Turns out that Francois Baroin, the French Finance Minister, wasn’t far wrong last week. The most hated man in the City of London said that Britain was in just as bad financial shape as eurozone countries like France, and that the rating agencies should be downgrading British debt. We have higher inflation, lower growth and larger debts than France which is currently on the downgrade ‘list of shame’. Now Moodies has put the UK on credit death watch too.
Who are the rating agencies? Well, they are private firms that specialise in giving credit risk ratings to banks and countries. Triple AAA means that the country is a very safe bet. Both Britain and France have this top rating, which allows them to borrow cheaply. But when they get on credit default watch, and both countries now are, then private investors think twice about lending to them, which makes the cost of their borrowing increase. The cost of borrowing has ballooned recently for countries like Portugal and Greece which the credit rating agencies think will default on their debts.
Yes,I know it’s complicated, and the fact that it’s all couched in the impenetrable jargon of the financial industry makes it worse. Few people can be bothered to find out what is going on in the financial fortresses of Europe because it is so difficult to make any sense of it. Take the year end rally.
In the dying days of 2011, the European Central Bank did what it said it wouldn’t do and threw 489 billion euros at the busted banks of Europe. What happens is this: the insolvent banks can’t borrow at the moment because no one is prepared to risk lending to them. So, what does the ECB do? It offers them unlimited funds at a give-away interest rate of 1%. The idea is that they will then lend to countries like Spain and Italy who are currently (because they are busted) paying 5% for their loans.
The banks are suddenly keen to gobble up the debt of Spain because they get a guaranteed “spread” that means a profit, on the deal. They borrow from the ECB at 1% and then lend to Spain at 5% and get 4% profit for doing absolutely nothing at all. They also use the money to lend to businesses at similar rates, and get millions of pounds of effortless profit. This becomes the bankers bonuses at the end of the year. This nonsense is what passes for financial management in Europe.
Because of this free money, everyone is suddenly happy and the stock markets forget about the eurozone sovereign debt crisis and deliver a nice year end rally, so that the financial community get a nice Christmas bonus. The European Central Bank is effectively giving money away – to incompetent and insolvent banks who have ruined themselves through their irresponsible lending policies. But the ECB can think of nothing better to do than to pour money over them like custard over a christmas pudding.
So, where does the ECB money come from? And if they can suddenly invent £500bn why don’t they give it direct to countries? Well, this is the ECB version of printing money. It’s what the Bank of England has been doing for the last two years. It violates all the principles of sound finance, needless to say, and stores up trouble for the future. But the alternative was an epic credit crunch in the New Year which would have seen the collapse of several very big European banks and a couple of countries. So the system has been salvaged again by the policy of stuffing bankers mouths with gold.
This is why Britain has suddenly become a dodgy credit risk. Last week, because it seemed easier for Britain to print money than the eurozone countries, the rating agencies thought Britain was less likely to default. This even though the inflation caused by money printing diminishes the value of investments denominated in sterling. But now, all of Europe is suddenly printing money, giving it away, trying to debase the euro and blow away sovereign debt by a wall of free cash. In the paradoxical world of high finance, this means that Britain has lost its inflationary advantage.
What is doubly bizarre, however, is that at the very same time as all this free money is being thrown around, the governments of the eurozone are undermining their own financial stability by imposing austerity regimes that destroy growth, increase government debt, and make the sovereign debt crisis even worse. The underlying problem is the absence of a central fiscal authority in the Eurozone able to issue bonds backed by all nations collectively. In the absence of a central treasury, the fixed exchange rate – coupled with the rigid austerity budget regime being imposed by Germany – is crucifying the weaker economies like Greece, Portugal, Spain and Ireland. The slowdown in growth makes it more expensive for them to finance their debts, which leads to credit rating agencies questioning their ability to avoid default. But for some reason, Germany seems to accept that it’s ok for the ECB to flash the cash, even as it is forcing governments to rein in.
Ireland is in a particularly sad position here because it really tried to make austerity work, slashing public sector wages and pensions, and throwing everything at the debt numbers. The economy responded and exports recovered, and six months ago it looked as if the republic really had turned the corner. But now with Europe slipping into recession again, Ireland is back where it started. It’s latest growth figures show a shrinkage of 2%. The rise in unemployment costs and the loss of tax revenue will make its debt crisis even worse.
The problem with Europe right now is that it is pursuing 1930s economics in a multinational age. This is what the IMF director, Christine Lagarde, meant last week when she warned of another Great Depression. Germany has persuaded itself that the eurozone problem is about lazy Greeks and Italians growing fat on borrowed money and expecting the hard working Germans to pay their debts. There is an element of truth in that of course, since the Med countries did allow borrowing to get out of control, and in Greece’s case had largely given up trying to collect taxes. Fiscal discipline is important, but it is not the whole story.
What Chancellor Angela Merkel seems incapable of grasping is that the real problem is deflation and uneven development. Economies like Greece and Germany are so different that they cannot be expected to compete on the same playing field. In terms of productivity, Greece is still in the 1960s, whereas Germany has the most efficient and productive export economy in the world. But that success in exports is in part a result Germany’s currency being effectively undervalued. If Germany were to leave the eurozone – of if the eurozone were to leave it – the deutschemark would rise rapidly against the currencies of competing nations. This would hit its exports and suck in more imports.
This is not an argument for ditching the euro, which has many benefits over the old ramshackle system of lots of little currencies inhibiting trade and investment. But as almost every economist in the world agrees, you can’t have a common currency without a central federal authority to issue bonds backed by all countries, make financial transfers between rich and poor regions and in extremis to back the banks of member states in trouble. This is what the United States of America possesses: a federal government with power to raise taxes and to redistribute them among states. In Europe we have a disunited states which is locked in a death spiral of deflation. The more the austerity, the bigger the debt. The bigger the debt; the more the austerity.
This is a horrible place to be, and Britain isn’t helping by indulging in schadenfreude and economic nationalism. One reason Britain is so out of sympathy is because we tried to steal a march on all of the euro countries two years ago by devaluing the pound in a bid to undercut them and boost our exports. Didn’t work, as it happened, but that doesn’t make the EU feel any better about it. There really is only one way out, and that is for all the G20 nations to recognise that they have played a role in creating the debt crisis and have a responsibility to resolve it.
Christine Lagarde is right to say that if nothing is done we will be back to the 1930s – to protectionism, competitive devaluation and worse. There will have to be a arbitrage on indebtedness in Europe, and a new global system of financial regulation. But this is very difficult and slow, and politicians prefer quick and dirty solutions, involving blame and retribution. Last week, we saw how quickly economic problems become translated into national confrontation. Fortunately, this is not the 1930s and we do not go to war as readily as in the past. But as this grim year staggers to a close let’s hope all nations realise that – trite as it sounds – there is no solution without goodwill. Happy Christmas.