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Saturday, August 31

"For Political Reasons" - The inconvenient truth about the euro

This essay is from the book Euro or Not?, which was published on June 5 in Helsinki, Finland, by the think tank Suomen Perusta. Authors of the book include current and previous members of the European Parliament, Finnish Parliament, a previous minister, economists and bloggers.

Suomen Perusta is operated by The Finns Party and the full document (in Finnish only) can be downloaded from the think tank’s website in PDF format – along with the previous publication How the euro area develops?

“For political reasons”
The European common currency is a failed project by any objective measure, but admitting the truth is politically difficult. [1,2]  In the participating countries, whole institutional chains from banks to politicians and from corporate management to intellectuals have bet their credibility — and even their existence — on the euro. When one understands this background, understanding the present, and what is still ahead, is much easier. I will begin with a description of the euro’s first crisis in the early nineties, followed by Finland’s final decision to join during the government of prime minister Lipponen; then detail the inconvenient truth of the current situation and finally, I will list possible future developments.

The horrors of the 90s – lessons not learned
In Finland the main problem was the liberalisation of the financial markets, combined with the need to break out from the Soviet Union’s circle of influence and a clear need to end the repeating inflation-devaluation cycle. These factors led the country to apply to and join the so-called power cores and the currency union as one of the first adopters. The Finnish media was largely pro-Europe and pro-euro, thanks to the late media magnate Mr Aatos Erkko, who approached all the major newspapers and television channels to entice them to join in on pro-EU and pro-euro campaigning. [3,4]

Germany’s domestic political motives destroyed the Exchange Rate Mechanism (ERM) project. When the two Germanies were united, chancellor Helmut Kohl decided to unify the currencies of West and East Germany at an exchange rate ratio of 1:1. This led to higher inflation and forced Germany’s central bank, the Bundesbank, to raise interest rates. Together with the bursting of the bubble of the eighties and the ensuing global recession, this put the other ERM member nations in a difficult position: they were forced to raise their own interest rates in the footsteps of Germany in order to maintain their fixed exchange rates. This led to a self-inflicted recession in most of the ERM countries. Only when on the brink of total destruction did most of the members finally float, devalue or expand their ERM exchange rate corridor to such a degree that they in effect devalued their domestic currencies.

For the elite in Finland it was practical that the deepest recession of any OECD country since WWII could be blamed on the collapse of the Soviet Union, debt-fueled consumerism, banks’ risk taking and international currency speculators. The downside of this was that the real culprit was neither named nor discussed, which gave even more reasons to continue on the selected track. Nobody wanted to admit that fixing the exchange rate was a major reason for the troubles. The myth of the Finnish currency’s fragility was born: the sky-high interest rates, the exchange rates manipulated by the speculators and the exodus of foreign investors.

In most of the ERM countries the situation was similar, and further analysis would have provided politically awkward results. Members of the elite probably started to believe the fairy tale themselves. The alternative of being wrong and having made a mistake was too discomforting. Even Germany’s monetary solo flight was not publicly condemned. [5-10]

More “medicine”
Mr Lipponen had made up his mind and with support from the corporate elite decided to continue on the euro train. Even a small accounting trick was used to make sure that the Maastricht criteria would surely be met.11 Belgium’s and Greece’s numbers were so bad that they could not have even been forged to meet the criteria, but they were still admitted. Also Italy was known not to meet the requirements. [12]

In the background, experts warned that by giving up monetary policy there would be no balancing mechanisms left, especially as fiscal policy too was locked up by the Maastricht treaty. If the exchange rate, interest rate or fiscal spending are not flexible, the only remaining adjustment tool would be aggregate demand – in practice, unemployment. If one adds to this the suboptimal currency area, the potential problems increase further. This is elementary macroeconomics and was widely known at the time – but all this was disregarded. [13,14,15]

Glimpse behind closed doors
An anonymous observer provides a glimpse into the darkness. My apologies for the strong language. (Lipponen was at the time the Social Democratic Party prime minister and Niinistö the National Coalition Party finance minister.)

I was at an event where P. Lipponen the Great cursed as ignorant clowns all those people who warned that given Finland’s industrial profile a mutual currency with Germany and France was not a good idea. And such stupid monkeys could be bought cheaper at a local zoo. Unfortunately I do not have video or audio recordings. In modern times someone would surely have recorded the best bits with their mobile phones.

Mr Lipponen was pissed off that none of the paid experts were able to come up with measures that could take the place of devaluation and other monetary policy measures. Behind the closed doors there was plenty of yelling and threatening, in the best tradition of the social democrats. Mr. Niinistö was more controlled, but he  also thought that people talking about the problems were simply stupid.

Messieurs Lipponen and Niinistö had simply decided with their European friends that the euro was the best thing that could ever happen to Finland. In both of their political parties there were no members able to do the math; they were either too old or too young. The pair overwhelmed any resistance. There were many more events where Lipponen sounded like a klaxon and Niinistö heavily harassed.

They never redeemed their promises to industry on measures to address the removal of the devaluation option. The promises were immediately forgotten after they got the euro decision. If bad deeds done to other people have an effect on the afterlife, they will both burn for a long time.

For the social democrats the euro crisis is a major pain because Mr Lipponen drove Finland’s membership. Now we see the laws of economics and especially the common currency fatally wounding the social democrats’ traditional voters, or rather their employers. If Lipponen, together with Niinistö, had not been the main architects of euro membership, the social democrats would be demanding an exit from the euro so loudly that their tonsils would show.

Urpilainen [Finland’s current finance minister from the Social Democratic Party] is in an odd spot. She must somehow find a way to cope with the “achievements” of the party’s still-living prime minister. Also, many of the people from those times are still active and in powerful positions. Because of this, statements ranging from pathetic to ridiculous will continue in the future.

On YouTube one can easily see how classy the discussions in parliament were – even in public. I wouldn’t award any points for artistic style, as a certain amount of nagging and complaining is part of politics, but it looks like decisions were not based on analytical merits when the parliament voted on euro membership in 1998. [16] At least in this respect little has changed.

Damage done: the inflating bubble…
Because of several factors working together (low capital ratios of banks, many banks already being publicly owned, banks holding government debt, The Basel regulators and the European Central Bank miscalculating risk and thus misallocating capital, convergence of interest rates, the need for current “core” countries to find customers for their industries and lenders for their banks), a huge flow of private capital went to countries where no money should have been sent.

While the internal current account imbalances of the euro area grew, everyone was happy and criticism and warnings were ignored. It is still being ignored, as one country’s deficit is another’s surplus. The German trade surplus would not be what it is today without the deficits in the periphery. There were warnings – Ireland’s unsustainable real estate boom was clear to outside observers – but there were no possible measures to take against single member’s credit growth or wage increases.

…deflates and hurts
In some countries debt growth started directly in the public sector but in most cases the culprit was high debt levels in the private sector. When economic troubles began, the private sector’s problems became the public sector’s problems. Lower tax income, higher social security payments and maintaining the banking system crippled the public finances of several countries.

This turned into a problem for the large banking countries of Europe: Germany, France and Netherlands. These countries’ banks had loaned money to the governments and the finance sectors of the crisis countries, and there was a risk of defaults and thus credit losses. This was unacceptable to France and Germany as they were preparing for the coming elections. As many of the banks were already largely owned by the state a Swedish-style capital injection in the form of a directed stock issue would not have been possible, or at least not large enough. Politically, the only option was to find new guarantors with high credit ratings and new lenders. This is why the crisis was called a euro crisis – to make all the euro area countries responsible for the potential losses of a few.

British and American banks also had large receivables from the crisis countries. The participation of these two countries in crisis-fighting costs was minimal compared to their original risk because of the crisis being defined as a euro area problem. This also meant that Finland, which had no banks with large positions in the crisis countries, was drawn into ever-growing debt mutualisation. Others benefit, Finland pays – because “the jobs of mothers and fathers have to be protected”. I assume that behind the scenes something else happened as well: threats, scaremongering, outright bribery and extortion – or perhaps just stupidity, vanity and “political reasons”.

Loss transfer to taxpayers
Without the possibility of exchange rate adjustments and the avoidance of debt restructuring, especially with the private sector involvement, there are only limited tools to solve this multidimensional crisis. The common currency rules out the usual solution of weakening one’s currency or adjusting interest rates, and no country has so far been prepared to jump ship and leave the euro area, not even Greece. The private sector involvement has been avoided because of the possibility of a domino effect that would topple all shaky countries and eventually even the solid ones that are the current creditors.

Private sector involvement is also hindered by the fact that there is less private capital left. Almost all of the most uncertain receivables have already been mutualised. Bilateral loans, indirect loans through special purpose vehicles like the European Financial Stability Facility and the European Stability Mechanism, the European Central Bank’s SMP-asset purchase programme, very lax LTRO-loans and recently the “unlimited” conditional OMT-program, and the less well-known and not public ELA.

In two years’ time the bad loans made by the European banks have been transferred to  taxpayers even though the whole project was sold to the voters as supporting the crisis countries. Follow the money, said the original investigative journalist. When there are no private sector loans left to cut, officials started to move the losses to bank depositors, like what happened in Cyprus. It is worth noting that although debt levels have continued rising during the past years the real economies are in recession. In a way, the solution has moved further down the road and has become more difficult despite apparently temporary steps of progress. The current round of internal devaluations and mass unemployment hardly equate with the success story that the euro was seen to be. Worryingly, the more bitter the medicine, and the less it works, the easier it will be to push the eventual agenda of full federalisation.

Rotten fruit
The euro crisis has thoroughly ruined transnational organisations. The International Monetary Fund's reputation as the most neutral and credible player in the international economy has been spoilt by its political actions. By transferring the excessive debts of the crisis countries to the IMF, the European states have in effect decided to finance the crisis countries outside the democratic process. Now the IMF’s resources are tied up. In Finland there is plenty of talk about the IMF as an independent and outside party, whose blessings and participation turn any bailout package into a credible one. This is exactly why France and Germany had pressured the IMF, and successfully did so. [17,18]

* * *


Euro area breakup
There are only a limited number of future paths. A return to national currencies (some or all of the countries) would even out the competitive differences between the countries, and history has proven it is both a market economy-based and efficient solution. It would also amount to a confession that the euro project has been a failure, and lead to difficult negotiations over the euro system’s balance sheet and debt redenominations. It would certainly create at least a temporary shock, and the credibility of the “new” national central banks would be difficult to establish, especially during and immediately after the shock. [19]

Federal union
Another option would be a full federal union that would include at least a mutual debt and joint budget and thus fiscal transfers between the member countries. In practice this would mean that the EU would have a right of veto over national budgets and taxation rights either directly or indirectly, and these tax receipts would be used to transfer funds from the better-performing countries to the poorer-performing countries. Because the euro area is not an optimal currency area and the competitive differences between the member nations are large, the federal elements would have to be larger than in e.g. the United States. [20] With the track record of the European decision-making and the often opposing interests, we can already guess how well designed, honest, fair and functioning a federal union would be.[21,22]

Muddle through to semi-federal union
After playing for time, extending loan maturities and promising reforms, while at the same time keeping growth minimal and unemployment high, sooner or later the competitive differences will narrow. It could take a very long time, and the narrowing might be too small to make a difference, with the price being a lost generation. Internal devaluations are slow, cruel and ineffective, and someone who has been unemployed for 10 years in Greece will definitely not return to the job market and compete against Germany like nothing ever happened. A muddle through would allow slow and opaque haircuts by maturity extensions and interest payment reliefs, and this would be enough to fool the electorate of the creditor countries. This rudderless semi-federal union would lead to a long but shallow recession in the creditor countries and an utter disaster in the crisis countries [23, 24]. As a bonus, economic performance might wear down the electorate and the opposition to a full federal union and eventually make possible a full Brussels-led command economy.

Monetary diaspora
The European Central Bank could design monetary measures that would target only certain countries in the euro area. Past measures have already included such features. Fragmented monetary policy could need restrictions on the free mobility of capital – like the ones already in use in Cyprus. The elite would save face as the euro would survive in name, although its core idea would have been destroyed.

Wild cards
Finland earlier had the choice of exiting and not participating in this mess. Either the courage or the intelligence to do this was lacking. After the already completed debt mutualisations, leaving would be a much more difficult process. But it is not impossible. There could be other willing leavers as well. The world after the German elections will surely be an interesting one.

My wish
Instead of the current muddle-through towards a federal union and continuous burdening of the Finnish government with others’ losses, it would be preferable to have a decent, fact-based discussion about what Finland’s options and goals are and the ways to reach such goals. Voters will understand if explanations are provided. Parties that still believe that the euro is a success story, that Greece will pay its debts and that the burden will have to be shared, are not credible or rational. Statements like that are in a hideous way populistic and are contrary to the available facts. Honesty instead would be a good foundation for co-operation and a new era. And a confession that mistakes are made – even by social democrats.

[1] When Can We All Admit the Euro is an Economic Failure?

[2] Europe in Brief

[3] Lehdistöneuvos: Erkko käänsi Hesarin EU-myönteiseksi

[4] Pekka Karhuvaara pitää lähtöä lehtitalojen yhteiseen EU-kampanjaan virheenä, joka haisi pahalle

[5] ERM at 'breaking point'

[6] Black Wednesday

[7] Krugman: Currency Crises

[8] Interpreting the ERM Crisis: Country-Specific and Systemic Issues

[9] The EMS Crisis in Retrospect

[10] Talouspolitiikan virheet laman taustalla. Suomen 1990-luvun kriisin syyt ja seuraukset lamatutkimuksen valossa

[11] Nolo totuus Suomen ehdottamista kriisilääkkeistä

[12] Operation Self-Deceit: New Documents Shine Light on Euro Birth Defects

[13]"Emua mahdoton perustella taloudellisilla hyödyillä"

[14] Revenge of the Optimum Currency Area

[15] Impossible trinity

[16] Euroon vai ei? Kiihkeää sanavaihtoa vuonna 1998

[17] The IMF needs to overcome its bipolar personality

[18] Time for a transparency revolution at the IMF

[19] Exit Special

[20] Euroliittovaltio ja suomalainen veronmaksaja

[21] Eurokriisi on monin eri tavoin luottamuskriisi

[22] Dokumenttiprojekti: Harmaa eminenssi

[23] How Europe Can Muddle Through Its Crisis

[24] Muddling through means deepening crisis for the euro zone