Introduction

The European Central Bank (ECB) just announced a $70 billion per month bond buying plan. And Greece will probably elect an anti-austerity government on Sunday. Neither will do much to remedy the problems of the Eurozone.

Why Great Hopes for ECB Bond Buying Are Nonsense

Peter Praet is the chief economist of the ECB. Here is his explanation for the bond-buying plan:

“…our monetary policy was no longer having the effect on private borrowing costs to which we were accustomed. It was obvious that the lending channels in the banking system had become dysfunctional; excessively restrictive borrowing conditions were suppressing demand. In response, the ECB did precisely what any central bank would have done: we acted…to bring down the average rate that households and firms have to pay….[and] we introduced a series of targeted longer-term refinancing operations to provide funding for banks at very low fixed rates for a period of up to four years…. Together, these measures offer a powerful response that addresses the root causes of impaired bank lending, thereby facilitating new credit flows to the real economy.

Praet should know better. He got a Ph.D. in economics from the Université libre de Bruxelles. Somewhere along the line, he must have read Keynes on “liquidity traps.” Liquidity traps occur when injections of cash into an economy by a central bank fail to result in more spending because interest rates fall. The spending problem in the Eurozone has very little to do with interest rate levels or problems with the banking system. With an overall unemployment rate of more than 11% and two countries with rates over 20%, nobody in their right mind wants to borrow to spend more on consumption or investment in the Eurozone!

Increased government expenditures are the only policy that would get the Eurozone out of its current quagmire. And with the German emphasis on austerity, that will not happen. So maybe I am being too tough on Praet. Maybe he, like Bernanke a few years back, knew the Germans would not allow pump priming, and so he tried to put the best face he could on monetary easing.

The Greek Election

Under pressure from Eurozone countries, Greece has eliminated its government deficit. This deflationary policy is the main reason its overall unemployment rate is still above 25% with 50% of young people out of work. The Greek people want a change, and they believe the Syriza party will bring it. But what can Syriza really offer?

Ms. Rena Dourou, a spokesman for Syriza, said the following: “Is it really right for thousands of people to commit suicide because of austerity policies? Is it really right that a whole people has to pay the heavy price for a completely wrong policy?" But she added that Greece would pay its debts and described the prospect of a “Grexit” – a Greek exit from the Eurozone and a return to the drachma – as “simple scaremongering” by the government. "We need policies which can bring about social justice and equality. That’s what the Greek people are about to vote for.”

Sadly, suggestions on exactly what Greece should do in the post-austerity era are few and far between. We hear talk of economic reforms, but what does this really mean? To answer this question, I quote from a 2012 IMF statement. While this document applies to Spain, the IMF tried the same thing in Greece.

To restore growth across the union, long-standing structural rigidities need to be tackled to raise long-term growth prospects. In many countries, labor market reforms are needed to raise participation and address disparities in protection that confine “outsiders” (typically younger workers) to low-wage, temporary jobs….targeted investment in infrastructure and human capital will support growth and employment. Lowering unit labor costs in the tradables sector is essential for deficit countries. This means productivity-enhancing reforms (e.g., lowering barriers to entry, making it easier for small firms to expand into foreign markets) and labor market measures that ensure that nominal wage developments are aligned with productivity growth.

These economic reform steps were tried by the IMF in Greece and failed. As long as Greece uses the Euro, the only reform that could solve Greece’s problems would be to make its economy as productive as Germany’s. That means the corruption, feather bedding, subsidies, and other features endemic in Greece would have to be removed. And that is not going to happen.

And note this important point: Reforms have been offered as a substitute for the Greek austerity. But in fact, eliminating corruption, feather bedding, and subsidies would mean reducing Greek income and that would cause Greek unemployment to rise. In short, most of the proposed reforms are nothing more than austerity in different clothing.

Another troubling question: How, exactly, is Greece going to pay its debts that amount to 170% of its GDP ($360 billion)? The IMF some time ago parted company with Germany and said debt relief for Greece is essential. I have heard no talk from Euro members about forgiving this debt. Of course, the ECB could use 5+ months of its bond buying to buy all of Greece’s debt….

Economic Viewpoints

Leading economists are as pessimist as I am about the future of the Eurozone. Nouriel Roubini compared the European problems with those in Japan: “But, in fact, the risks in Europe are even worse. While the Japanese have stagnated, Japan has not suffered the sort of debt crisis that’s affected the Eurozone. This is because, unlike the Eurozone, the Bank of Japan has the flexibility and willingness to monetize debt and print money.” Roubini also talks of “Asymmetric Adjustment”. “In the Eurozone, this means that countries that tend to spend too much (for example, Greece and Italy) and those that tend to save too much (for example, Germany and The Netherlands) both get hurt when the flow of money ceases. When a shock to the economy arrives, the lending tends to dry up. In this scenario, debtor countries are forced to spend less — but nothing forces the lending countries to adjust and save less.” Roubini concludes” “In short, Germany, and other core Eurozone nations like The Netherlands, don’t want to get stuck in a transfer union where they might be forced to subsidize Portugal and Italy and Greece and Spain forever. If Europe wants to avoid becoming the Florida of the world—a peninsula full of vacationers and retirees—then it must urgently consider radical reforms.”

Joseph Stiglitz has expressed similar views:

The EU’s malaise is self-inflicted, owing to an unprecedented succession of bad economic decisions, beginning with the creation of the euro. Though intended to unite Europe, in the end the euro has divided it; and, in the absence of the political will to create the institutions that would enable a single currency to work, the damage is not being undone. Though intended to unite Europe, in the end the euro has divided it; and, in the absence of the political will to create the institutions that would enable a single currency to work, the damage is not being undone…. The issue is not Greece. It is Europe. If Europe does not change its ways – if it does not reform the Eurozone and repeal austerity – a popular backlash will become inevitable. Greece may stay the course this time. But this economic madness cannot continue forever. Democracy will not permit it. But how much more pain will Europe have to endure before reason is restored?

The Fundamental Eurozone Problem

Many people do not understand the fundamental economic problem in the Eurozone. The following simplified example makes the point. If Germany can produce a product more cheaply than Greece, everyone, including Greeks, will buy the product from Germany. Now if Greece and Germany had their own currencies, their relative values would adjust (the Greek currency would weaken relative to Germany’s) so Greece could sell its product. However, if they both must use the same currency, this “adjustment vehicle” will not work. The result for Greece is that it buys all its goods from Germany, its unemployment rises and it literally runs out of money (€s). The only way to rectify this situation? As suggested above, Greece would have to implement economic reforms that make Greece competitive with Germany. But don’t hold your breath on this; it won’t happen.  

The Solution

At the very least, Greece and other “weak sisters” should pull out of the Eurozone and go back to their own currencies. In 2011, I wrote a letter to the leaders of Greece, Spain and Portugal on how to pull out. No doubt, these will be complex and disruptive undertakings. But there are no alternatives, unless, as Roubini has suggested, Europe wants to become the “Florida” of the world.

Postscript: Germany Does Not Escape Austerity Effects

Those who oppose Germany’s steadfast insistence on austerity can take some satisfaction in what has happened to German exports. As Table 1 indicates, German exports to many European countries have fallen significantly. In 2007, exports to these countries constituted 31% of German exports. By 2013, that share had fallen to 23% as exports to these countries had fallen by 18%.

Table 1. – German Exports to Selected European Countries

Source: UN Comtrade