Stephen King: Euro meltdown would pave the way for another Great Depression
Outlook: Imagine that Europe is unable to agree on a convincing solution. What sort of system would we be left with?
Monday 17 October 2011
The euro's future is all our futures. Whether or not you like the single currency, the world economy's health depends on its survival. Should the euro collapse, we will find ourselves heading into another Great Depression.
Its establishment removed the currency risk which had inhibited investment across the eurozone. Suddenly, a single European capital market became a reality. Germans could invest in Italy, Spaniards could invest in France and Belgians could invest in Portugal. National borders which had so limited economic opportunity simply dissolved.
Its arrival led, within Europe, to a turbocharged version of globalisation. But it was an unstable version: the abolition of multiple currencies also led to the emergence of massive imbalances.
German exports went through the roof. Partly this was luck: Germany happened to make a lot of capital goods, precisely the kinds of things in demand in China and elsewhere. German exports also did well because its companies maintained strict control over their labour costs even though they no longer had to face the tyranny of Deutsche Mark appreciation.
The rise in exports could have persuaded Germans to live the good life. They might have spent the benefits of their new-found competitiveness on consumer goods, sucking in more imports and keeping their balance of payments position in check. They decided, instead, to save the income and their trade surplus soared.
For Germans, a big trade surplus is a sign of success, so much so that many in Berlin think others should follow their example. While it's a familiar lament, it is also economically illiterate. For every German trade surplus, there has to be an offsetting deficit elsewhere in the world. Everyone cannot follow the German model. Indeed, the bigger the German surplus, the more other countries will have to head in the opposite direction.
Although we tend to think about trade surpluses and deficits in terms of competitiveness, this is mostly the wrong approach. A country that manages to sell more exports may be more competitive than it was previously, but that in no way implies that it should refuse to buy more imports. Indeed, it may be that two countries both become more competitive simultaneously, allowing them to export more to each other with no impact on their balance of payments position.
In truth, surpluses and deficits are much more about the balance between domestic savings and investment. If Germans want to save more than they invest, they may end up with a balance of payments current account surplus regardless of their competitiveness. The surplus savings may leak abroad and end up funding someone else's current account deficit.
Over time, Germany has lent more while countries like Italy have borrowed more. But to know what's caused what, we need to look at the capital markets. If lenders chose to increase lending and had to persuade borrowers to borrow more, interest rates would have to fall. If, instead, borrowers chose to increase their borrowing and had to persuade lenders to lend more, interest rates would have to go up.
For much of the euro's life, the story has been much more about the generosity of lenders than the desperation of borrowers. Until the 2008 crisis, interest rates on peripheral debt fell lower and lower. In effect, Germany's export success was generating higher surplus savings which had to find a home. With the end of currency risk, these savings went south, forcing interest rates in Italy, Spain and elsewhere downwards. As rates fell, so southern European nations borrowed more.
Unfortunately, the crisis then intervened. Incomes ended up lower than expected and the ability of southern debtors to repay their northern creditors was seriously impaired. The creditors chose to blame those in the south for having borrowed too much. Yet, it was at least as much a story about the creditors having lent too much. Demanding austerity from the south was all very well but it was hardly the fairest way of sharing the burden.
Moreover, it hasn't worked. Many investors now believe that, in the absence of common cause between north and south, the euro will be torn apart. And they're making their own contribution to the process. They sell Italian bonds while buying their German counterparts, figuring that, in a post-euro world, a new Italian currency would fall against a new German currency. And they sell the institutions that own Italian bonds. In the absence of political unity, we end up with financial mayhem.
Imagine that Europe is unable to agree on a convincing solution. Imagine that the anti-euro bets increase and that the single currency crumbles. What sort of financial system would we be left with?
With the reintroduction of currency risk, financial institutions would have to unwind a huge chunk of their cross-border holdings. There would be no point investing French pensions in Italian lira assets if a newly-introduced lira were to find itself constantly falling against the currencies of northern Europe. It would leave French pensioners seriously short of French franc savings. There would also be massive legal uncertainty. If the euro disappeared, how would an Italian bond issued in euros and owned by a French institution be valued?
The rush to unwind would create massive doubts over the health of individual institutions, leading to a drying-up of credit. Lending would collapse, bankruptcies would soar and co-ordination among European policymakers would be nigh-on impossible to achieve. We would face financial anarchy on a scale big enough to throw Europe – and much of the rest of the world – into another Great Depression.
So we need a solution. And it's a solution that must accept collective responsibility. The north may want to blame the south but that is the wrong strategy. In the event of a euro meltdown, the northern creditors would suffer as much as anyone else. Berlin and Paris will now have to take political risks to come up with a solution. But it's better to take political risks – including a sharing of the burden between creditors and debtors – than to face monumental economic failure.
Stephen King is the global chief economist at HSBC
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