credible policies to restrain government excess in future.

European Governments will soon start financing their deficits with new money (Recovery fund )

Monetary technology on its own can only facilitate commerce. It cannot paper over unsustainable government policies depleting resources and crowding out capital, thereby undermining the division of labor and capital and associated growth in the capital stock itself, which underlies all economic progress.

we are about to enter in a turbulent historical moment

Always remember :

-CPI is inflation past

-monetary supply/ credit is inflation present

-fiscal deficit is inflation future


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