Europe at the Abyss; US Housing in the Abyss; Who is to Blame?

Robert Samuelson on Real Clear Politics says Europe at the Abyss

It has come to this. A year after rescuing Greece from default, Europe is staring into the abyss. The bailout has proved insufficient. Greece needs more money, and it can't borrow from private markets where it faces interest rates as high as 25 percent. There is no easy escape.

What's called a "debt crisis" is increasingly a political and social crisis. Already, unemployment is 14.1 percent in Greece, 14.7 percent in Ireland, 11.1 percent in Portugal and 20.7 percent in Spain.

Some causes of Europe's plight are well-known: the harsh recession following the 2008-2009 financial crisis; aging populations coupled with costly welfare states. But there's also another less recognized culprit: the euro, the single currency now used by 17 countries.

Launched in 1999, it aimed to foster economic and political unity. For a while, it seemed to succeed. In the euro's first decade, jobs in countries using the common currency increased by 16 million.

It was a mirage. For starters, the euro fostered a credit bubble that led to booms in housing, borrowing and consumer spending. But one policy didn't fit all: Interest rates suited to Germany and France were too low for "periphery" countries (Greece, Ireland, Portugal and Spain).

Money poured into the periphery countries. There was a huge compression of interest rates. In 1997, rates on 10-year Greek government bonds averaged 9.8 percent compared to 5.7 percent for similar German bonds. By 2003, Greek bonds fetched 4.3 percent, just above the 4.1 percent of German bonds.

"The markets failed. All this would not have occurred if banks in Germany and France had not lent so much," says economist Desmond Lachman of the American Enterprise Institute. "It was like the U.S. housing market." Both American and European banks went overboard in relaxing credit standards.

"Markets Failed" Says Desmond Lachman

Few economic statement make my hair stand straight up more than that bit of complete nonsense from Lachman. The markets did not fail. Bureaucrats who dreamed up the Euro failed.

Those bureaucrats devised a currency union with nothing more than suggestions on fiscal controls. Making matters far worse, countries in the Euro-Zone have widely differing political philosophies and policies.

That currency union was not brought about by the market. The free market would never have done such a silly thing.

Every major currency union in history without a political and fiscal union has failed. There is a nice Table of Monetary Unions on the site Euro Know that shows just that.

Bureaucrats, not the free market knew better. Bureaucrats, not the free market failed.

Not Different This Time

Potential problem were recognized well in advance by many. In February 1995 The Independent wrote a misguided editorial Why we say Yes to a single currency.

The rationale of The Independent was "It's different this time".

The economic arguments that, on balance, Britain will be better off inside the currency union than outside are persuasive. The discipline of a permanently fixed exchange rate would significantly reduce the risk of a return to high inflation and create greater certainty for companies and investors. There would also be lower transaction costs. There is no doubt that a successful single currency would strengthen Europe's position on the global economic stage.

The opponents of the single currency do not agree. They argue that the experience of the ERM and events since Black Wednesday show that to be locked into a single currency is damaging. Exchange rates, they point out, can act as important "shock absorbers" in times of unexpected crisis. These are powerful arguments. They are most powerful when applied to some EU members - notably Spain, Portugal and Greece - whose less developed economies would make the exigencies of a single currency regime punishing, unpopular and potentially disastrous.

But this is not the condition of Britain today. In 1992 the needs of the British economy were at odds with the priorities of the Bundesbank. They were trying to control inflation, we needed to get out of recession. By contrast, in 1999 six or seven countries will find themselves at the same stage in the cycle, with very similar economic priorities. So things are likely to be different.

Points of Failure Predicted In Advance

Things were not different were they?

Ironically, in that 1995 article, The Independent pointed out the exact points of failure: Spain, Portugal and Greece.

Tony Dolphin, Chief Economist of AMP Asset Management, wrote a response to that article less than a week later. Please consider, European monetary union: the benefits, the problems and the traveller's tale

The potential benefits of European monetary union are questionable, the potential costs could be very serious. A successful monetary union requires that the economies joining it are broadly the same, especially in regard to their response to external and internal inflation shocks. This is not the case in Europe. Take two examples: oil and housing.

The effect of a sustained, steep rise in the oil price will be very different in Germany, which is highly dependent on imported oil and gas; in France, where nuclear power is used to generate a high proportion of energy needs; and in the UK, where the North Sea sector of the economy would actually benefit. Imagine trying to set an appropriate, anti-inflationary interest rate policy for a monetary union including these three economies should the oil price double.

The housing sectors of European economies also differ, with the UK's high level of home ownership financed by variable rate mortgages not being found elsewhere. It is easy to envisage a situation where the interest rate policy of a European monetary union was entirely inappropriate for the housing sector of the UK economy.

These and other structural differences between European economies will not disappear over the next four years, nor at any time in the foreseeable future. Until they do, the economic argument against European monetary union is powerful, and far more clear cut than the political arguments for or against.

Yours faithfully,
Tony Dolphin
Chief Economist
AMP Asset Management

Failure of the "One Size Fits Germany Policy"

I have no idea what Tony Dolphin is doing today but put him in the class of those who can say "I told you so." Here is the key paragraph:

"It is easy to envisage a situation where the interest rate policy of a European monetary union was entirely inappropriate for the housing sector of the UK economy."

The UK did not adopt the Euro but Spain did. Interest rates in Germany were not appropriate for Spain. The result was a Spanish housing bubble of epic proportion that has now collapsed.

One interest rate policy simply does not work. For further discussion, please see ECB's "One Size Fits Germany" Policy; Rate Hikes to Stress PIIGS

Compounding Spain's misery, Trichet has embarked on a rate-hiking campaign at the worst possible time, with Spanish unemployment in excess of 20%, and youth unemployment near 40%.

Housing Market Nonsense

Note that Lachman also blames US banks for the housing bubble.

"It was like the U.S. housing market." Both American and European banks went overboard in relaxing credit standards.

That too is nonsense in that it does not place the blame where it belongs, on the Fed. The Fed held interest rates too low, too long. Money was too loose, banks lent.

Blaming banks for lending when real interest rates are hugely negative is tantamount to placing a bottle of vodka in front of an alcoholic, telling the alcoholic it is the best vodka in the whole world, then blaming the alcoholic for what happens next.

Fed is the Problem

Not only did the Fed hold interest rates too low, too long, the Greenspan Fed endorsed derivatives, subprime loans, and adjustable rate mortgages. Meanwhile Bush was praising the "Ownership Society" and Barney Frank was in the back pocket of Fannie Mae and Freddie Mac.

Ben Bernanke was totally clueless, in complete denial about the bubble, going so far as to say home prices were "based on fundamentals".

None what has transpired has had remotely anything to do with the failure of the free markets. We have a failure of regulation, not a failure to regulate. Lachman, like Bernanke, really needs to get a clue.

You cannot fix a problem until you understand what the problem is. Unfortunately, politicians and economists in both the US and Europe are still in denial. Statements by those blaming markets instead of politicians and the Fed, do not help.

Addendum:

The biggest failure of regulation was the very creation of the the Fed. That should be be obvious but the sad state of affairs in regards to economic understanding says I need to spell it out.

Those screaming about the free market need to answer this question: Could the free market possibly have done any worse the serial bubble-blowing moral-hazard policies of the Fed?

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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