Dan Alpert's Two Cents

In Flanders Fields of Dreams (or, €Zone Core c. 2012 = AIG c. 2008?)

With the outcome of the EU meeting in Brussels leaving much in doubt heading into next year, it may be appropriate to reflect for a moment on how far we have come in a century. For all the cross-border conflict, at least imbalances and disputes among continental nations are being addressed at the points of pens rather than that of weapons.

The union of Europe, and even the troubled monetary merger of 17 of its constituent powers, is more than the Utopian wish of war-fearing lands but – however challenged – is an accomplishment to be ranked among the highest order of historic civic achievements.

Nonetheless, the emergence of a flawed monetary union a dozen years ago has had unfortunate, unintended, although not entirely unexpected, consequences. These outcomes have arisen only in part from the failure of the common currency to foster uniform fiscal behavior.

For what was arguably unforeseeable, 20 years ago in Maastricht, was the emerging a global excess in the supply of labor, productive capacity and, finally, capital from the post-socialist countries. That surplus enabled the governments and people of the Euro-nations, armed with a newly unified major currency, to borrow vast sums without lenders caring much about, or pricing in, underlying fiscal (im)prudence.

Certainly, the Eurozone was not alone in the foolish indulgence in easy credit. I have written reams on the subjects of the global imbalances and the concentrated surpluses, emanating from emerging nations, that underlie the credit crisis and most of the economic disruption the world is facing. The U.S. and the U.K. (and, far earlier, Japan) were chronic credit abusers, and, to a meaningful extent, enablers.

Nevertheless, the Anglo-American economic and political universe has shown a slightly better ability than that of the Eurozone nations to properly diagnose and appreciate the continuing challenges facing us.

What has emerged from Brussels – a stone’s throw from the mournful battlefields of the first world war – is not a resolution of those challenges, but rather a restatement of the earlier dream that order, structure and the rule of law can overcome the laws of macroeconomic behavior.

“If we structure it, they (the financial markets) will come,” I imagine some in the core to be thinking.

Alas, one of the leitmotifs of the global financial crisis is that highly structured borrowing arrangements have proven to be fields of dreams when disconnected from underlying realities.

I spent much of last week briefing public policy panels, members of the U.S. congress and a brilliant delegation of press, officials and economists from Germany – and being briefed by them in return. And throughout the various discussions, as the ineffective Brussels summit approached, the magnitude of the gap between wishes and realities became all the more evident.

The fissure between government policy and the needs of the financial markets remains as wide as ever.

My message in Washington was that there are solutions to our domestic and global problems, and they can be achieved on a relatively middle-ground from the point of view of the mainstream of the economics profession, if only there was the urgency to do so.

Speaking last Wednesday, together with my friend and co-author Nouriel Roubini, I predicted that there is nearly a 50% chance of what Dr. Roubini is currently forecasting (which should be familiar to most readers of this blog, if not just most readers of contemporary economics) bearing down on the U.S. before the next American election; and nearly a 100% chance that those who prevail in that election will be dealing with facts sufficiently onerous to generate popular pressure for the sort of actions we should have undertaken during the events of 2007-2009 (see “The Way Forward” by Dr. Roubini, Dr. Robert Hockett of Cornell University and myself).

Putting the dysfunctional U.S. policy making apparatus aside, I am afraid that the issue for Europe is more immediate and – in the absence of a central bank that certain members of the zonal core, particularly Germany, would permit to act as a lender of last resort – far more vexing.

There is not much debate about the source of the problem: Too much debt (both sovereign and private sector) in countries that consume more than they produce, and severe imbalances within the zone between the debtor and creditor countries and, more acutely, between debtor/current account deficit economies of the periphery and the surplus economies that are part of the core.

It is often said these days that Germany, the world’s second largest surplus economy after China, has benefited greatly from a Euro that is weaker than a Deutschemark would be relative to the strength of Germany’s economy. This is, of course, quite true.

From the German perspective, this benefit came at significant cost. The cost of absorbing East Germany and the current account deficits that preceded Germany’s steady rise to surplus during the past decade; of stagnant real wages, consumer restraint, and budgetary discipline after they entered persistent surplus in 2004. Also hard to dispute.

That the German people might expect similarly responsible sacrifice from others would seem reasonable, if only the distressed economies of the Eurozone were capable of such action. In the current macroeconomic climate they are not. It is one thing for Germany to have shown restraint in a rapidly growing global environment – but something altogether different amidst global deleveraging, excess supply and insufficient relative demand.

Were austerity actually to be effected throughout southern Europe (arguably Ireland is taking a stab at it), the results would be intolerable given the continuation of global supply/demand imbalances. The years of slow, painful re-balancing – that internal devaluation is meant to produce in the periphery – will most certainly challenge the periphery’s ability to repay its creditors. Growth from internal devaluation, even if it occurred without rending the social fabric of those countries, will not occur fast enough to avoid enormous challenges to repayment/refinancing of creditors.

The states in the core know that the financial markets (and, now, the rating agencies) doubt that their own institutions can withstand those challenges – to say nothing of the fiscal shortfalls that are already befalling Greece, debt repayment aside, and threaten its latitudinal peers. They know they must contribute.  But – barring agreement among all 17 to have the ECB print money and certainly devalue the Euro, making all of Europe more competitive (and it should be said, to demonstrate my neutrality, causing myriad headaches on this side of the Atlantic) – they don’t have the money without imposing upon their own people, literally in some cases.

So the core nations therefore wish to utilize their individual credit in lieu of cold hard cash – several, and not joint, promises to pay into various funds if they are truly needed to defend the current system. This brings the matter full circle. Because should the situation deteriorate to the point that economists and credit analysts believe is not unlikely, the parties most damaged would be guaranteeing their own losses and the money so promised will go the way of every chimera.

What “should” work, however – what is structured to carefully appeal to the markets and to buy time to amend a poorly constructed currency union – is actually cold comfort to the capital markets.

Those markets remember well the recent history of a “AAA” internationally respected credit that promised to cover trillions in losses in situations it thought should never have been possible. It too, although not surprisingly as it was not a sovereign nation (even though it acted like one), lacked the ability to print its own currency. Yes, the underlying fear of the capital markets, is that the core is seeking to transform itself into AIG circa 2008.

And the markets have been to that movie before.

This essay is being offered released for republication. Contact for original if desired.

3 Responses to “In Flanders Fields of Dreams (or, €Zone Core c. 2012 = AIG c. 2008?)”

futuresmktDecember 14th, 2011 at 6:42 pm

Regression to the mean always resonated with me.
How it could not have been foreseen that the post-colonial shards/nations would not improve their productive capacity (absent intervention) is simply unfathomable. We are essentially witnessing the collapse (rapid) of free/cheap capital surplus in the West without the corresponding readjustment in spending (at an equivalent rate). This is a macro, secular readjustment, as you referenced.
We estimate the global under/unemployment rate approaches 30%-40%! We translate that into secular deflationary pressure.
What happens to those economies as they watch communal TV/cable/satellite? Let's consider that the short term thinking(incompetence?) and greed of the masters of the global financial infrastructure have gotten us to this place (recent major/minor examples: RMB revaluation issue/MF Global).
If Might(however defined) makes Right, let's game the next 25 years.

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