Great Recession and the mechanics of a Euro Breakup (wonkish)

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Yesterday, Saturday February 18, 2012, I received an email from the chief editor of Variant Perception, a global macroeconomic research group, informing me on their latest research paper titled “A Primer on the Euro Breakup”. I was kindly asked to redistribute their work, so I thought the best way to do so would be, by publishing this article in which I will expand on issues related to a potential breakup of the Eurozone, the mechanics of deflation and the origins of the Great Recession.

The people at Variant Perception consider “default, exit and devaluation” as the optimal strategy for countries currently mired in a deep recession and seen as insolvent, like Greece and Portugal; as well as for countries that are hardly pressed, yet are considered to be illiquid rather than insolvent, like Italy and Spain. In short the drafters of the “A Primer on the Euro Breakup” argue that exiting the euro would not have the cataclysmic implications many economists across the globe argue it would. They provide historical data of other breakups of currency unions, arguing that the macroeconomic indicators show that these can occur with little short-term pain and considerable long-term gain.

After reading their paper I may say that I disagree both with their diagnosis and their conclusions. However I am perfectly willing to republish their work, as I consider it very important to elaborate on alternative solutions to the crisis or to other versions of the broader “truth”. In addition I am always in favor of a healthy dialogue, even when the participating views are diametrically opposed.

What follow is the report of Variant Perception titled “A Primer on the Euro Breakup” and then my article, in which I shall lay down my views on the broader issue, without however engaging in a direct commentary of the paper of Variant Perception. Their work has offered me the incentive to bring together my views on issues that I have already explained in previous articles of mine.

VP – February 2012 – Eurozone Breakup – Summary

What follows are my views, which are separated into sections to facilitate the reader.


  • Intro and methodology: Approaching a complex issue
  • The origins of the Great Recession and the Eurocrisis
  • Deflation and the “debt-deflationary spiral”
  • Redesigning instead of breakup
  • The mechanics of a Eurozone breakup and concluding remarks

I. Intro and methodology: Approaching a complex issue

In approaching a complex issue, such as the systemic crisis of the euro, one needs to bear in mind that no easy answers exist. Using methods that shed light only on one facet of the matter, might be correct in terms of scientific approach, but can easily lead to false conclusions when policy is concerned. In particular one always needs to be skeptical about the researches of any single discipline on the matter in question, given two fundamental problems that exist:

  1. The general: Social sciences, such as political science, sociology, economics (yes it’s a social science) are profoundly different from positive sciences. In positive sciences natural laws might be discovered and constants may be identified, through empirical research. As such, we know that water will always evaporate once it has reached a particular temperature, or an apple will always fall in a given way when there is gravity and so on. In social sciences this is not the case, since the subject of study is the human being, which is far more complex than natural phenomena, as it is unpredictable. This should not imply that social sciences are not “sciences”, nor that there is nothing we can learn from studying human behavior. To the contrary social sciences have helped us immensely to further develop our civilization. Yet it is important to comprehend the difference between the two branches of science, in order to realize that prediction is much harder, when the subject in question is the human being – more so when we are dealing with collections of humans (societies, economy etc.).
  2. The particular: The science of economics has not yet developed effective tools that allow for pinpoint estimates, nor does it possess a coherent framework that allows for a deep understanding of the actions of human beings, their interconnections and their (co)relations. This is especially true when speaking of macroeconomics, i.e. the field that studies economic aggregates such as GDP. The indices that are widely used by macroeconomics are more than imperfect and must always be used with caution. In addition they are aggregates which tell us little about the dynamics of the forces that compose them (the individuals), while they can easily mislead us a lot. Policies that have relied on macroeconomic indices have time and again proven to be problematic and largely ineffective in reaching their goals. The European Union and the Eurozone in particular provides one such example: The Stability and Growth Pact. It is the set of macroeconomic criteria that need to be met for a state to be part of the eurozone. Such criteria are the debt ratio, the budget deficit, inflation and long-term interest rates. The failure of the SGP to prevent the current systemic crisis of the euro is a clear sign of its flawed scope and method (instead of revising their original idea, European policy-makers are now planning to repeat the same mistake by implementing the new treaty, the fiscal compact, which is more of the same).

With the above two in mind, I may say that in approaching a highly complex issue such as the systemic crisis of the Euro, we need to be aware that we can easily reach wrong conclusion if we focus on one side of the matter, especially if that is done with the use of imperfect tools, such as macroeconomics. I am not saying that the conclusions will necessarily be wrong, nor am I suggesting the abolition of specialized studies in facets of a given issue. I am only stressing the need for a different approach in making policy proposals, one that views the subject from many perspectives.

This is perhaps the main reason why many policy papers that have been published in the past by prolific academics or think tanks have failed to take material form – they are one-sided, thus apolitical. As such I personally am very skeptical in using macroeconomic indices to see how the world works, while I am also hesitant to rely on historical data of other currency unions, since the conditions are profoundly different, as each case is in fact unique – and the eurozone is seen by the vast majority (if not all) of experts as a sui generis entity, thus things become even more complex, favoring a case-by-case approach.

To elaborate on the prospect of a Eurozone breakup, we must first identify the problem in question. The eurozone is not an abstract currency union, existing in laboratory conditions, whereby academics and policy-makers would have the power to shape the world according to their intentions. There are particular dynamics that have existed prior to the actual crisis, which are fundamentally important in evaluating the so called “debt-deflationary spiral” and the mechanics that influence the real economy, the financial system and the fiscal finances.

II. The origins of the Great Recession and the Eurocrisis

The purpose here is not to provide a definite account of the causes of the Great Recession. It is just to outline the forces that led to it, which will be of use to us as we evaluate the issues that are directly related to the ongoing crisis in the eurozone. The origins of the crisis are identified, in my view, mainly in two areas:

  1. The artificially low interest rate policy of the Federal Reserve Bank in the United States, which encouraged large-scale malinvestment and caused the housing bubble
  2. The increase in the “investments” in financial derivatives thanks to the perverse incentives provided by states and central banks.

Concerning the first parameter, economist Paul Murphy argues the following in his article titled “Did the Fed cause the Housing Bubble?” (Apr. 14, 2008):

The case against the Fed is straightforward: In an attempt to jumpstart the economy out of recession, Greenspan slashed the federal funds target from 6.5% in January 2001 down to a ridiculous 1% by June 2003. After holding rates at 1% for a year, the Fed then steadily ratcheted them back up to 5.25% by June 2006. The connection between these moves by the central bank, versus the pumping up and popping of the housing bubble, seemed to be more than just a coincidence. On the contrary, it looked like a classic example of the Misesian theory of the business cycle, in which artificially low interest rates lead to malinvestments, which then require a recession to correct.</p>

To support his point Murphy provides the two following figures, which clearly indicate how the Fed followed an inflationary policy in the early 2000’s:

Chart 1. Source:

Chart 1 shows that the real interest rates were at very low levels, comparable only to the rates in the 1970’s. This clearly is an indicator of easy monetary policy.

Chart 2. Source:

For chart 2 Murphy himself argues the following:

There are a few interesting features of the above graph. First, note that the growth rate in 2002 (8.7%) was higher than in 2001 (5.6%). (Henderson and Hummel may have given the opposite impression, because of the units involved. The base bounced around like crazy because of huge injections and then drainages because of Y2K and 9/11.) Second, note that the base growth in 2002 was about as high as any year from the 1970s, except 1979 (when base growth was 9.2%).[2] Everybody in this debate agrees that the 1970s were characterized by excessively loose monetary policy. It is hard to see then how Greenspan’s behavior during the serious onset of the housing boom can be described as moderate.</p>

In parallel to the perverse, inflationist monetary policy of the Fed, we were witnessing an unprecedented growth of the financial sector and in particular the rise of “private money”, i.e. financial derivatives that were used as if they were money (store of value, means of exchange etc.).

The account of Yanis Varoufakis on the matter is simply brilliant:

Wall Street was attracting $5 billion of fresh capital from abroad every working day. On top of that, it was attracting another $5 billion daily from two domestic sources: Corporate profits (which were soaring as a result of accelerating productivity in an era of zero real wage rises) and the interest on debts incurred by middle and lower income groups in the US (the debts of Americans who borrowed on credit cards and against their homes to keep up with the Joneses, banking on ever increasing house prices).</p>

Now, I have a question for you. One that does not require a push of your button: When every day of the week, for twenty years in a row, a banker has $10 billion more to play with than she had the previous day, what do you expect her to do? Nothing? Of course not! Even if she holds it in her hands for a few minutes before passing it on, she will find ways of making it work for her. It is the nature of the beast. That is what bankers do. Expecting them to do otherwise is like expecting a bird not to fly or a crocodile not to ambush.

Well, ladies and gentlemen, bankers did what bankers do. It came to be known as financial engineering and the new mode of business was labelled financialisation. Securitised derivatives, CDOs, CDSs and the like were the tools. And by golly did they work for them. Every one of the dollars that passed through their sticky fingers was pumped up using the new tools of the trade and yielded between $30 and $100 for them.

Was that the result of Out of Control Greed? No, Out of Control Greed was the effect. The cause was the tsunami of capital that went through their hands. And, if my analysis holds water, that tsunami was an integral part of the Grand Hoover that kept global capitalism going on the basis of the constant feeding of the US twin deficits; a feeding frenzy that kept Germany, Japan and China in business, and able to find markets for their increasing trade surpluses.

The above two combined with the creation of the Euro led to the following artificial conversion in interest rates between Core and Peripheral Eurozone economies, as depicted in the chart below (click on image to enlarge).

Eurozone interest rate convergence. Source: BBC

All these combined led to the creation of all sorts of bubbles. In the eurozone in particular it allowed for the massive borrowing of the Greek state, the bubbles in Ireland, Spain and so on. As such much of the growth we were experiencing all these years was unreal, since it was boosted by cheap credit rather than an expansion of the capacity of our economies to produce real goods and services and accrue wealth.

This naturally brings us to the second section of this analysis, which concerns deflation and the arguments that many stress about the so-called debt-deflationary spiral in which the Eurozone supposedly finds itself.

III. Deflation and the “debt-deflationary spiral”

In mainstream economics, deflation is depicted as the black hole of the economy. Economists generally fear deflation, since they argue that if prices keep falling then investment will be averted. In addition this diminishes profits for the businesses, thus leading to bankruptcies, foreclosures and layoffs, which in turn lead to further bankruptcies and the process continues until the economy is reduced into rabble. This logic could hold true when the economy is growing, though again that is debatable. The point though which matters to us the most is the mechanics of deflation in the midst of a recession, since that is what we are now supposedly experiencing. Deflation in the midst of a recession is first and foremost a natural part of the business cycle. There is a boom followed by a bust, there simply is no other way. Second, deflation is actually good for the economy, especially in the midst of a recession since it functions as a shock absorber.

But first the general view as expressed by Murray Rothbard:

Rather than a problem to be dreaded and combatted, falling prices through increased production is a wonderful long-run tendency of untrammelled capitalism. The trend of the Industrial Revolution in the West was falling prices, which spread an increased standard of living to every person; falling costs, which maintained general profitability of business; and stable monetary wage rates—which reflected steadily increasing real wages in terms of purchasing power. This is a process to be hailed and welcomed rather than to be stamped out.</p>

Then the particular view about the mechanics of deflation in the midst of a recession. The following is a quote taken from the article of Mark Thornton, titled “The Lehman Brothers Plan“:

First, under deflation, the prices of capital goods fall dramatically. This initially happens with stock prices plunging, but eventually the prices of office buildings, warehouses, retail stores, etc., also fall.</p>

Second, the price of labor will fall as the unemployment rate rises. Wage rates are somewhat “sticky” compared to stock prices and leasing rates for commercial space, but they do tend to fall in real terms if they are not propped up by government intervention and unemployment insurance.

Third, the prices of consumer goods will also fall — but not as much. The demand for “nondiscretionary” consumer goods is not elastic. Things like milk, flour, tobacco, electricity, daycare, and iPhone apps have what economists call “income-inelastic demand” because we don’t change the amount we buy either when our incomes increase or decrease. In the past, for example, the quantity demanded of margarine has actually increased when our incomes go down.

This means that in the deflationary-corrective process, the prices of land, capital goods, commodities, and labor are falling relative to consumer goods. This provides potential profit opportunities for entrepreneurs to purchase these greatly depreciated resources in order to make products to sell to the consumer. In other words, the deflationary process is more like a shock absorber than the black hole imagined by mainstream economists.

Not only do profit opportunities emerge, but wage-labor opportunities are scarcer and less attractive. Both influences encourage entrepreneurial behavior, and this is a key factor in any corrective recovery process.

From the above, we may argue that deflation leads to a reallocation of capital, which is ultimately good for the economy as it will lead to robust growth, deriving from the production and consumption of real goods and services, on a new solid basis.

Bringing this to the systemic crisis of the Euro allow me to say that there is no such thing as a “debt-deflationary spiral” that has ostensibly gripped the area. The latest reports from Eurostat show that inflation in the euro area averages around 2.7~3% and there is no sign whatsoever, that there is a tendency for prices to fall sharply.

In addition the comprehensive set of welfare subsidies at national and supranational level, suggest that labor costs will not decrease, or their decrease will be ancillary. Similar narrative for all other sectors of the economy that depend on state subsidies.

One of the reasons unemployment is rising while the crisis deepens, is exactly because the authorities have not allowed deflation to kick in and correct the distortions in the capital structure. The real downward spiral that we are experiencing in the Eurozone is largely due to relatively high inflation in an environment of diminishing real incomes and little to no growth (stagflation).

IV. Redesigning instead of breakup

Bringing all the afore-mentioned to the paper that provided me with the opportunity to compose this article, I shall now look into the potential breakup of the eurozone, whether that is desirable and whether there are alternative paths.

What we need to keep in mind when speaking of the Eurozone is that even though we are referring to a currency union, in truth we are dealing with a political project. To understand this, one needs to be familiar with the European Integration process, which is characterized by gradualism. Incremental steps are made towards the direction of an ever-closer union, ultimately leading to a political union, which is still not clear how will it operate (federation? confederation? etc.)

The European integration process has a particular pattern that starts from step-by-step economic integration, which then brings about the need for further integration as the half-built edifice cannot possibly be sustainable. In short economic integration brings the need for political integration. Within this context the euro was seen as a tool in the hands of policy-makers willing to accelerate this process. Hence even though the euro never satisfied the criteria of an Optimal Currency Area, it was established, with the hope/conviction that over the medium-term/long-term further integration would cover the gaps of the system and produce a true currency union, backed by a genuine fiscal union – a process that would be facilitated by the even more intense economic integration. As such one cannot omit the political dimension of the matter when speaking about the breakup or the redesign of the Eurozone.

The euro is a very big political investment for the European Union and thus cannot be abandoned with a light heart, since its breakup can easily affect the overall balance in the EU and halt the momentum of integration. Therefore even if the euro as a currency was not sustainable (which is not the case), European leaders would still have a very strong incentive to fight tooth and nail for its preservation. Yet the euro is not insolvent nor unsustainable in the long-run for two rather simple reasons:

  1. Even in the extreme case of a series of defaults in the European periphery, the currency itself will not receive any mortally wounding hit, since it is a fiat currency that several states will still be willing to use. As such the euro itself cannot collapse because of economic pressures – this can only be done if its constituent states agree on its breakup in favor of national currencies, which however is still unlikely.
  2. As the crisis continues, many policies that were once considered unthinkable are ultimately being implemented. We have seen the violation of the no-bailout clause (there have been bailouts), the no-intervention by the ECB (ECB is intervening like crazy), the no-debt restructuring (Greece will restructure its debt, by imposing a “haircut” on its private creditors) etc. This suggests that over the medium-term more “taboos” will be broken, implying that what is needed to save the currency will eventually be done. And this is something admitted by myself, who am not at all optimistic.

Hence once facing a dilemma of the sort “breakup or redesign” the European policy-makers will clearly vote for the latter. The euro will be redesigned and this will start from the ratification of the fiscal compact, which will have to be followed by a legal framework that will establish a uniform tax base (not tax rates), a unified banking sector and a genuine fiscal union, with a common treasury capable of raising revenue and issuing bonds of its own.

I am not saying that there is no chance for a currency breakup. To the contrary, such prospect is quite likely if policy-makers continue their “extend and pretend” practices. I am only arguing that for as long as Europeans can stick to the euro, they will do so.

This also provides the political answer to whether unilateral exits from the euro would be beneficial – they would clearly be to the detriment of the state in question, as far as politics are concerned (for an economic approach on the issue matter see “Exit of Greece from the Euro is collective suicide” and “Currency union vs fixed exchange rate – Greek Euro Exit”).

V. The mechanics of a Eurozone breakup and concluding remarks

To me if the euro should ever be broken up, for whatever reason that may be, it must be done in an orderly way, since the interconnections that it has created over these years are such, that if not taken into prior account will definitely lead to a sub-optimal level for all parties involved, while it will definitely have a negative impact on the world economy. I do not share the view that a potential collapse of the euro would be “cataclysmic”, I am only saying that better make the transition as smooth as possible – this is a matter of common sense.

Coming to the conclusion of this article, I may say that there are several remarks in the report of Variant Perception which are worth examining and which definitely hold true. I recommend you have a view at their report, since I repeat I always am in favor of a healthy dialogue, even if there are contrasting views, as is currently the case since I so not agree with their thesis.

Finally I would say that the above definitely do not exhaust any of the subjects in question. They only provide a framework of thinking, that can facilitate us in (a) understanding the crisis, (b) evaluating policies and/or policy proposals. Much more needs to be said and in fact much more has actually been said in previous articles of mine. The point is to always remain open to alternative ideas, never be dogmatic, never take anything for granted; while also never exclude scenaria that might be politically or economically or socially undesirable; since everything is possible under the conditions we now find ourselves in.

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