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Krugmenistan vs Austeria

Note: see update below

Paul Krug­man has a recent post about how the coun­try of Esto­nia is appar­ent­ly pissed at him over his objec­tions to the asser­tion that Esto­ni­a’s aus­ter­i­ty-pol­i­cy has been a stun­ning suc­cess. It’s a fas­ci­nat­ing sto­ry that holds a num­ber of rel­e­vant lessons for the conun­drum the globe finds itself in at the moment.

The gist of Krug­man’s argu­ment is that the Esto­nia recov­ery has­n’t actu­al­ly been all that great: A 20% drop in GDP from 2007–2009 fol­lowed by rebound that’s brought Esto­nia back up to around 92% of its peak 2007 GDP. While this may be true, the aus­ter­i­ty-defend­ers make the case that this is real­ly all a mat­ter of selec­tive data-manip­u­la­tion and the gov­ern­men­t’s aus­ter­i­ty poli­cies. Plus, Krug­man real­ly pissed off Toomas Hen­drik Ilves, the pres­i­dent of Esto­nia. And, appar­ent­ly, a lot of the rest of Esto­nia:

Busi­ness Week
Krug­menistan vs. Esto­nia
By Bren­dan Gree­ley on July 20, 2012

In May 2009, months after the pas­sage of a $787 bil­lion stim­u­lus pack­age in the U.S., Estonia’s gov­ern­ment took the oppo­site tack: the hard line. It did not dip into the country’s reserves or bor­row mon­ey. Min­is­ters say they nev­er even con­sid­ered devalu­ing what was then Estonia’s cur­ren­cy, the kroon, which would have derailed a 10-year plan to adopt the euro. To main­tain the country’s bal­anced bud­get, a tra­di­tion it had hon­ored since the end of the Sovi­et occu­pa­tion, Estonia’s gov­ern­ment froze pen­sions, low­ered state salaries by about 10 per­cent, and raised the val­ue-added tax by 2 per­cent. The gross domes­tic prod­uct dropped more than 14 per­cent that year.


On June 6, in a blog post titled “Eston­ian Rhap­sody,” Krug­man took on what he called “the poster child for aus­ter­i­ty defend­ers.” In his post, he graphed real GDP from the height of the boom to the first quar­ter of this year to show that, even after a recov­ery, Estonia’s econ­o­my is still almost 10 per­cent below its peak in 2007. “This,” he wrote, “is what pass­es for eco­nom­ic tri­umph?”

“It was like an attack on Eston­ian peo­ple,” says Palmik, in an office above his plant, sur­round­ed by blue­prints for his new pro­duc­tion line. “These times have been very dif­fi­cult. Peo­ple have kept togeth­er. And this Krug­man took all these facts that he want­ed.”

Over the course of a week’s vis­it to three cities in Esto­nia, I met only two peo­ple who didn’t know what Krug­man wrote about their recov­ery. This is not because Esto­nia is a coun­try of blog-obsessed ama­teur econ­o­mists. It’s because Toomas Hen­drik Ilves picked a fight.

Ilves is the pres­i­dent of Esto­nia. The night Krug­man wrote his post, Ilves was in Riga, on a state vis­it to Latvia. He gave a talk to the city’s busi­ness com­mu­ni­ty, offer­ing what he calls “moral sup­port” for Latvia’s own aus­ter­i­ty pol­i­cy. He went to a recep­tion on a boat, then returned to his hotel and pulled out his iPhone. “I read some­where ‘Krug­man attacks Esto­nia,’ and I thought, well, let’s look at his blog,” says Ilves. “I said ‘What the f …’” Ilves does not com­plete the word.

Estonia’s pres­i­dent has lit­tle for­mal pow­er. As in the U.K., the prime min­is­ter runs the gov­ern­ment. Like the Queen of Eng­land, Ilves has only a bul­ly pul­pit. On June 6, stand­ing in front of the Riga Radis­son, he linked to Krugman’s post and wrote five tweets in 73 min­utes.

8:57 p.m. Let’s write about some­thing we know noth­ing about & be smug, over­bear­ing & patron­iz­ing: after all, they’re just wogs
9:06 p.m. Guess a Nobel in trade means you can pon­tif­i­cate on fis­cal mat­ters & declare my coun­try a “waste­land.” Must be a Prince­ton vs Colum­bia thing
9:15 p.m. But yes, what do we know? We’re just dumb & sil­ly East Euro­peans. Unen­light­ened. Some­day we too will under­stand. Nos­tra cul­pa.
9:32 p.m. Let’s sh*t on East Euro­peans: their Eng­lish is bad, won’t respond & actu­al­ly do what they’ve agreed to & reelect govts that are respon­si­ble.
10:10 p.m. Chill. Just because my country’s pol­i­cy runs against the Received Wis­dom & I object doesn’t mean y’all got­ta fol­low me.

The tweets made the Eston­ian papers and the inter­na­tion­al press. The next morn­ing Jür­gen Ligi, the country’s finance min­is­ter since 2009, had to com­ment on them at a press con­fer­ence. “Maybe the style can be argued,” he tells me. “For exam­ple, the reac­tion was real­ly sen­si­tive, blam­ing Krug­man, but the gen­er­al idea was right. Krug­man was clear­ly wrong. He clear­ly doesn’t under­stand dif­fer­ences of choic­es between Amer­i­ca and in a small econ­o­my. By a Nobelist, it was a shame.”


Since inde­pen­dence, Esto­nia has focused on becom­ing part of the West. It joined NATO, the Coali­tion of the Will­ing, and the Euro­pean Union. Mart Laar, Estonia’s first post-Sovi­et prime min­is­ter, likes to say that when he was elect­ed, he had read only one book on eco­nom­ics, Mil­ton Friedman’s Free to Choose. The coun­try is open, effi­cient, and wired. On the World Bank’s Ease of Doing Busi­ness Index, it ranks 24th out of 183. Esto­nia speaks a lan­guage close to Finnish, and its strongest trade ties are with Fin­land and Swe­den. At the Kadri­org, Ilves pro­duces a col­ored map rank­ing the most com­pet­i­tive economies in the Euro­pean Union. Esto­nia sits in the sec­ond tier, behind the Nordic coun­tries, grouped with Ger­many and the Unit­ed King­dom.


Note that Esto­nia isn’t the the only for­mer East­ern-Bloc coun­try to embrace lais­sez-faire eco­nom­ics with a fer­vor in the last two decades. Accord­ing to this piece by George Mason Uni­ver­si­ty pro­fes­sor Peter Boet­tke, the writ­ings of econ­o­mist Mil­ton Fried­man played a role in the col­lapse of the Sovi­et Union. Now, since Boet­tke is Boet­tke is an Aus­tri­an-school econ­o­mist and direc­tor of the Koch-found­ed/­fund­ed Mer­ca­tus Cen­ter, we should­n’t be sur­prised by the Fried­man-ori­ent­ed enthu­si­asm. Ok, we should be kind of sur­prised. But gen­er­al­ly speak­ing, think of Fried­man as the leader of right-wing “Chica­go School” counter-attack against Key­ne­sian­ism in the lat­ter half of the 20th cen­tu­ry (and you can think of the Aus­tri­an School as the crazy aunt liv­ing in the attic that went mad from her gold obses­sion).

Skip­ping down in the arti­cle...


Ilves divides Europe into coun­tries that fol­low the rules and coun­tries that don’t. And he has start­ed wor­ry­ing about a new kind of pop­ulism in Europe: peo­ple who play by the rules and are unwill­ing to help those who didn’t. Ilves points to Fin­land, where the True Finns par­ty has won votes by reject­ing bailouts, and to Slo­va­kia, where the prime min­is­ter lost a con­fi­dence vote last year for her sup­port of Europe’s bailout fund.

Esto­ni­ans, in their own eyes, have always fol­lowed the rules, and in 2009 took their lumps to do so. Ilves says Estonia’s aver­age salary is 10 per­cent below the min­i­mum salary in Greece. He says pen­sions are also much low­er, and civ­il ser­vants retire 15 years lat­er. “You can imag­ine why there might be some frus­tra­tion,” Ilves says.


The point made by Esto­ni­a’s pres­i­dent about the frus­tra­tions Esto­ni­ans feel over the per­ceived unfair­ness of the euro­zone bailouts is a crit­i­cal aspect the entire euro­zone cri­sis, and the Esto­ni­ans aren’t the only ones that share this sense of resent­ment. They did indeed “take their lumps”, vol­un­tar­i­ly. All three Baltic nations were still issu­ing their own cur­ren­cies when the cri­sis hit (Esto­nia joined the euro in 2011), and so all three had the option of devalu­ing their cur­ren­cies instead of embrac­ing the “inter­nal devaluation”/austerity approach. All three of the “Baltic Tigers” choose aus­ter­i­ty and it hurt. A lot. In addi­tion Latvia and Lithua­nia both had nation­al debts under 20% of their GDP debt and Esto­nia has had a bal­anced bud­get for two decades and almost no pub­lic debt at all. Humans are wired to per­ceive and dis­like inequal­i­ty. Researchers were appar­ent­ly able to insti­gate a strike in a capuchin mon­key com­mu­ni­ty sim­ply by shift­ing from a fair to unfair rewards sys­tem. We’re wired to per­ceived unfair­ness. It makes us tricky crit­ters to rule: we can sense injus­tice.

The sen­ti­ment that “we took our lumps for our suc­cess and now you’re ask­ing us to bailout a bunch of layabouts!?” is a very real sen­ti­ment across much of EU right now and it’s under­stand­able. And since the Baltic tigers have seen their economies rebound in the last cou­ple of years after swal­low­ing the bit­ter pill of wage cuts, there’s also the under­stand­able sen­ti­ment that the euro­zone’s ail­ing economies (the PIIGS) should sim­ply learn the lessons of the suc­cess of the Baltic states’ exper­i­ment with crash course aus­ter­i­ty. Unfor­tu­nate­ly, even when a pop­u­lace pays dear­ly in terms of aus­ter­i­ty the lessons drawn from their col­lec­tive expe­ri­ences may not be entire­ly applic­a­ble to a neigh­bor­ing nation also under­go­ing an eco­nom­ic cri­sis. Many of the same lessons that apply in the Baltics may also apply in the dis­tressed eco­nom­ics of Spain and Italy too. But a lot lessons don’t apply across dif­fer­ent economies. So the “we’ve paid, so should they”, sen­ti­ment is both an under­stand­able state­ment, but also a mis­guid­ed sen­ti­ment. Under­stand­ably mis­guid­ed sen­ti­ments are a big part of con­tem­po­rary pol­i­tics and pol­i­cy-mak­ing:

Finan­cial Times
Myths and truths of the Baltic aus­ter­i­ty mod­el
June 28, 2012 12:16 pm by Neil Buck­ley


Latvia and its Baltic neigh­bours Esto­nia and Lithua­nia suf­fered the world’s steep­est eco­nom­ic con­trac­tions in 2009 amid swinge­ing aus­ter­i­ty mea­sures. But now they find them­selves in the front­line of the debate over aus­ter­i­ty ver­sus growth as the best way to tack­le the eurozone’s debt prob­lems.

Even before Ms Lagarde’s com­ments, the Baltics were the talk of the eco­nom­ic blo­gos­phere after a spat between Paul Krug­man, the Nobel eco­nom­ics lau­re­ate and aus­ter­i­ty crit­ic, and Eston­ian pres­i­dent Toomas Ilves.

Ilves called Krug­man “smug, over­bear­ing and patro­n­is­ing” on twit­ter after a Krug­man blog ques­tioned whether Estonia’s “incom­plete” bounce­back from a Depres­sion-lev­el slump should be con­sid­ered an “eco­nom­ic tri­umph”.

So are the Baltics real­ly a mod­el for, say, Greece or Spain? The answer is prob­a­bly not – though they may pro­vide lessons. And that makes the Baltic states’ achieve­ments no less extra­or­di­nary.

The three for­mer Sovi­et states binged on cheap cap­i­tal in the 2000s, hop­ing to nar­row the eco­nom­ic gap with west­ern Europe in dou­ble-quick time. They became heav­i­ly reliant on short-term exter­nal financ­ing. When Lehman Broth­ers’ col­lapse cut off inter­na­tion­al liq­uid­i­ty, their economies – and tax rev­enues – hit the wall.

Com­pet­i­tive­ness, mean­while, had been sharply erod­ed by hefty pre-cri­sis wage increas­es. All three had also pegged their cur­ren­cies to the euro. They were des­per­ate to avoid a mon­e­tary deval­u­a­tion, tor­pe­do­ing their chances of join­ing the sin­gle cur­ren­cy.

So they pio­neered the “inter­nal” deval­u­a­tion – low­er­ing real wages and costs – that Ger­many, in par­tic­u­lar, is pre­scrib­ing for way­ward euro­zone economies. They slashed pub­lic sec­tor spend­ing, wages and jobs, while car­ry­ing out struc­tur­al reforms.

Con­sump­tion col­lapsed. Latvia, the most extreme case – and the only Baltic coun­try to receive an IMF bailout – saw its econ­o­my con­tract, peak to trough, by a quar­ter, and by 18 per cent in 2009 alone. Unem­ploy­ment tripled in three years to 21 per cent. Lithuania’s econ­o­my shrank near­ly 15 per cent in 2009, Estonia’s 14 per cent.

But all three returned to growth dur­ing 2010, and last year Estonia’s 7.6 per cent, Lithuania’s 5.8 per cent and Latvia’s 5.5 were the fastest growth rates among EU economies.

This recov­ery appears more than a “dead cat bounce”, instead reflect­ing a gen­uine recov­ery in com­pet­i­tive­ness. From spring 2010 to autumn 2011, the three saw year-on-year growth in total exports run­ning at above 20 per cent. Esto­nia and Lithua­nia expe­ri­enced peak export growth of a stun­ning 45 per cent in the first quar­ter of 2011, notes Anders Aslund of the Peter­son Insti­tute for Inter­na­tion­al Eco­nom­ics.

But the Baltics’ expe­ri­ence may not be trans­fer­able, or entire­ly rel­e­vant, to euro­zone periph­ery coun­tries.

First, the Baltics were not, like Greece, strug­gling under a moun­tain of debt – which their big falls in GDP would have made, pro­por­tion­al­ly, an even big­ger bur­den. Each had gov­ern­ment debt below 20 per cent of GDP in 2008 – Estonia’s was in low sin­gle dig­its.

The Baltic states also expe­ri­enced far more explo­sive pre-cri­sis growth than, say, Greece. In 2005–2007, Latvia’s econ­o­my grew by a third; salaries dou­bled. The eco­nom­ic crash took it back only to 2005.


Unions, too, are much weak­er than in, say, Greece. That made street protests against spend­ing cuts, thought not entire­ly absent, much more mut­ed.

And final­ly, emi­gra­tion has played a huge role as a safe­ty valve. Latvia’s pop­u­la­tion has shrunk about 10 per cent since 2000, to 2m. True, peo­ple were seek­ing bet­ter-paid jobs abroad even dur­ing the pre-2008 boom. But Mihails Haz­ans, Latvia’s biggest expert on the sub­ject, says emi­gra­tion rose sharply after aus­ter­i­ty was launched, and increas­ing­ly involved entire fam­i­lies. Some esti­mates sug­gest Lithuania’s pop­u­la­tion has declined by at least as much.


As the above excerpt indi­cates, there are a num­ber of dif­fer­ences between the eco­nom­ic sit­u­a­tion fac­ing the Baltic states and the PIIGS but it’s impor­tant to keep in mind that near­ly ALL the of the EU’s ail­ing economies had num­ber of big things in com­mon. For starters, they near­ly all had a major hous­ing boom (Por­tu­gal being an excep­tion). And it was a hous­ing boom that fueled a pri­vate — not pub­lic — debt binge in the years lead­ing up to the finan­cial melt­down:

Busi­ness Week
Krug­menistan vs. Esto­nia
By Bren­dan Gree­ley on July 20, 2012


In the 1990s, Estonia’s labor costs were low, and the work­force was skilled and edu­cat­ed, so the Finns moved south and start­ed busi­ness­es. In a way, Esto­nia was Finland’s East Germany—close, cheap, and cul­tur­al­ly famil­iar. Around 2004, Swedish and Finnish banks began to com­pete aggres­sive­ly to sell mort­gages in Esto­nia, and Esto­ni­ans began to build new hous­es. Var­blane lists what he calls the “dread­ful devel­op­ments” of the boom years. Pri­vate debt increased from 10 per­cent to 100 per­cent of GDP. As debt flowed into the coun­try, work­ers left man­u­fac­tur­ing for more lucra­tive jobs in con­struc­tion. Wages grew rapid­ly, and pro­duc­tiv­i­ty growth flat­tened out. Man­u­fac­tur­ing became more expen­sive. Domes­tic debt began to crowd out for­eign invest­ment.

The crash was nec­es­sary, says Finance Min­is­ter Ligi, “to cor­rect our under­stand­ing about growth poten­tial.”


It’s inter­est­ing to note that the coun­tries with the high­est rates of home own­er­ship in Europe tend to be amongst the poor­est nations and vice ver­sa. Keep in mind that the hous­ing bust did­n’t just wipe out the pri­vate wealth of Europe’s poor­est nations. It was also the cat­a­lyst for the sub­se­quent spike in pub­lic debt. It was clas­sic hous­ing bub­ble in action: as the con­struc­tion of new hous­es freezes and exist­ing home val­ues fall a nation won’t find itself only with col­laps­ing tax base. But there’s also the bailouts. Bub­bles pret­ty much always involve exces­sive lend­ing by the banks. So when that bub­ble bursts, home­own­ers and spec­u­la­tive investors default on their loans. And when enough bor­row­ers default, the banks default...at least if it’s a small­er bank. If the bank is BIG enough (i.e. too-big-to-fail BIG), it’s gets bailed out. And THAT’S REALLY EXPENSIVE.

So have the Baltics fol­lowed this strange dynam­ic of a pri­vate-sec­tor/debt-fueled boom and bust? In addi­tion to the self-imposed aus­ter­i­ty mea­sures, did the Baltic nations also have bank­ing crises fol­low­ing their hous­ing crash­es that lead to a pub­lic bailout of their banks? Was an expe­ri­ence like that part of what’s led to resent­ment in the Baltic nations over the ongo­ing bailouts in the PIIGS? Well...sort of:

Esto­nia avoid­ed a cri­sis with its bank­ing sys­tem in large part because its bank­ing sys­tem “is most­ly dom­i­nat­ed by Nordic banks”, and the Nordic banks are doing just fine. Most­ly. So while pri­vate debt lev­els are still high rel­a­tive to the low per-capi­ta incomes, the Eston­ian bank­ing sys­tem isn’t fac­ing a risk of insol­ven­cy because that sys­tem is, in effect, a sub­sidiary of the Nordic banks.

Lithua­nia and Latvia also have bank­ing sys­tems dom­i­nat­ed by their Nordic neigh­bors, but they haven’t been quite as for­tu­nate as Esto­nia. In Decem­ber 2008, Latvia received a 7.5 bil­lion euro “bailout” in the form of an emer­gency loan with lots of aus­tere-strings attached. This was fol­low­ing a run on the nation’s sec­ond largest bank, Parex, the pri­or month. The run was only quelled after the Lat­vian gov­ern­ment stepped in and pur­chased a 51% share in the bank and assumed it(and did some oth­er stuff). In 2009, Parex got a sec­ond round of “state cap­i­tal injec­tions”.

In Decem­ber last year both Lithua­nia and Lati­va got to expe­ri­ence a new bank run. Or, more pre­cise­ly, an ATM-run. This was fol­low­ing the col­lapse and state takeover of Lithua­ni­a’s 5th largest bank, Sno­ras, and its Lat­vian sub­sidiary. The cost of this bailout, 1 bil­lion euros, is enough to raise Lithu­ni­a’s pub­lic debt from 33% to 40% of GDP. And the cause of this col­lapse? Good ol’ bad ol’ greed and fraud per­pe­trat­ed by a con­stel­la­tion of for­eign and domes­tic oli­garchs.

So the Baltic states are very much in a posi­tion to under­stand how much it sucks to have to bail out a bunch of banks that made for­tunes in the build up of the bub­ble and/or fraud. Its under­stand­able that there might be an expec­ta­tion that oth­er coun­tries ALSO bail out their banks using pub­lic debt. Any­thing else would be unfair.

Now, if the Baltic Tigers had to endure years of aus­ter­i­ty while also foot­ing the bill for the bailout of pri­vate banks, why should­n’t the same be asked of the PIIGS? It’s a rea­son­able ques­tion for aus­ter­i­ty-weary mem­bers of the pub­lic to ask, even if its cou­pled to an unrea­son­able demand. So why should­n’t the PIIGS also just shrink their economies through “inter­nal devaluation”(austerity) and export their way back to eco­nom­ic health? Well, this gets us back to some of the main sim­i­lar­i­ties and dif­fer­ences between the sit­u­a­tions fac­ing a nation like Esto­nia and, say, Spain and Italy.

First, the sim­i­lar­i­ties: The Baltic nations may have still had their own cur­ren­cies when the cri­sis hit (recall that Esto­nia did­n’t join the euro until last year), but their cur­ren­cies were/are being pegged to the euro as a pre­req­ui­site for even­tu­al­ly join­ing the euro. Sim­i­lar­ly, the PIIGS are all euro­zone mem­bers. So Baltic Tigers and the PIIGS all shared the same under­ly­ing cur­ren­cy and the same conun­drum of being unable to deval­ue their cur­ren­cies in the face of a cri­sis. And cur­ren­cy deval­u­a­tion is one of the basic tools in the finan­cial-cri­sis tool­box. All of the coun­tries we’re talk­ing about lack that basic tool. Sim­i­lar­ly, all of the coun­tries in ques­tion lack a sec­ond pri­ma­ry tool that nor­mal­ly exists for coun­tries with a cen­tral bank: the abil­i­ty to sim­ply print more mon­ey. New­ly cre­at­ed print­ed mon­ey can be invalu­able in the midst of an eco­nom­ic cri­sis. It can finance emer­gency stim­u­lus spend­ing via the ind, it can buy up gov­ern­ment debt...generically speak­ing, the abil­i­ty of a cen­tral bank to print cre­ate more mon­ey sim­ply allows a gov­ern­ment to do some­thing in an emer­gency. But this isn’t an option for the euro­zone mem­bers or those aspir­ing to join the euro­zone. Sim­i­lar­ly, instead of print­ing more mon­ey a gov­ern­ment could just bor­row more and spend it on a stim­u­lus. But if you’re a mem­ber of the the euro­zone (or an aspir­ing mem­ber like the Baltics), that option is sim­ply no longer there. This is why the “inter­nal devaluation”/austerity pro­to­col that the Baltic Tigers com­mit­ted them­selves to in the wake of their hous­ing bub­bles sort of seemed like the default option for the entire euro­zone: once you take the option of print­ing new mon­ey, bor­row­ing more, stim­u­lus spend­ing, and cur­ren­cy deval­u­a­tion off the table, aus­ter­i­ty real­ly is one of the only options left.

Now, obvi­ous­ly, an econ­o­my can’t just print its way to pros­per­i­ty. Part of the rea­son the euro­zone’s top pol­i­cy-mak­ers are so adamant­ly opposed to the non-aus­ter­i­ty path out cri­sis for the PIIGS is because the only cen­tral bank that could print that new mon­ey is the Euro­pean Cen­tral Bank (ECB). All of the indi­vid­ual euro­zone nations still have their own cen­tral banks, but they can’t just print new euros. Only the ECB can do that. And the ECB was set up with strict con­trols on how much it could expand the mon­ey sup­ply. Now why would the euro­zone mem­bers have done such a strange thing? Well, in large part its because the euro­zone’s most influ­en­tial mem­ber, Ger­many, has a pow­er­ful nation­al mem­o­ry of how out of con­trol gov­ern­ment mon­ey cre­ation led to hyper­in­fla­tion in the 1920’s and the sub­se­quent hor­rors of the 1930’s. Grant­ed, his­to­ri­ans actu­al­ly point towards the defla­tion­ary poli­cies of the 30’s as the real cat­a­lyst of the eco­nom­ic calami­ty of the ear­ly 30’s that led to the rise of Hitler, but mem­o­ry can be a weird thing. As is the case with the Baltics, this hyper­fear of hyper­in­fla­tion may be a mis­un­der­stand­ing, but it’s an under­stand­able mis­un­der­stand­ing.

Of course, oth­er than print­ing more mon­ey or “inter­nal deval­u­a­tion”, there’s also the option an exter­nal bailout. It’s a famil­iar sce­nario at this point: call the IMF, ask for a bailout, get bailed out but with a bunch of aus­ter­i­ty mea­sures and pri­va­ti­za­tions of state assets as part of the agree­ment (e.g. “struc­tur­al reform”), and declare suc­cess. It’s pret­ty much the tem­plate for the euro­zone bailouts and that should­n’t be a sur­prise since the IMF is one third of the “troikas” we now find run­ning run­ning Greece, Ire­land, and Por­tu­gal. And, of course, a coun­ty can find itself in a sit­u­a­tion where it can print more mon­ey, deval­ue the cur­ren­cy, get an IMF bailout, and still end up default­ing. It’s a sit­u­a­tion Rus­sia found itself in back in 1998, with a num­ber of rel­e­vant lessons for today:

NY Times
The Euro in 2010 Feels Like the Ruble in 1998
Pub­lished: May 12, 2010

MOSCOW — As the finan­cial mar­kets try to absorb news of a res­cue pack­age for Greece and oth­er tee­ter­ing euro-zone economies, some bankers and econ­o­mists see par­al­lels to Russia’s default in 1998.

A decade ago Rus­sia was walk­ing in the same shoes as Greece is today, striv­ing to restore con­fi­dence in gov­ern­ment bonds by seek­ing a huge loan from the Inter­na­tion­al Mon­e­tary Fund and oth­er lenders. Then, as now, the debt cri­sis was roil­ing glob­al finan­cial mar­kets. And hopes were pinned on a bailout — one that in Russia’s case did not work.

“Greece cre­ates a remark­able sense of déjà vu,” Roland Nash, the head of research for Renais­sance Cap­i­tal invest­ment bank in Moscow, wrote in a recent note to investors. The 1998 bailout designed for Rus­sia, in the form of a res­cue pack­age offered by the Inter­na­tion­al Mon­e­tary Fund, had the effect of fore­stalling but not pre­vent­ing Russia’s default­ing on its for­eign debt.

Dur­ing the month between the announced res­cue and that default, Russ­ian and West­ern banks fran­ti­cal­ly cashed out of short-term debt as it matured, changed the rubles into dol­lars and spir­it­ed the mon­ey out of Rus­sia.

The bailout propped up the exchange rate through this process, enrich­ing those bond­hold­ers who got out ear­ly and leav­ing the embit­tered Russ­ian pub­lic hold­ing the debt and hav­ing to pay back cred­i­tors, includ­ing the I.M.F. By Aug. 17, 1998, when the gov­ern­ment announced a de fac­to default on Russia’s for­eign debt and said it would allow the ruble to float more freely against the dol­lar, the World Bank and mon­e­tary fund had dis­bursed about $5.1 bil­lion of the bailout mon­ey.

Some ana­lysts say that if a sim­i­lar pat­tern takes hold in the euro-zone res­cue, it could be Euro­pean tax­pay­ers pay­ing for the bailout while investors in Greek debt are large­ly made whole.

In Russia’s case, the mon­e­tary fund, spurred to action by the Clin­ton administration’s wor­ries about the polit­i­cal con­se­quences in Rus­sia of a finan­cial col­lapse, cob­bled togeth­er an aid pack­age that was enor­mous by the stan­dards of the day.

The mon­e­tary fund and oth­er lenders first pro­posed $5.6 bil­lion, but then raised it to $22.5 bil­lion, includ­ing pre­vi­ous com­mit­ments — the equiv­a­lent of $29.5 bil­lion in today’s dol­lars.

In Greece, the fund and Euro­pean Union ini­tial­ly pro­posed a bailout of 110 bil­lion euros, or $139 bil­lion, last week. After mar­kets react­ed skep­ti­cal­ly, Euro­pean finance min­is­ters met over the week­end and pro­posed a near­ly $1 tril­lion finan­cial sup­port pack­age for Greece and oth­er weak euro zone economies. They pro­posed form­ing an invest­ment fund guar­an­teed by the gov­ern­ments of rich­er Euro­pean Union coun­tries like Ger­many and France that would also draw on mon­e­tary fund mon­ey.

With Rus­sia, the suc­ces­sive bailout pro­pos­als were quick­ly judged by the mar­kets as too lit­tle, too late — as hap­pened with the Greek cri­sis before the lat­est announce­ment.

“You need speed to put out a for­est fire,” Ana­toly B. Chubais, who was the lead Russ­ian nego­tia­tor with the Inter­na­tion­al Mon­e­tary Fund in the 1998 cri­sis, said in writ­ten respons­es to ques­tions about the Greek bailout.

Edmond S. Phelps, a Nobel lau­re­ate and Colum­bia Uni­ver­si­ty econ­o­mist, in a tele­phone inter­view cit­ed a les­son from the 1998 bailout: lenders should announce their high­est num­ber as quick­ly as pos­si­ble, to keep inter­est rates down and low­er the cost of a bailout. Inter­na­tion­al lenders, he said, need to go in “with all their guns blaz­ing.”

Mr. Nash, in his investor note, wrote that bond investors ana­lyz­ing the sit­u­a­tion in Greece and the oth­er weak south­ern Euro­pean economies may be doing what bond investors did dur­ing the Rus­sia cri­sis — siz­ing up under­ly­ing neg­a­tive finan­cial forces so potent that many investors bet against even the big­ger bailout pack­age.

Back then, as now, a glob­al eco­nom­ic cri­sis had ren­dered local economies uncom­pet­i­tive at the exist­ing exchange rates. Rus­sia at the time had pegged the ruble to the dol­lar, Greece today is locked into the euro zone.

In Russia’s case, the prices for the country’s main­stay petro­le­um exports had plum­met­ed the pre­vi­ous year because the eco­nom­ic con­trac­tion in Asia in 1997 had dimin­ished demand. The ruble was under pres­sure to fol­low this trend down­ward. For many months, though, the Russ­ian cen­tral bank kept the ruble pegged to the dol­lar — a dol­lar that was gain­ing strength as glob­al investors sought a safe har­bor.

Only after the Russ­ian cen­tral bank final­ly did deval­ue the ruble in August 1998, which plunged by 70 per­cent with­in a month, did the Russ­ian econ­o­my begin to recov­er. The turn­around was faster than any­body imag­ined. With­in a year, Russia’s econ­o­my had recov­ered to pre­cri­sis lev­els and a decade of rapid growth fol­lowed. Banks rushed back to do busi­ness in Rus­sia.

Russia’s oil woes back then may be anal­o­gous to the gap today between Greece’s and South­ern Europe’s low pro­duc­tiv­i­ty and the high salaries its work­ers receive in euros. But the fix may be hard­er to achieve.

“Greece, fun­da­men­tal­ly, does not have a debt prob­lem,” Mr. Nash wrote. “It has an econ­o­my which is not com­pet­i­tive at the pre­vail­ing exchange rate and which lacks the struc­tur­al flex­i­bil­i­ty to become com­pet­i­tive.”


Yes, Rus­sia, in the end, faced a sit­u­a­tion with a num­ber of par­al­lels to what coun­tries like Greece or the Baltics face: a cur­ren­cy pegged to a stronger inter­na­tion­al stan­dard (the dol­lar in Rus­si­a’s case, the euro EU case) was sup­posed to give for­eign­er investors the kind of con­fi­dence in the coun­try that would spur long-term invest­ments and a dynam­ic econ­o­my. But when a cri­sis hits — a hous­ing crash in the EU and the Asian finan­cial cri­sis of 1997 for Rus­sia — that com­mit­ment to an arti­fi­cial­ly strong cur­ren­cy can become a lia­bil­i­ty. And those efforts to main­tain that arti­fi­cial strength can end up sim­ply pro­vid­ing the for­eign investors a “get out of jail free” card, so to speak. The bailout props up the cur­ren­cy dur­ing a time when for­eign lenders are all tempt­ed to head for the exits.

As the com­men­ta­tors in the above arti­cle point­ed out, the man­age­ment of a finan­cial cri­sis isn’t sim­ply a mat­ter of tech­no­crat­ic manip­u­la­tion of this or that inter­est rate. It’s clos­er to psy­cho­log­i­cal war­fare: the cen­tral bank and gov­ern­ment in cri­sis has to con­vince for­eign investors that the whole house of cards isn’t going to burn down. THAT’s why the abil­i­ty abil­i­ty of a cen­tral bank to print its own mon­ey at will and in unlim­it­ed amounts is such a sharp dou­ble-edge sword: When used appro­pri­ate­ly, a cen­tral bank can assure mar­kets that there won’t be a “liq­uid­i­ty event”. That’s what hap­pens when the mar­ket for some­thing freezes up when, for instance, you have tons of sell­ers and no buy­ers. When that hap­pens for a com­mod­i­ty or stock the price tends to plunge in a pan­ic. But when it hap­pens to a gov­ern­men­t’s sov­er­eign debt mar­ket the entire econ­o­my freezes. Liq­uid­i­ty events in any of the key mar­kets, like short-term gov­ern­ment debt, is how economies die, so the ability/threat of a cen­tral bank to print unlim­it­ed amounts of cash and use it to buy a crit­i­cal secu­ri­ty (usu­al­ly gov­ern­ment debt) is a very pow­er­ful tool to use ward of a liq­uid­i­ty event. But once that spig­ot real­ly is turned on, it’s not espe­cial­ly easy to turn off and it real­ly can poten­tial­ly over­whelm a coun­try’s mon­ey sup­ply. In oth­er words, you don’t real­ly want to turn on the unlim­it­ed-mon­ey fire hose unless there’s real­ly a fire. But if you’re going to use that fire hose, use it ear­ly and use it over­whelm­ing­ly. Rus­sia and the IMF had that fire hose in 1998 but did­n’t use it in time and end­ed up default­ing any­ways (a 70% deval­u­a­tion in their cur­ren­cy with­in an month was basi­cal­ly a default).

So, if cur­ren­cy deval­u­a­tion — like Rus­sia drop­ping the ruble’s cur­ren­cy peg to the dol­lar — is effec­tive­ly a default, and defaults are to be avoid­ed at all cost, how does cur­ren­cy deval­u­a­tion avoid spook­ing for­eign investors? Well, once again, one of the pri­ma­ry jobs (and tools) of a cen­tral bank is the man­age­ment of the psy­chol­o­gy of the mar­ket­place. When investors or spooked, cen­tral banks are sup­posed to step in and pre­vent a pan­ic. When investors get over­ly exu­ber­ant and move into “bub­ble” ter­ri­toriy, cen­tral banks are sup­posed to step in and “remove the punch bowl”. And when investors are REALLY spooked over about the long-term via­bil­i­ty of a nation’s econ­o­my, a cen­tral bank’s job is con­vince investors that there real­ly is a future for this coun­try. Cur­ren­cy deval­u­a­tion is one of the main tools that can give the world a sense that a coun­try real­ly does have a future. When a coun­try can export again, that light at the end of a tun­nel might not look so much like an oncom­ing train, and noth­ing helps a coun­try export more than a cur­ren­cy deval­u­a­tion. Think of the abil­i­ty of a cen­tral bank to print unlim­it­ed mon­ey as one of the pri­ma­ry tools avail­able for deal­ing with imme­di­ate liq­uid­i­ty crises, where­as the abil­i­ty to deval­ue a cur­ren­cy is sort of a long-term solu­tion. In a finan­cial pan­ic, you need both short term AND long term solu­tions and you need them simul­ta­ne­ous­ly.

Now, if the Baltics were able to rebound suc­cess­ful­ly (well, ok, that depends on you who ask to define “suc­cess­ful­ly”), why can’t nations like Spain, and Italy just fol­low that same mod­el? Well, now we return to the sim­i­lar­i­ties and dif­fer­ences between and economies like Spain and Italy, and one like Esto­nia. One obvi­ous dif­fer­ence between the two nations is that Spain and Italy are sim­ply much much larg­er than any of the Baltics. If they’re going to export their way back to health some­one else has to buy all those exports. That’s a lot eas­i­er to do in tiny economies like the Baltics where much of the eco­nom­ic growth of the past decade involved for­eign man­u­fac­tur­ers mov­ing in and set­ting up fac­to­ries for export. In oth­er words, if you’re already an export-ori­ent­ed econ­o­my, export­ing your way back to health is just a lot eas­i­er to do. And if you’re a tiny export-ori­ent­ed econ­o­my with wealthy neigh­bors, it’s that much eas­i­er.

Near­ly every­one agrees that Spain and Italy need more exports, but can they just “inter­nal­ly deval­ue” and export to the rest of the world in place of the nor­mal cur­ren­cy-deval­u­a­tion? Well, in the­o­ry, and over a long peri­od of time. Aus­ter­i­ty mea­sures could remain, unem­ploy­ment could lan­guish at high rates and wages could con­tin­ue to fall. But here’s the prob­lem: unlike a cur­ren­cy deval­u­a­tion, which sort of has the effect of uni­form­ly bring­ing down every­one’s wages in a nation (at least with respect to the out­side world), “inter­nal deval­u­a­tion” does­n’t rely a nice smooth mech­a­nism like cur­ren­cy deval­u­a­tion. Instead, it relies on folks just tak­ing a big pay cut. As many folks as pos­si­ble. And here’s the prob­lem: wages are “sticky”. Unem­ploy­ment may rise, but that does­n’t smooth­ly trans­late into low­er wages. Instead, what we’ve seen in Spain and Italy is sim­ply high unem­ploy­ment, but with lit­tle improve­ment in over­all “com­pet­i­tive­ness” because wages haven’t fall­en. And nei­ther should we expect them to unless a coun­try sub­mits to some sort of cen­tral­ized wage author­i­ty. That’s just the messi­ness of real life inter­fer­ing with eco­nom­ic the­o­ry. Even Esto­nia, a coun­try that con­scious­ly embrace “inter­nal deval­u­a­tion”, wages did even­tu­al­ly fall, but they were still pret­ty “sticky”:

Busi­ness Week
Krug­menistan vs. Esto­nia
By Bren­dan Gree­ley on July 20, 2012

Krug­man was right about one thing: Wages were sticky. But they weren’t glued. They declined slight­ly in 2009 and 2010. They have grown since, but the larg­er wage trend since 2007 is flat. Anec­do­tal­ly, some indus­tries report­ed wage cuts of as much as 30 per­cent. Pro­duc­tiv­i­ty, in the mean­time, recov­ered. And both look rough­ly where they’d be now had there been no hous­ing boom. As hoped, Estonia’s growth in 2010 and 2011 came from exports. The gov­ern­ment points proud­ly to Ericsson’s (ERIC) recent deci­sion to build a plant near Tallinn. Estonia’s politi­cians seem relieved that the coun­try has resumed its right­ful place in the world: man­u­fac­tur­ing, exports, and sobri­ety.


So why can’t this work for Spain and Italy? Well, it could work...in the long run. Once a coun­try’s spir­it and econ­o­my is suf­fi­cient­ly bro­ken, those wages will even­tu­al­ly fall. But why can’t this work in the short run? Well, once again, it could...in a dif­fer­ent world. More specif­i­cal­ly, it could poten­tial­ly work in a world that had the glob­al demand to buy all those new­ly com­pet­i­tive Span­ish and Italy exports. That’s a very dif­fer­ent world from the one we live in today and that brings us to one of the cen­tral prob­lems with the entire austerity/“internal deval­u­a­tion” approach to solv­ing these kinds of sov­er­eign debt crises: “inter­nal deval­u­a­tion” might increase exports and reduce imports, but it comes at an enor­mous cost that isn’t near­ly as cost­ly when cur­ren­cy deval­u­a­tion is used instead: “inter­nal deval­u­a­tion” breaks the inter­nal econ­o­my:

Spain is More Com­pet­i­tive than You Think
Jun 18, 2012 1:00 AM EDT
Fiona Bra­vo

You know Spaniards are depressed when Coca-Cola broad­casts a tele­vi­sion com­mer­cial encour­ag­ing cit­i­zens to “go get ’em.” The spot cuts away from for­eign com­men­ta­tors pre­dict­ing Spain’s immi­nent col­lapse to show­case the country’s strengths: engi­neers, high-speed trains, and, of course, soc­cer. In the midst of a cur­ren­cy cri­sis, steep cred­it down­grades, and a 100 bil­lion euro bailout of its bank­ing sys­tem, it’s easy to be pes­simistic about Spain. But there are some grounds for opti­mism.

Start with exports. While Span­ish wages rose much faster than the euro zone aver­age dur­ing the pre-cri­sis years, large exporters kept costs under con­trol, allow­ing them to stay rel­a­tive­ly com­pet­i­tive. Mean­while Span­ish employ­ers with more than 250 work­ers stayed just as pro­duc­tive as their Ger­man, Ital­ian, and French coun­ter­parts, accord­ing to BBVA, Spain’s No. 2 bank.

Con­se­quent­ly, despite Asia’s rise, Spain has man­aged to hang on to its glob­al mar­ket share of exports. That puts it in a league with Ger­many and well ahead of most of the euro zone. Indi­tex, the appar­el group best known for its Zara retail chain, is a poster child of Span­ish com­pet­i­tive­ness. It shrugged off the Euro­pean finan­cial cri­sis and even deliv­ered a sharp rise in first-quar­ter prof­its.

The catch is that exports, which account for about 30 per­cent of Spain’s GDP, can’t com­pen­sate for the steep drop in demand at home. Yet some com­pa­nies are doing well inside Spain. Mer­cadona, the largest pure­ly domes­tic gro­cer, boost­ed sales by 8 per­cent last year, to 17.8 bil­lion euros. Its unique busi­ness mod­el is stud­ied in the class­rooms of top Amer­i­can busi­ness schools.


Spain’s emblem­at­ic com­pa­nies show that this can be done. But their suc­cess has been despite, not because of, the country’s politi­cians and rigid employ­ment laws. Spain has already imple­ment­ed painful reforms, par­tic­u­lar­ly in the labor mar­ket, but they will take time to feed into the econ­o­my. The bank bailout may even­tu­al­ly ease the ongo­ing cred­it crunch, but in the short term the country’s spi­ral­ing bor­row­ing costs will make it hard­er for Span­ish entre­pre­neurs to finance their busi­ness­es. In the mean­time, the hope in Madrid is that the country’s nation­al soc­cer team, win­ner of the last World Cup, will pro­vide some respite from the doom and gloom.

As the above arti­cle high­lights, one of the fun­da­men­tal prob­lems with the “inter­nal deval­u­a­tion” approach is that any boost to exports comes at a pret­ty sig­nif­i­cant cost to the inter­nal econ­o­my: If the Key­ne­sian solu­tion to a fis­cal cri­sis involves more infla­tion (in the form of cur­ren­cy deval­u­a­tion and more pub­lic debt), the “aus­te­ri­on” solu­tion is more unem­ploy­ment. And in the infla­tion vs unem­ploy­ment debate, the unem­ploy­ment approach rarely seems to work. One of the main rea­sons the eco­nom­ic rebound of the Baltic nations has been point­ed out as an excep­tion­al exam­ple of the pow­er of aus­ter­i­ty is because suc­cess with aus­ter­i­ty alone is excep­tion­al­ly rare. It just does­n’t help a coun­try to break its non-export-ori­ent­ed econ­o­my. This is part­ly do to fact that sov­er­eign debt cri­sis are vir­tu­al­ly nev­er only about long-term con­cerns over the eco­nom­ic via­bil­i­ty of a nation. There is always a short-term com­po­nent to the cri­sis, and the clos­er a nation gets to default the greater those short-term con­cerns become in the minds of inter­na­tion­al investors. And if there’s one thing those inter­na­tion­al investors don’t want to see in a coun­try fac­ing a debt cri­sis it’s a surge in debt cou­pled with a col­lapse in con­fi­dence. Remem­ber, cen­tral bank­ing is as much about wag­ing psy­cho­log­i­cal war­fare as it is a task of man­ag­ing the econ­o­my. If a surge in debt is used in a large pro-stim­u­lus man­ner that cre­ates real con­fi­dence that the gov­ern­ment is seri­ous about address­ing the eco­nom­ic prob­lems both in the short, medi­um, and long-run, the mar­kets will be will­ing to accept that surge in debt and a cri­sis can be avert­ed. But if a surge in debt is tak­ing place amidst aus­ter­i­ty mea­sures due to a col­laps­ing inter­nal econ­o­my AND this is all tak­ing place in a col­laps­ing inter­na­tion­al economy...well, that’s just a recipe for dis­as­ter. Exact­ly the kind of dis­as­ter we’ve been see­ing across the euro­zone. Aus­ter­i­ty is, at best, a long-run solu­tion. Finan­cial pan­ics are short-term traps that may or may not involve long-term con­cerns. But regard­less of whether or not long-term “com­pet­i­tive­ness” con­cerns are part of what’s dri­ving the pan­ic, any solu­tion that requires long-term patience on the part of inter­na­tion­al investors is pret­ty much doomed to fail.

So why is Ger­many, leader of the euro­zone, so adamant about aus­ter­i­ty as the only mod­el? Well, part­ly because Ger­many tried aus­ter­i­ty less than a decade ago and it worked...sort of. Ger­many may have imple­ment­ed its own ver­sion of austerity/“internal deval­u­a­tion” in 2005, but that’s also not a great exam­ple of the val­ue of aus­ter­i­ty in the midst of a sov­er­eign debt cri­sis. Ger­many was­n’t in the midst of finan­cial pan­ic and the glob­al econ­o­my was still growing...it was a very dif­fer­ent sit­u­a­tion from what Spain and Italy find them­selves in today (Plus, the Ger­mans had some “help” that cush­ioned the blow). But it’s also impor­tant to keep in mind that the wage cuts expe­ri­enced Ger­man work­ers in the mid 2000’s were real and painful. One again, the desires of the Ger­man pub­lic to see the PIIGS pay for their bailout might be mis­guid­ed, but it’s under­stand­ably mis­guid­ed. But that just explains the mass psy­chol­o­gy of the gen­er­al pub­lic. The behav­ior of Ger­many’s politi­cians, on the oth­er hand, is less under­stand­able. It’s actu­al­ly pret­ty per­plex­ing:

The Irish Times — Fri­day, July 20, 2012
Bun­destag gives back­ing for bailout of Span­ish banks


GERMAN FINANCE min­is­ter Wolf­gang Schäu­ble will add Berlin’s sup­port for bail­ing out Span­ish banks today after receiv­ing the back­ing of a large Bun­destag major­i­ty yes­ter­day evening.

Some 473 MPs vot­ed in favour of con­tribut­ing almost €30 bil­lion in Ger­man loans and guar­an­tees to the Span­ish pack­age of up to €100 bil­lion, run­ning over 18 months.

But oppo­si­tion was more marked than in pre­vi­ous bailout votes: some 97 of a total of 620 MPs opposed the move, includ­ing 22 from the coali­tion ranks, with a total of 13 absten­tions.

The gov­ern­ment failed to get an absolute, so-called “chan­cel­lor” major­i­ty, though six coali­tion politi­cians were miss­ing from the mid­sum­mer par­lia­men­tary recall.

Before the vote, Mr Schäu­ble said finan­cial mar­kets had “doubts” about Spain’s eco­nom­ic health and the bailout would help Madrid buy time to com­plete cut­backs and reforms already under way.

“Spain is on the right path to sol­id state finances but this progress is endan­gered by inse­cu­ri­ty over its finan­cial sec­tor,” he said.

“We have a strong inter­est in allow­ing Spain to con­tin­ue to reform.”

He assured MPs that full lia­bil­i­ty for all loans lay with the Span­ish state, dis­miss­ing spec­u­la­tion in some quar­ters that recap­i­tal­is­ing euro zone banks would let states off the hook for lia­bil­i­ty.

Mr Schäu­ble denied this was the case with the Spain bailout, insist­ing Euro­pean lead­ers would dis­cuss this issue only after a Euro­pean bank­ing reg­u­la­tor was in place and oper­at­ing to everyone’s sat­is­fac­tion.

“Any­one who talks about imme­di­ate, direct refi­nanc­ing of banks through the ESM (bailout fund) or of col­lec­tive lia­bil­i­ty for banks in the euro sys­tem is shoot­ing his mouth off,” he said, a dig at euro zone bailout chief Klaus Regling.

Oppo­si­tion leader Frank Wal­ter Stein­meier, par­lia­men­tary head of the Social Democ­rats (SPD), said his par­ty would sup­port the bailout for euro zone sta­bil­i­ty – but as a show of sup­port for the euro zone and not for the gov­ern­ment.

He accused Angela Merkel’s coali­tion of unset­tling vot­ers by spin­ning a “fairy tale” of fis­cal­ly pru­dent Ger­mans sur­round­ed by fis­cal­ly reck­less neigh­bours.

“Ger­many is no blessed isle. The cri­sis will hit even export-dri­ven coun­tries [such as Ger­many] and, as one export mar­ket after anoth­er hits the skids, we can­not rule out that we will be dragged down,” he said.

Mr Stein­meier put the gov­ern­ment on notice that the SPD would not con­tin­ue to sup­port euro zone bailouts for banks unless cred­i­tor involve­ment was agreed.


OK, first off, kudos to SPD leader Frank Stein­meier. By call­ing out Merkel for sell­ing Ger­man vot­ers on a fairy tale of “lazy South­ern­ers” we might be see­ing a sign that the pow­er of the pol­i­tics of per­ceived inequal­i­ty is fad­ing in Ger­many. Now let’s hope the same hap­pens in Fin­land. Soon. Far-right polit­i­cal gains aren’t just being seen in the cri­sis-hit euro­zone mem­bers. Fin­land, with one of the strongest economies in europe, saw the far-right True Finns par­ty surge to 19% of the vote in last year’s elec­tions based on anti-bailout sen­ti­ment. And that sen­ti­ment has­n’t sub­sided since then as the south­ern economies con­tin­ue to erode. In fact, Fin­land man­aged to extract a spe­cial con­ces­sion in exchange for its sup­port of the lat­est Span­ish bank bailout: col­lat­er­al val­ues at ~40% of its share of the loans to Spains banks. The syn­er­gis­tic rela­tion­ship between the euro­zone cri­sis and the rise of rad­i­cal polit­i­cal groups is a grow­ing and most trou­bling phe­nom­e­na.

So what are we see­ing here with the Ger­man par­lia­ment demand­ing that Spain’s pub­lic accept the full lia­bil­i­ty for a 100 bil­lion euro bailout of Spain’s banks? Isn’t that just going to exac­er­bate the under­ly­ing sov­er­eign debt cri­sis? Well yes, but we’re not just see­ing the pol­i­tics of bailout-resent­ment on dis­play here. One way to look at it is we’re see­ing an attempt to do the unprece­dent­ed: cen­tral bank­ing does­n’t real­ly have prece­dent for deal­ing with finan­cial pan­ics using the aus­ter­i­ty-only approach. The accept­ed par­a­digm for quelling a pan­ic is for the cen­tral bank to act as a “lender of last resort”. In oth­er words, the cen­tral bank needs to threat­en to do what­ev­er it can to stop the pan­ic. Stim­u­lus spend­ing, buy­ing debt, print­ing mon­ey, any­thing. It may not be a per­fect approach but it does have a track record of work­ing. But in our brave new world of the euro­zone, the only cen­tral bank in the euro­zone with the pow­er to buy bonds and issue euros is the ECB. And not only does the ECB not want to use its pow­er of lender of last resort. It’s man­dat­ed to do one thing only: main­tain “price-sta­bil­i­ty”. That’s a fan­cy way of say­ing “avoid infla­tion at all costs”. Defla­tion is fine, though...you can’t have “inter­nal deval­u­a­tion” with­out defla­tion. And the spe­cial funds set up to help “bailout” the PIIGS (the EFSF and the ESM) can’t actu­al­ly buy sov­er­eign debt them­selves. At least not unlim­it­ed amounts. Only the ECB could tech­ni­cal­ly engage in these activ­i­ties and be a “lender of last resort” but it’s man­dat­ed not to do so:

Thurs­day, July 5, 2012
Mar­shall Auer­back: All Roads Lead to the ECB

By Mar­shall Auer­back, a hedge fund man­ag­er and port­fo­lio strate­gist. Cross post­ed from New Eco­nom­ic Per­spec­tives

We’ve always been a fan of Pro­fes­sor Paul De Grauwe from Uni­ver­si­ty of Leu­ven, who has con­sis­tent­ly point­ed out the struc­tur­al flaws inher­ent in the orig­i­nal struc­tures of the EU. Recent­ly, Pro­fes­sor de Grauwe wrote an excel­lent analy­sis explain­ing why the lat­est “res­cue plan” cob­bled togeth­er by the Euro­zone author­i­ties is des­tined to fail.

The key points:

1) ECB is not cur­rent­ly a ‘lender of last resort’. The ECB was set up with fun­da­men­tal flaws, where “… one of the ECB’s main con­cerns is the defense of its bal­ance sheet qual­i­ty. That is, a con­cern about avoid­ing loss­es and show­ing pos­i­tive equi­ty- even if that leads to finan­cial insta­bil­i­ty.” This is a pro­found­ly mis­con­ceived idea. As we have not­ed many times, a pri­vate bank needs cap­i­tal – clear­ly because there are pru­den­tial reg­u­la­tions requir­ing that – but because it can become insol­vent. It has not cur­ren­cy-issu­ing capac­i­ty in its own right. While the ECB has an elab­o­rate for­mu­la for deter­min­ing how cap­i­tal is from the nation­al mem­ber banks at an intrin­sic lev­el, it has no need for cap­i­tal. It could oper­ate for­ev­er with a bal­ance sheet that if held by a pri­vate bank would sig­nal insol­ven­cy. There are no com­pa­ra­ble con­cepts for a cur­ren­cy issuer and a cur­ren­cy user in terms of sol­ven­cy. The lat­ter is always at risk of insol­ven­cy the for­mer nev­er, so the ECB’s focus on prof­itabil­i­ty is not only mis­guid­ed, but lead­ing to inad­e­quate pol­i­cy respons­es.

2) The cre­ation of the Euro­pean Finan­cial Sta­bil­i­ty Facil­i­ty (EFSF) and the ESM has been moti­vat­ed by the over­rid­ing con­cern of the ECB to pro­tect its bal­ance sheet and to avoid engag­ing in “fis­cal pol­i­cy”. The prob­lem again goes back to the cre­ation of the euro: no supra­na­tion­al fis­cal author­i­ty to go with a supra­na­tion­al cen­tral bank, which means that the only enti­ty that can con­ceiv­ably car­ry out “fis­cal trans­fers” of the sort exem­pli­fied by a bond buy­ing oper­a­tion is the ECB. Sure, the actu­al fis­cal trans­fers can be ’sub­con­tract­ed” to the EFSF and ulti­mate­ly the ESM, but it can only work if the latter’s bal­ance sheet is linked to the ECB’s, giv­ing it the same unlim­it­ed capac­i­ty to buy up the bonds and there­by deal with the insol­ven­cy issue. As things stand now, per de Grauwe: “The enlarged respon­si­bil­i­ties that are now giv­en to the ESM are to be seen as a cov­er-up of the fail­ure of the ECB to take up its respon­si­bil­i­ty of the guardian of finan­cial sta­bil­i­ty in the Euro­zone; a respon­si­bil­i­ty that only the ECB can ful­fill”.

3) Relat­ed to this prob­lem is the fact that the ESM has been giv­en only finite resources as per Germany’s stip­u­la­tion the minute it begins. It is cap­i­talised at 500bn euros. And it’s unclear that Ger­many can go much fur­ther, giv­en that there are cur­rent­ly 3 con­sti­tu­tion­al chal­lenges which the ESM is now fac­ing with­in Germany’s courts. This will delay rat­i­fi­ca­tion of the vote tak­en last week by Germany’s par­lia­ment to rat­i­fy the ESM’s exis­tence, as well as lim­it­ing its fire­pow­er going for­ward. The ESM’s “bazooka” is in effect a pop-gun. Con­se­quent­ly, as de Grauwe argues, “Investors will start fore­cast­ing the moment when the ESM will run out of cash. They will then do what one expects from clever peo­ple. They will sell bonds now rather than lat­er.”

As is clear from every FX cri­sis in the past, “A cen­tral bank that pegs the exchange rate and has a finite stock of inter­na­tion­al reserves to defend its cur­ren­cy against spec­u­la­tive attacks faces the same prob­lem. At some point, the stock of reserves is deplet­ed and the cen­tral bank has to stop defend­ing the cur­ren­cy. Spec­u­la­tors do not wait for that moment to hap­pen. They set in motion their spec­u­la­tive sales of the cur­ren­cy much before the moment of deple­tion, trig­ger­ing a self-ful­fill­ing cri­sis. “

Until Europe’s author­i­ties have this fig­ured out, the cri­sis will con­tin­ue. All roads lead back to the ECB.

Once again, the ECB sim­ply isn’t allowed do what the Fed­er­al Reserve of Bank of Japan can do because the ECB’s man­date is lim­it­ed to one thing: “price sta­bil­i­ty”. Fight­ing infla­tion is pret­ty much it’s one and only pri­or­i­ty. And not sur­pris­ing­ly, that’s also the only man­date of the Bun­des­bank. As the Bun­des­bank goes, so goes the ECB. The night­mare of the Weimar Repub­lic lives on, but in reverse and in neigh­bor­ing coun­tries.

So what is this new par­a­digm that we’re see­ing here? What is the les­son for the world that the ECB (Bun­des­bank) has in store for the rest of us? Well, in some ways this an unprece­dent­ed approach to cen­tral bank­ing and eco­nom­ic man­age­ment. In oth­er ways it’s old school. Aus­tri­an old school:

The Hang­over The­o­ry
Are reces­sions the inevitable pay­back for good times?

By Paul Krugman|Posted Fri­day, Dec. 4, 1998, at 3:30 AM ET

A few weeks ago, a jour­nal­ist devot­ed a sub­stan­tial part of a pro­file of yours tru­ly to my fail­ure to pay due atten­tion to the “Aus­tri­an the­o­ry” of the busi­ness cycle—a the­o­ry that I regard as being about as wor­thy of seri­ous study as the phlo­gis­ton the­o­ry of fire. Oh well. But the inci­dent set me thinking—not so much about that par­tic­u­lar the­o­ry as about the gen­er­al world­view behind it. Call it the over­in­vest­ment the­o­ry of reces­sions, or “liq­ui­da­tion­ism,” or just call it the “hang­over the­o­ry.” It is the idea that slumps are the price we pay for booms, that the suf­fer­ing the econ­o­my expe­ri­ences dur­ing a reces­sion is a nec­es­sary pun­ish­ment for the excess­es of the pre­vi­ous expan­sion.

The hang­over the­o­ry is per­verse­ly seductive—not because it offers an easy way out, but because it does­n’t. It turns the wig­gles on our charts into a moral­i­ty play, a tale of hubris and down­fall. And it offers adher­ents the spe­cial plea­sure of dis­pens­ing painful advice with a clear con­science, secure in the belief that they are not heart­less but mere­ly prac­tic­ing tough love.

Pow­er­ful as these seduc­tions may be, they must be resisted—for the hang­over the­o­ry is dis­as­trous­ly wrong­head­ed. Reces­sions are not nec­es­sary con­se­quences of booms. They can and should be fought, not with aus­ter­i­ty but with liberality—with poli­cies that encour­age peo­ple to spend more, not less. Nor is this mere­ly an aca­d­e­m­ic argu­ment: The hang­over the­o­ry can do real harm. Liq­ui­da­tion­ist views played an impor­tant role in the spread of the Great Depression—with Aus­tri­an the­o­rists such as Friedrich von Hayek and Joseph Schum­peter stren­u­ous­ly argu­ing, in the very depths of that depres­sion, against any attempt to restore “sham” pros­per­i­ty by expand­ing cred­it and the mon­ey sup­ply. And these same views are doing their bit to inhib­it recov­ery in the world’s depressed economies at this very moment.

The many vari­ants of the hang­over the­o­ry all go some­thing like this: In the begin­ning, an invest­ment boom gets out of hand. Maybe exces­sive mon­ey cre­ation or reck­less bank lend­ing dri­ves it, maybe it is sim­ply a mat­ter of irra­tional exu­ber­ance on the part of entre­pre­neurs. What­ev­er the rea­son, all that invest­ment leads to the cre­ation of too much capacity—of fac­to­ries that can­not find mar­kets, of office build­ings that can­not find ten­ants. Since con­struc­tion projects take time to com­plete, how­ev­er, the boom can pro­ceed for a while before its unsound­ness becomes appar­ent. Even­tu­al­ly, how­ev­er, real­i­ty strikes—investors go bust and invest­ment spend­ing col­laps­es. The result is a slump whose depth is in pro­por­tion to the pre­vi­ous excess­es. More­over, that slump is part of the nec­es­sary heal­ing process: The excess capac­i­ty gets worked off, prices and wages fall from their exces­sive boom lev­els, and only then is the econ­o­my ready to recov­er.

Except for that last bit about the virtues of reces­sions, this is not a bad sto­ry about invest­ment cycles. Any­one who has watched the ups and downs of, say, Boston’s real estate mar­ket over the past 20 years can tell you that episodes in which overop­ti­mism and over­build­ing are fol­lowed by a bleary-eyed morn­ing after are very much a part of real life. But let’s ask a seem­ing­ly sil­ly ques­tion: Why should the ups and downs of invest­ment demand lead to ups and downs in the econ­o­my as a whole? Don’t say that it’s obvious—although invest­ment cycles clear­ly are asso­ci­at­ed with econ­o­my­wide reces­sions and recov­er­ies in prac­tice, a the­o­ry is sup­posed to explain observed cor­re­la­tions, not just assume them. And in fact the key to the Key­ne­sian rev­o­lu­tion in eco­nom­ic thought—a rev­o­lu­tion that made hang­over the­o­ry in gen­er­al and Aus­tri­an the­o­ry in par­tic­u­lar as obso­lete as epicycles—was John May­nard Keynes’ real­iza­tion that the cru­cial ques­tion was not why invest­ment demand some­times declines, but why such declines cause the whole econ­o­my to slump.

Here’s the prob­lem: As a mat­ter of sim­ple arith­metic, total spend­ing in the econ­o­my is nec­es­sar­i­ly equal to total income (every sale is also a pur­chase, and vice ver­sa). So if peo­ple decide to spend less on invest­ment goods, does­n’t that mean that they must be decid­ing to spend more on con­sump­tion goods—implying that an invest­ment slump should always be accom­pa­nied by a cor­re­spond­ing con­sump­tion boom? And if so why should there be a rise in unem­ploy­ment?

Most mod­ern hang­over the­o­rists prob­a­bly don’t even real­ize this is a prob­lem for their sto­ry. Nor did those sup­pos­ed­ly deep Aus­tri­an the­o­rists answer the rid­dle. The best that von Hayek or Schum­peter could come up with was the vague sug­ges­tion that unem­ploy­ment was a fric­tion­al prob­lem cre­at­ed as the econ­o­my trans­ferred work­ers from a bloat­ed invest­ment goods sec­tor back to the pro­duc­tion of con­sumer goods. (Hence their oppo­si­tion to any attempt to increase demand: This would leave “part of the work of depres­sion undone,” since mass unem­ploy­ment was part of the process of “adapt­ing the struc­ture of pro­duc­tion.”) But in that case, why does­n’t the invest­ment boom—which pre­sum­ably requires a trans­fer of work­ers in the oppo­site direction—also gen­er­ate mass unem­ploy­ment? And any­way, this sto­ry bears lit­tle resem­blance to what actu­al­ly hap­pens in a reces­sion, when every industry—not just the invest­ment sector—normally con­tracts.

As is so often the case in eco­nom­ics (or for that mat­ter in any intel­lec­tu­al endeav­or), the expla­na­tion of how reces­sions can hap­pen, though arrived at only after an epic intel­lec­tu­al jour­ney, turns out to be extreme­ly sim­ple. A reces­sion hap­pens when, for what­ev­er rea­son, a large part of the pri­vate sec­tor tries to increase its cash reserves at the same time. Yet, for all its sim­plic­i­ty, the insight that a slump is about an excess demand for mon­ey makes non­sense of the whole hang­over the­o­ry. For if the prob­lem is that col­lec­tive­ly peo­ple want to hold more mon­ey than there is in cir­cu­la­tion, why not sim­ply increase the sup­ply of mon­ey? You may tell me that it’s not that sim­ple, that dur­ing the pre­vi­ous boom busi­ness­men made bad invest­ments and banks made bad loans. Well, fine. Junk the bad invest­ments and write off the bad loans. Why should this require that per­fect­ly good pro­duc­tive capac­i­ty be left idle?

The hang­over the­o­ry, then, turns out to be intel­lec­tu­al­ly inco­her­ent; nobody has man­aged to explain why bad invest­ments in the past require the unem­ploy­ment of good work­ers in the present. Yet the the­o­ry has pow­er­ful emo­tion­al appeal. Usu­al­ly that appeal is strongest for con­ser­v­a­tives, who can’t stand the thought that pos­i­tive action by gov­ern­ments (let alone—horrors!—printing mon­ey) can ever be a good idea. Some lib­er­tar­i­ans extol the Aus­tri­an the­o­ry, not because they have real­ly thought that the­o­ry through, but because they feel the need for some pres­ti­gious alter­na­tive to the per­ceived sta­tist impli­ca­tions of Key­ne­sian­ism. And some peo­ple prob­a­bly are attract­ed to Aus­tri­an­ism because they imag­ine that it deval­ues the intel­lec­tu­al pre­ten­sions of eco­nom­ics pro­fes­sors. But mod­er­ates and lib­er­als are not immune to the the­o­ry’s seduc­tive charms—especially when it gives them a chance to lec­ture oth­ers on their fail­ings.


Keep in mind that Paul Krug­man wrote the above cri­tique of the Aus­tri­an School of eco­nom­ics in 1998, a decade before the cur­rent cri­sis. It’s also an amaz­ing­ly pre­dic­tive cri­tique. What Krug­man wrote about the Aus­tri­an approach to eco­nom­ics is pret­ty much what has hap­pened: a finan­cial cri­sis was turned into a moral­i­ty play and the ensu­ing aus­ter­i­ty-poli­cies end­ed up tak­ing down entire nation­al economies. And with Krug­man now the biggest oppo­nent of this neo-Aus­tri­an School of eco­nom­ics, it’s no sur­prised that we end up see­ing lots of fan­fare over the “Krug­menistan vs Esto­nia” sto­ry. After all, if the ECB was to suc­cess­ful­ly save the euro­zone with aus­ter­i­ty alone, that would send a pow­er­ful mes­sage to all future economies around the globe that aus­ter­i­ty works. What’s we’re see­ing here isn’t Krug­menistan vs Esto­nia. It’s Krug­menistan vs Aus­te­ria. It’s the ulti­mate moral­i­ty play where the final moral of the sto­ry is that gov­ern­ment social spend­ing does­n’t work and only leads to dis­as­ter. We are being taught that cen­tral banks should­n’t step in to act as the lender of last resort. That will only put off the nec­es­sary pain required for prop­er reform. One can see how this is an emo­tion­al­ly com­pelling approach to macro­eco­nom­ics. And if you’re look­ing at the con­se­quences of this approach, one can see how it’s also a giant blun­der. An under­stand­able giant blun­der, sure, but still a giant blun­der. The Aus­tri­an School of eco­nom­ics isn’t just a piece of our past: it’s intend­ed to be our future too. Our blun­der­ous future.

So how is the euro­zone sup­posed to pro­ceed for­ward and not con­tin­ue on as a giant fis­cal trap for its denizens? Well, one approach would be for the ECB to drop the moral­i­ty play and act like a real cen­tral bank. We just got a sign today that the ECB may do just that when ECB head Mario Draghi announced that the ECB is ready to start buy­ing sov­er­eign bonds again. As he put it, “these are not emp­ty words now”. Then again, he also said that the ECB must still act with­in it’s mandate...the sin­gle man­date of fight­ing infla­tion. So these may, once again, be emp­ty words. Still, it’s progress.

But ECB bond buy­ing is still only a short-term solu­tion. The euro­zone needs a long-term solu­tion and tit-for-tat aus­ter­i­ty real­ly isn’t going to cut it. If the euro­zone mem­ber nations end up view­ing each oth­er as either moochers or cru­el aus­ter­i­ty freaks it’s just not going to work. So here’s a free tip bor­rowed from a bil­lion­aire: the euro­zone needs to remem­ber the birth lot­tery. It’s a sim­ple con­cept pop­u­lar­ized by bil­lion­aire War­ren Buf­fett and it’s one most use­ful best ideas the guy has ever had. Think of it like this: We don’t con­trol where we’re born, who our par­ents are, what our nat­ur­al traits might be (phys­i­cal­ly, IQ, etc), and real­ly much else. At least not until we get old­er and begin to make our own way in the world. And even once we become adults there is still an immense amount of our world that is well beyond our indi­vid­ual con­trol. So with that in mind, if you were a hypo­thet­i­cal future cit­i­zen of the euro­zone but you could­n’t con­trol any­thing about which coun­try you were born in and any of your oth­er nat­ur­al traits, how would you want that euro­zone to be struc­tured?

Here’s a sec­ond tip: Part of the Aus­tri­an School involves a fix­a­tion on the going back to the gold stan­dard. There are a lot of prob­lems with the gold stan­dard, but as is the case with aus­ter­i­ty-pol­i­tics there’s just an immense amount of emo­tion­al pull to the idea of a “hard” cur­ren­cy. Now, since human­i­ty is fac­ing an immi­nent nat­ur­al resource cri­sis, per­haps the aspir­ing Aus­tri­an School econ­o­mists could start focus­ing their men­tal efforts on some­thing much more use­ful: an vital nat­ur­al resources stan­dard. As they say, you can’t eat gold. Fresh water and top soil, on the oth­er hand, real­ly help with eat­ing. A mean­ing­ful nat­ur­al resources stan­dard would no doubt have a num­ber of prob­lems, but at least it’s not a dead end like gold. We’re all dead in the long run, but human­i­ty is dead if we don’t get this resource crunch under con­trol. That’s real aus­ter­i­ty.

Here’s a final tip, although it’s not real­ly for the euro­zone. It’s for Mitt Rom­ney. And it’s not real­ly a tip. It’s more of a dec­la­ra­tion: Mit­tens, you have some messed up friends.

Well, I guess we know whether of not the ECB’s recent change of heart is real or not. It’s not:

Bun­des­bank pours cold water on ECB bond buy hopes

FRANKFURT | Fri Jul 27, 2012 6:38am EDT

(Reuters) — Ger­many’s Bun­des­bank damp­ened expec­ta­tions for fur­ther action by the Euro­pean Cen­tral Bank on Fri­day by uphold­ing its resis­tance to the ECB buy­ing bonds, a day after ECB Pres­i­dent Mario Draghi raised expec­ta­tions such a move could be on the cards.

Draghi sent a strong sig­nal to mar­kets on Thurs­day that the ECB was prepar­ing fur­ther pol­i­cy action, say­ing that the ECB was ready, with­in its man­date, to do what­ev­er it takes to pre­serve the euro, refer­ring also to inflat­ed bor­row­ing costs, which some saw as a hint the bank could revive its bond pur­chase pro­gram.

The Bun­des­bank, which oppos­es the ECB’s Secu­ri­ties Mar­kets Pro­gram (SMP) because it treads too close to the cen­tral bank’s ulti­mate taboo of state financ­ing, said on Fri­day it was still not in favor of such a step.

“The Bun­des­bank con­tin­ues to view the SMP in a crit­i­cal fash­ion,” a Bun­des­bank spokesman said “The mech­a­nism of bond pur­chas­es is prob­lem­at­ic because it sets the wrong incen­tives.”

The ECB has spent more than 210 bil­lion euros on gov­ern­ment bonds, hav­ing bought them in the sec­ondary mar­ket.



52 comments for “Krugmenistan vs Austeria”

  1. House­keep­ing note: Com­ments 1–50 avail­able here.

    Posted by Pterrafractyl | July 13, 2016, 5:18 pm
  2. If you were expect­ing that the post-Brex­it envi­ron­ment in the EU was going to be at least some­what less aus­ter­i­ty-crazed so as not to lead to any addi­tion­al ‘-exits’, pre­pare to be dis­ap­point­ed. And if you live in Spain or Por­tu­gal pre­pared to be extra dis­ap­point­ed:


    EU declares Spain, Por­tu­gal in vio­la­tion of deficit rules

    By EurActiv.com with AFP

    Jul 7, 2016 (updat­ed: Jul 7, 2016)

    The Euro­pean Com­mis­sion on Thurs­day (7 July) offi­cial­ly declared Spain and Por­tu­gal in vio­la­tion of the EU rules on gov­ern­ment over­spend­ing, the first step towards unprece­dent­ed penal­ties against mem­bers of the 28-coun­try bloc.

    “The Com­mis­sion con­firms that Spain and Por­tu­gal will not cor­rect their exces­sive deficits by the rec­om­mend­ed dead­line,” the EU’s exec­u­tive arm said in a state­ment.

    If endorsed by the EU’s finance min­is­ters, the Com­mis­sion is then legal­ly oblig­ed to pro­pose fines against the two neigh­bour­ing coun­tries, which were both hit hard by the finan­cial cri­sis.

    “Late­ly, the two coun­tries have veered off track in the cor­rec­tion of their exces­sive deficits and have not met their bud­getary tar­gets,” said Vald­is Dom­brovskis, the EU Commission’s vice-pres­i­dent in charge of the euro.

    “We stand ready to work togeth­er with the Span­ish and Por­tuguese author­i­ties to define the best path ahead,” he said.

    Many EU pow­ers led by Ger­many have long hoped for the Com­mis­sion to final­ly crack down on pub­lic over­spenders, but with pop­ulist fires burn­ing after the Brex­it vote, min­is­ters meet­ing in Brus­sels on Tues­day could decide to delay their imme­di­ate endorse­ment.

    “There is uncer­tain­ty creep­ing in light of the UK vote result,” an EU diplo­mat told AFP.

    France and Italy will be the most will­ing to delay the penal­ty process, fear­ing that their own years of EU rule break­ing would put them next in line for a sanc­tion by Brus­sels.

    Ahead of the Com­mis­sion announce­ment, Por­tuguese Prime Min­is­ter Anto­nio Cos­ta warned that Brus­sels would fos­ter a rise in Euroscep­ti­cism in Por­tu­gal if EU sanc­tions are applied.

    In a let­ter to the Euro­pean Com­mis­sion, Cos­ta cit­ed “the results of the UK ref­er­en­dum and its impact on the Euro­pean Union” as rea­sons why the Com­mis­sion should refrain from full imple­men­ta­tion of the rules.


    In 2013, Spain received three extra years to cut its deficit below the manda­to­ry 3% of GDP of the pact.

    Despite the fact that this was the third time Madrid had been grant­ed lee­way since 2009, the deficit reached 5.1% of GDP in 2015, high­er than pre­vi­ous­ly announced.

    The Euro­pean Com­mis­sion’s lat­est fore­cast pre­dicts that the Span­ish deficit will be 3.9% of GDP this year and 3.1% in 2017.

    In April, the exec­u­tive and the ECB con­clud­ed that the need­ed progress on fis­cal con­sol­i­da­tion in Spain “has come to a halt, with part of the struc­tur­al adjust­ment imple­ment­ed in ear­li­er years being reversed”.

    Fol­low­ing the elec­tions on 4 Octo­ber, a three-par­ty coali­tion led by the Social­ist Par­ty came to pow­er in Por­tu­gal. The new gov­ern­ment failed to sub­mit its draft bud­get for 2016 by 15 Octo­ber, as the EU’s fis­cal rules said, and sent the draft pro­pos­al only on 22 Jan­u­ary 2016.

    After assess­ing the first draft, the Com­mis­sion con­clud­ed that the bud­get was “in clear breach of the Sta­bil­i­ty and Growth Pact”, and request­ed more mea­sures.


    “Many EU pow­ers led by Ger­many have long hoped for the Com­mis­sion to final­ly crack down on pub­lic over­spenders, but with pop­ulist fires burn­ing after the Brex­it vote, min­is­ters meet­ing in Brus­sels on Tues­day could decide to delay their imme­di­ate endorse­ment.”

    Deficits too high? That’s fine. Or rather, that’s a fine. Gee, why is there so much antipa­thy towards the EU these days?

    Still, the Euro­pean Com­mis­sion still has to endorse the sanc­tions and if the EU’s finance min­is­ters endorse the plan, the Com­mis­sion is legal­ly man­dat­ed to do so. Sur­prise! The EU’s finance min­is­ters backed the sanc­tions:


    EU backs sanc­tions on Por­tu­gal, Spain for break­ing deficit rules

    Hol­ly Elly­att | Katy Bar­na­to
    Tues­day, 12 Jul 2016 | 11:00 AM ET

    Finance min­is­ters of the Euro­pean Union (EU) backed sanc­tions on Spain and Por­tu­gal for breach­ing Euro­pean rules on bud­get deficit tar­gets on Tues­day.

    “The Coun­cil found that Por­tu­gal and Spain had not tak­en effec­tive action in response to its rec­om­men­da­tions on mea­sures to cor­rect their exces­sive deficits ... The Coun­cil’s deci­sions will trig­ger sanc­tions under the exces­sive deficit pro­ce­dure,” the Euro­pean Coun­cil said in a state­ment on its web­site on Tues­day.

    The deci­sion came after a meet­ing in Brus­sels on Tues­day of the EU’s eco­nom­ic and finan­cial affairs coun­cil (or Ecofin), made up of eco­nom­ic and finance min­is­ters from the bloc.They met to dis­cuss if Spain and Por­tu­gal should be sanc­tioned for breach­ing rules stat­ing that coun­tries’ bud­get deficits must remain with­in 3 per­cent of gross domes­tic prod­uct (GDP).

    The Euro­pean Com­mis­sion — the exec­u­tive arm of the EU — now has 20 days to rec­om­mend if fines should be imposed.

    “Those fines should amount to 0.2 per­cent of GDP, though Por­tu­gal and Spain can sub­mit rea­soned requests with­in 10 days for a reduc­tion of the fines,” the coun­cil said in its state­ment on Tues­day.

    How­ev­er, Spain’s act­ing econ­o­my min­is­ter, Luis de Guin­dos, said he believed any fines imposed would be “null or zero,” accord­ing to Reuters.

    He added that Spain would revise cor­po­rate tax reg­u­la­tion to knock 6 bil­lion euros ($7.9 bil­lion) off the state bud­get and would save anoth­er 1.5 bil­lion euros through low inter­est rates on pub­lic debt, accord­ing to Reuters.

    De Guin­dos told CNBC on Tues­day that he was sure Spain could get its deficit below three per­cent by 2017.

    “With respect to the sit­u­a­tion for Spain it would be some­thing of a para­dox to impose a finan­cial penal­ty to the best-per­form­ing Euro­pean econ­o­my, which is Spain. And I think this con­sid­er­a­tion is shared by many peo­ple, not only at the Eurogroup but also at the Ecofin,” he told CNBC on Tues­day.


    Spain’s head­line deficit peaked at 11 per­cent in 2009 dur­ing the height of the finan­cial cri­sis, before falling to 10.4 per­cent of GDP in 2012 and 5.1 per­cent in 2015, while the rec­om­mend­ed tar­get for 2015 was 4.2 per­cent of GDP. Por­tu­gal, mean­while, saw its head­line deficit decline from 11.2 per­cent of GDP in 2010 to 4.4 per­cent in 2015, while the rec­om­mend­ed tar­get for 2015 was 2.5 per­cent of GDP.

    How­ev­er, EU offi­cials are wary to impose fines on coun­tries that are still recov­er­ing from the finan­cial cri­sis. There is also lit­tle polit­i­cal appetite to do any­thing that could increase anti-EU sen­ti­ment, par­tic­u­lar­ly after euroskep­ti­cism led to a major­i­ty of Britons vot­ing to leave the EU last month.

    Por­tu­gal’s Finance Min­is­ter Mario Cen­teno told CNBC on Mon­day that sanc­tions would not be appro­pri­ate, but stopped short of call­ing Por­tu­gal’s treat­ment unfair.

    “We will do our job, which is pre­cise­ly to argue in favor of no sanc­tions for Por­tu­gal — at least a very low lev­el of sanc­tions. The point here is we do have our incen­tives right and we are very much com­mit­ted to our fis­cal con­sol­i­da­tion,” Cen­tano said.

    Pierre Moscovi­ci, Euro­pean com­mis­sion­er for eco­nom­ic affairs, told CNBC on Mon­day that the Com­mis­sion want­ed to act in a “cred­i­ble” man­ner.

    “This Com­mis­sion wants to respect the rules. This Com­mis­sion wants to be cred­i­ble and sta­bil­i­ty is our road map … We don’t want to penal­ize economies in recov­ery and we know that Por­tu­gal and Spain suf­fered from a severe cri­sis and the pri­or­i­ty for them is to reduce unem­ploy­ment. So dia­logue is a good qual­i­ty,” he said.

    He added that the threat of sanc­tions alone “prob­a­bly will lead to a stronger cor­rec­tion and to a clear­er point of view.”

    France and Italy

    Spain and Por­tu­gal are by no means the only or indeed worst offend­ers when it comes to break­ing EU deficit rules.

    France and Italy (the euro zone’s sec­ond- and third-largest economies respec­tive­ly) have come under repeat­ed fire for break­ing deficit rules.

    France now has until 2017 to bring its deficit into line — it looks set to achieve it hav­ing reached a deficit of 3.5 per­cent in 2015.

    Mean­while, Italy won what Dom­brovskis called an “unprece­dent­ed amount of flex­i­bil­i­ty” from the Com­mis­sion in May that gave it more time and lee­way to meet bud­get deficit tar­gets.

    Eye­brows have been raised over the Com­mis­sion’s appar­ent tol­er­ance for rule-break­ing (or reluc­tance to pun­ish offend­ers).

    The Ifo Insti­tute not­ed last month that since 1999 there had been 165 instances of EU states break­ing the deficit rules. Ifo Pres­i­dent Clemens Fuest said the amount of deficit vio­la­tions was “aston­ish­ing” and showed the rules were not work­ing.

    The Munich-based insti­tute list­ed the worst vio­la­tors of deficit rules and France topped the list with 11 vio­la­tions, ahead of Greece, Por­tu­gal and Poland with 10 each. The U.K. had nine vio­la­tions, Italy (eight), Hun­gary (sev­en) and Ire­land and Ger­many had five each.

    “In con­trast, strong bud­getary dis­ci­pline was evi­dent in Lux­em­bourg, Esto­nia, Fin­land, Den­mark and Swe­den, each with zero vio­la­tions,” Ifo said. Its cal­cu­la­tions were based on fig­ures from the EU Com­mis­sion between 1999 to 2015.

    The Ifo Insti­tute not­ed last month that since 1999 there had been 165 instances of EU states break­ing the deficit rules. Ifo Pres­i­dent Clemens Fuest said the amount of deficit vio­la­tions was “aston­ish­ing” and showed the rules were not work­ing.”

    Yep, Spain and Por­tu­gal, two of the hard­est hit EU mem­bers, get to be the test sub­jects in the first attempt to use “raise deficits in order to pro­vide the incen­tives to low­er them” tech­nique for forc­ing mem­ber states to get their deficits below 3 per­cent. But as we can see, this is obvi­ous­ly just the start of what is expect­ed to be a reg­u­lar occur­rence. Sanc­tion­ing mem­bers as they crawl out of Depres­sion-lev­el eco­nom­ic cat­a­stro­phes is very much part of the vision of the future EU.

    And now that Spain and Por­tu­gal are get­ting sanc­tioned, it’s going to be per­ceived as wild­ly unfair if this treat­ment isn’t rapid­ly applied to oth­er mem­ber states like France and Italy. So, in the imme­di­ate post-Brex­it envi­ron­ment, it looks like EU has already cre­at­ed for itself a dynam­ic where the EU had bet­ter start a sanc­tion-spree, specif­i­cal­ly tar­get­ing the the most eco­nom­i­cal­ly pre­car­i­ous economies, if it’s going to cre­ate a sense of fair­ness and sol­i­dar­i­ty and shore up anti-‘exit’ sen­ti­ments. Oops.

    Posted by Pterrafractyl | July 13, 2016, 5:19 pm

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