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Friday, November 21, 2014 2:33 PM

Reply From Pettis on Spain; Prisoner's Dilemma in Reverse; EMU End Game

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In response to Spain Needs to Debate Leaving the Euro; Tooth Fairy Economics I received a nice email from Michael Pettis confirming my translation was correct. He also attached the original article in English.

Michael Writes ...

Thank's Mish.

I am attaching the original, but the translations you got were basically right and covered the main points, which you understand anyway.

  1. Excessive debt impedes growth, and very few sovereign debt crises in history have been resolved by growth
  2. The only other way to "resolve" a debt crisis is to assign the losses to one group or another
  3. It is usually workers through unemployment and middle class savers through hidden or explicit taxes who end up paying
  4. It may or may not be worthwhile to save the banks at the expense of the middle and working classes, but at the very least we should discuss it openly and make sure that this is what we have really decided is in the best interests of the country.

Original Text in English
Spanish Government Debt is not Sustainable

Within four years of the 1837 crisis, before it was truly a united country under a central government, two-thirds of American states, including several of the richest, defaulted on their foreign debt. The US survived. If the European Union is to survive, European debt must be resolved. The longer we wait, the more likely a permanent breakup of the euro and the European Union.

Depending more on faith than on economics or history, Madrid assures us that with the right reforms Spain will eventually grow out of its debt. Every country facing a debt crisis has made the same promise, but has nearly always failed. Excess debt itself prevents growth, and even without the straightjacket of the euro Spain probably cannot grow out of its debt.

Even those who reject debt forgiveness admit that only Germany’s guarantee, hidden behind the ECB, prevented Spain from defaulting. Because the German banking system could not survive a default even in one country, they point out, Berlin has no choice but to guarantee Spanish debt forever.

They are terribly wrong. In spite of their hateful policies right-wing extremists throughout Europe have succeeded mainly because protecting the euro and the European banks creates tremendous costs for the working and middle classes. By attacking Europe, these extremists exploit the refusal of Europe’s leaders to acknowledge their mistakes. The longer the economic crisis continues, the greater their prospect for winning, and the greater the likelihood of national defaults and an end to Europe.

But even without the extremists, Spanish debt cannot be sustained. Only the promise by the ECB in July 2012 to do “whatever it takes” to protect the euro prevented Spain and other countries from defaulting. But as debt continues to grow faster than GDP throughout Europe, the ECB’s burden increases inexorably month by month. At some point growing debt and more weakness in the German economy will threaten the credibility of the ECB guarantee, which will become worthless – slowly at first, and then very suddenly. Spain’s default would follow within months.

What is more, Germany’s willingness to support European debt is not permanent. In order to protect its banks Berlin is playing the same game that Washington played with Latin America in the 1980s. While debt is continuously rolled over, German banks are rebuilding capital to protect themselves from the default many in Berlin believe will come. Saving the banks implicitly means transferring wealth from German and European households, either openly through taxes or, which is politically easier, in a hidden way by manipulating interest rates.

This is what happened during the Latin American crisis. American banks aggressively rebuilt their capital mainly at the hidden expense of ordinary American households while insisting that Latin American countries didn’t need debt forgiveness, just more reform. But the many reforms led anyway to terribly high unemployment and brutal social instability throughout the region.

By 1987-88, when American banks finally had sufficient capital, Washington finally admitted that full debt repayment was impossible, and in 1990 American banks forgave 35 percent of the external debt of Mexico, followed by that of nearly every other country over the next few years. As happens throughout history, it was only then that Latin American finally started to grow.

The same must happen in Spain. German and other European banks must rebuild their capital, but it will take many more years before they are successful. Only then, after Spain suffers meaningless unemployment and tremendous social harm, will Berlin “discover” that Europe requires debt forgiveness.

Even if saving the banks is worth the pain, the choice does not fully belong to Spain. The defaults by the tiny economies of Cyprus and Greece nearly brought down the system. If Portugal, France, Italy, or any third country decides it will not pay, the resulting panic would force Spain into crisis anyway. Every country in Europe must be willing to pay the cost of protecting the banks, or they will all fail together.

History clearly tells us that the cost of repaying the debt will be terribly high and that the debt crisis will probably happen anyway. This means that ordinary people must pay twice, once in the form of hidden transfers that recapitalize the banks, and once in the form of high unemployment and social erosion, and in most cases they get none of the advantages because the crisis occurs anyway.

To avoid repeating this tragic history Spain must debate the debt openly and honestly, and it must decide democratically, if protecting European banks is worth many more years of pain. Perhaps it is indeed worth the cost to avoid default, but we should know that history suggests that no matter how hard we struggle the crisis will probably happen anyway.

The United States made many mistakes, including civil war, before it became a single country with a single currency, against the opposition of many who opposed union, but the genius of its system allowed it to acknowledge mistakes and adjust. There is no reason why Europe cannot recognize that it imposed the euro in an unsustainable way, and adjust. If it doesn’t, the most likely winners are the extremist parties who want to destroy the European Union forever.
Thanks Michael!

I side with Pettis on all four points above. In general we agree on things but there are a couple of things on which we disagree. I expect to write about one of them pretty soon.

Cascade of Discussion

I agree with point four that discussion is needed. But actually, I would go so far as to say it's not worth saving the banks and the bondholders - the wealthy - at the expense of everyone else, offering Greece,  Spain, and Cyprus as proof.

The problem with such a discussion is the cascade effect. If Spain has an open honest discussion, then so must Italy, Portugal, France, Germany and every country in the EU.

The reason has to do with contingent liabilities.

Under the euro monetary union, each country has a percentage responsibility to pick up the tab if another country defaults.

The table below shows the current maximum level of guarantees for capital given by the Eurozone countries. The amounts are based on the European Central Bank capital key weightings.

CountryGuarantee Commitments (EUR) MillionsPercentage
Austria€ 21,639.192.78%
Belgium€ 27,031.993.47%
Cyprus€ 1,525.680.20%
Estonia€ 1,994.860.26%
Finland€ 13,974.031.79%
France€ 158,487.5320.32%
Germany€ 211,045.9027.06%
Greece€ 21,897.742.81%
Ireland€ 12,378.151.59%
Italy€ 139,267.8117.86%
Luxembourg€ 1,946.940.25%
Malta€ 704.330.09%
Netherlands€ 44,446.325.70%
Portugal€ 19,507.262.50%
Slovakia€ 7,727.570.99%
Slovenia€ 3,664.300.47%
Spain€ 92,543.5611.87%
Eurozone 17€ 779,783.14100%

There is not a single country in the European Monetary Union (EMU) that could afford to pick up its percentage of responsibility should another country fail.

No One Wants Honest Discussion

With that cascade setup, the ECB certainly does not want an honest discussion.  German Chancellor Angela Merkel does not want an honest discussion. No one in favor of the euro project wants an honest discussion.

So there will not be an honest discussion. Instead there will be mass denial by everyone except from the fringe groups: Beppe Grillo's M5S in Italy, Marine Le Pen's Front National Party in France (extreme right), Alexis Tsipras' Syriza party in Greece (radical left), and the newly formed Podemos party (radical left), in Spain.

For discussion of the latter, please see Spanish Reader on Rise of "Podemos" a New Far-Left Political Party in Spain.

Prisoner's Dilemma in Reverse

In the standard Prisoner's Dilemma setup, two prisoners are better off if they do not talk, but they talk out of fear the other prisoner will talk.

In this case, it is in the best interest of the people to have a discussion, but the act of discussion immediately sets in motion a guaranteed breakup of the eurozone for reasons shown above.

History Lesson 

History suggests, as Pettis states: "ordinary people must pay twice, once in the form of hidden transfers that recapitalize the banks, and once in the form of high unemployment and social erosion, and in most cases they get none of the advantages because the crisis occurs anyway."

History also suggests no monetary union without a fiscal union has ever survived. 

Different Kind of Honest Discussion

The discussion that really needs to take place isn't whether Spain should leave, Greece should leave, or Italy should leave (because as soon as one does a cascade of uncontrolled exits will occur).

Rather, the discussion that needs to happen is for Merkel to get everyone together and work out a plan for a clean breakup. Arguably the best thing would be for Germany to exit first.

But no one wants that discussion either.

EMU End Game

Since no one can or will discuss anything (until one of the radical parties wins an election outright), here are the possibilities

  1. An uncontrolled messy breakup of the EMU
  2. Mass printing by the ECB to cover all foreign debt
  3. Extreme suffering and pain  in peripheral Europe for another decade or so

Note that options two and three still leave intact all of the structural problems of the euro.

The most likely course is extreme suffering and pain until a radical party wins somewhere and then declares the European Monetary Union (EMU) null and void and all debt associated with it null and void as well.

Mike "Mish" Shedlock

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