As the European economic crisis continues and even grows deeper, the EU responds with measures that are anything from irrelevant to entirely counter-productive. The austerity policies that the EU and the ECB are forcing upon troubled member states belong in the latter category, right out at the edge of political sanity. Almost as ridiculously self-defeating is the new EU bailout scheme for deficit-ridden state governments. Referred to as a “rescue fund”, this program is going to buy treasury bonds from governments in order to keep the interest rates down on the loans that those governments have to take to cover their deficits.
This rescue fund has not yet been activated, but that could very well happen soon. EurActiv has the story:
Spanish Prime Minister Mariano Rajoy kept financial markets guessing yesterday (29 October) over whether he will seek a credit line from the eurozone’s rescue fund but said he would do so “when I think it is in the interests of Spain”. … [Italian Prime Minister Mario] Monti said it was vital that the European Central Bank’s bond-buying programme to support troubled states be activated, a strong hint that Spain should take the plunge, since he also said Italy did not need a bailout. “It is of paramount importance that the instrument is put to work, that it does not remain theoretical,” Monti said. Monti said earlier this month that if Spain were to request a credit line from the eurozone’s rescue fund, triggering ECB intervention, it would calm financial markets. While Rajoy maintained his ambiguity, he omitted previous demands to know more details of the ECB’s bond-buying plan before making up his mind.
The “rescue fund” is self-defeating and counter-productive for two reasons. First, it pumps out newly printed euros – i.e., increases money supply – at a time when demand for money is very low. The short-term effect of this is a depreciation pressure on the euro: when the euro falls vs. other big currencies, import prices start rising. This creates an import-price driven inflation threat at a time when the economy is at the trough of a recession.
Long term, printing money creates a domestic inflation pressure. It is unlikely that this will happen throughout the euro zone, but if this bailout scheme – sorry, “rescue fund” – is going to continue to buy, e.g., Spanish treasury bonds in perpetuity, the effect will be similar to that which has brought about dangerous levels of inflation in countries like Argentina and Venezuela.
Which brings us to the second reason why the rescue fund idea is self-defeating. The fund essentially promises to feed government spending with expanding money supply. (It is extremely unlikely that the fund can sustain for any period of time if funded by tax revenues.) The practical meaning of this is that welfare states like Greece, Spain, Portugal and Italy can continue to dole out entitlements – work-free income – to large groups of their citizens. These entitlements are then used to pay for daily expenses, which of course keeps consumer demand at a reasonable level. But the flip side is that the more people are allowed to remain on entitlements, the fewer people will participate in the work force. As fewer participate in the work force, there will be less production to go around, which means less supply compared to demand – an inflation driver right there – and fewer taxpayers.
As the taxpaying population shrinks, whether in absolute or relative terms, the government’s need for more rescue-fund bailout cash persists and even increases. The EU digs itself into a hole of endless money supply expansion, and its only collateral will be treasury bonds that will be in such abundant supply that you would have to pay people to take them off your hands.
It is rather disturbing that the prime ministers of Italy and Spain can discuss the “rescue fund” so casually, without even hinting at any of the problems associated with it.
Perhaps they are blinded by the short-term effect on interest rates that this and similar schemes can have. EurActiv again:
Rome’s borrowing costs have fallen since July, partly due to the European Central Bank’s pledge to buy unlimited quantities of bonds if necessary to help states that request aid and accept strict conditions, but also on hopes that Monti may stay on after next year’s general election.
But, says the report, there are other factors at work that erode any gains from this reckless “rescue fund” commitment:
Italian and Spanish bond yields rose on Monday, partly due to uncertainty in the eurozone’s recession-stricken third and fourth largest economies. But Italy paid less than a month ago to sell €8 billion of six-month bill. The euro also slipped on doubts over whether Greece, the country that triggered Europe’s debt crisis, can agree to a deal on new austerity measures and its international lenders can figure out how to make its huge debts sustainable.
And that is precisely the question that no one wants to answer. The reason is simple: if Europe’s political leaders were to actually take a close look at the crisis they are struggling with, they would inevitably reach the conclusion that the cause is the welfare state and its conglomerate of over-promising, work-discouraging entitlement programs. That, however, would require a fundamental course correction in European politics, in the public policy debate and in how Europeans in general live their lives.
Nevertheless, the only way out for Europe is to structurally reform away its welfare state. Otherwise, the entire continent will be crushed under the pressure from, on the one hand, those who want to raise taxes to save the welfare state and, on the other hand, those who want to save the welfare state with austerity-driven spending cuts. Both strategies are destructive and entirely counter-productive: higher taxes depress private-sector activity and erode the tax base; spending cuts reduce government spending without cutting taxes, thus raising the government’s net burden on the private sector.
There is ample evidence around Europe of what austerity does to a country. In addition to the most obvious disaster, Greece, the Spanish crisis offers a disturbing but important case study. The national government is doing its very best to force austerity upon the regions, something that works well – from a strictly administrative viewpoint – in a centralized nation-state like Greece (or Sweden, which was put through the grinders of austerity in the ’90s). But Spain is not a traditional nation state: its provinces are autonomous to a point where the country more resembles a federation than anything else.
Because of their relative independence, the Spanish provinces are pushing back against the national austerity agenda. I discussed this problem in September. A more elaborate analysis is offered by Helena Spongenberg of the EU Observer:
The result of Sunday’s regional elections in northern Spain has given Madrid a bit of breathing space and support for the austerity measures needed to put the fifth largest economy in the European Union back on track. But it has also given the conservative government a bit of a headache when it comes to Spain’s continued unity.
In addition to the problems with keeping Catalonia from seceding, the national government has to deal with the two northern provinces of Galicia and the Basque Country. Both held regional elections on October 21, and as Spongenberg explains, partly as a result of the election outcomes the two regions respond quite differently to the austerity efforts:
The past year’s austerity measures taken by the current Spanish government – led by President Mariano Rajoy’s centre-right Partido Popular – got the thumbs up in Galicia. … [It] was feared that voters in Galicia would take their anger of Madrid’s severe budget cuts out at the polls, as it happened at the regional election in Andalusia in March when the Social Democrats defeated PP. The fears were unfounded and PP has even increased its absolute majority gaining 41 (previously 38) seats out of 75 in the Galician Parliament. … The election in the Basque Country, however, turned out as expected – or rather, as feared by the government in Madrid. Two out of three lawmakers in the Basque Parliament are now Basque nationalists – 48 seats out of 75. … The moderate nationalist party PNV was the overall winner with 27 seats, and is set to form a minority government in Vitoria … PNV backs further regional autonomy from Madrid, but [PNV leader] Urkullu also promised in the election rally to bring a new law on Basque independence to a referendum in 2015.
Spongenberg sees this as a temporary mandate for the national government to…
…go ahead with further austerity measures. But Rajoy can hardly relax for long. Spain is in its second recession since the crisis began in 2008; an economic bailout of the country is imminent; another general strike is set for November 14th; and the separatists in Catalonia are expected to win the elections on November 25th.
The question that Spanish voters should ask themselves is whether or not the welfare state is so dear to them that they are willing to risk the unity of their country to save it. That is, after all, the essence of what the national government is saying when it continues to impose austerity on the Spanish economy.
As I explained above, there is no alternative in relying on the “rescue fund” as an alternative to austerity. Not only does the “rescue fund” come with all the negative consequences outlined here, but the Spanish government will in all likelihood have to double down on its austerity policies in order to get any money. That would create a double-whammy for the Spanish economy: short-term destruction of growth and jobs, and long-term threats of inflation.
It is sad to see an entire continent commit macroeconomic suicide. It is even sadder when it is happening in the name of an ideology. But the saddest part of it all is that the alternative – structural reform to end the welfare state – could so easily be done, with excellent results for everyone, especially the poor, needy and unemployed.
For a first glimpse of how this can be done, from an American perspective, click here.