The fiscal discipline delusion

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Fiscal discipline is needed, yet it must be accompanied by a surplus recycling mechanism and by a healthy banking system, in order to achieve economic stability, convergence and growth. Image Source: Reuters

Everybody in Europe and beyond has become familiar with the phrase “fiscal discipline” and everybody has heard on many occasions top ranked politicians putting the blame for the current systemic crisis of the euro on the lack of this “fiscal discipline” in certain states (we all know which states they mean). The President of the European Council was the latest in the row to repeat the same thing. In an official document from his speech at the London School of Economics Mr. Rompuy states the following:

Excessive debt is a problem that has hit a number of countries across the world, not only in Europe. But its existence in some Eurozone countries has had an impact right across the Eurozone and indeed the single market. We have discovered that three countries representing about 6% of the GDP of the euro area, could threaten the financial stability of the Eurozone, as well as the stability of the banking sectors in all Member States. Lack of financial oversight played its role. But clearly, the financial and monetary interdependence had been hugely underestimated. Without the fiscal irresponsibility in some countries, there would never have been a crisis in the Eurozone.</p>

Mr. Van Rompuy is a very smart person and I am sure he has equally smart assistants who all know that the above statement is detached from reality and is misleading. The reason is that it puts the blame for the crisis on excessive public spending of a small minority of states and neglects the real sources of our problems, those being the systemic flaws of the Euro architecture and the ill regulated, quasi-bankrupt European banking system.

It is preposterous to blame certain states for their public spending and advocate that this is the source of the crisis and not even make mention to the over-leverage of European banks who “invested” on financial derivatives like there was no tomorrow. The leverage ratio in Europe was far greater than that of Wall Street as Europe’s banks proved to be even more greedy than their counterparts on the other side of the Atlantic. When Wall Street collapsed in 2008 it was more than certain that Europe’s banks would fall apart since this over-leverage proved that Europe’s banks were more of a basket-case than Wall Street.

Public money was used to bail out banks when the financial crisis was transmitted to Europe and let us not forget that the bailouts to individual states are an indirect private bank bailout, since the lion’s share of the funds end up in Europe’s banks, who are the main creditors of these states. Ireland came to the need of a bailout even though the country was fiscally disciplined and even though it was considered a model state from the IMF and other standards (so what applied to Greece certainly did not apply to Ireland, yet both are blamed for more or less the same things). It is more than certain that if no bailouts were ever issued to states then public money would still be used to directly bail out banks otherwise they would fall apart thus leading to a serious recession in the European core and a massive depression in the European periphery – a threat that still exists (why will Greece be bailed out again? exactly because major European banks are still exposed to Greek debt and the risk of a chain effect is still very high). So in one way or another public money would have to be used to fund bailouts, otherwise the European banking system (this ill-regulated system) would collapse, taking down with it the real economy.

The above alone would have been enough to prove that the austerity obsession that plagues Europe is self-defeating, yet I simply cannot omit the structural flaws of euro which are the main reason that the constituent economies of the single currency can not converge and the distance between them increases instead. The Euro lacks a fundamentally important mechanism that would ensure stability. That is a surplus recycling mechanism that would take the accumulated surpluses of the North and recycle/reinvest them with profit in the deficit regions so as to ensure balanced growth and to bridge the distance between surplus and deficit regions.

Anyone can understand that if countries run a trade deficit (mainly with Germany in our case) and if money does not flow back in their economies to fill in the gap, at some point the two will diverge, which means that the deficit region will have to borrow to cover the gap otherwise fall apart from this dynamic. Whereas if the surpluses of let’s say Germany were recycled with profit to let’s say Greece through this mechanism, then Greece would be growing in a healthy way and not need to (over)borrow, while Germany would have a sustainable trade relation with Greece. This is just what the United States did after WWII, they took their surpluses and gave them to Europe (especially Germany) and Japan, so as to be able to build this much needed healthy trade relation.

Believing that a group of states, with dissimilarities, with different levels of competitiveness and capacity to grow, with trade imbalances between them, can achieve convergence and economic stability only by means of fiscal discipline is a delusion and a serious misunderstanding of the fundamentals of a currency union and our current situation in the eurozone.

Fiscal discipline is needed, yet it must be accompanied by a surplus recycling mechanism and by a healthy banking system, in order to achieve economic stability, convergence and growth. The insistence of certain European leaders that the crisis is caused by fiscal discipline apart from being politically dangerous (it fuels populism), is also economically ineffective and will only lead to unpleasant consequences for the eurozone as a whole. I hope European leaders realize that they are on the wrong path before it is too late.