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European Debt Crisis Bailout Fund Proposal … Just Another Bad Idea

Economics / Global Debt Crisis Mar 11, 2010 - 06:21 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleMartin Hutchinson writes: Has bailout mania finally reached Europe?

The 16 nations that make up the Eurozone are seriously exploring the creation of a "European Monetary Fund," a bailout fund that would help euro-member countries that can't pay their debts.

This has the potential to be a pretty good idea. If structured correctly, the EMF could provide the discipline and stability that the euro needs.

However, I'm not holding my breath: Given the EU's track record, the EMF bailout plan will most likely evolve into yet another slush fund for politicians - as well as a drag on the European economy.

Even when the euro was founded in 1999, it was obvious that its central weakness was the lack of control over budget deficits. As the following chart demonstrates, the so-called "Maastricht Criteria" had established theoretical limits of 3% of gross domestic product (GDP) for such deficits. But there were no proper mechanisms for enforcing those limits, or for preventing the bankruptcy of a country that fell into such difficulties.

Since the birth of the euro 11 years ago, an additional problem has appeared. Well-run, highly disciplined economies such as the one in Germany keep their inflation rates low, their productivity growth high and their wage costs under control. The upshot: These economies gradually become more internationally competitive, and run balance-of-payments surpluses.

This tendency was hidden in the euro's early years by Germany's struggles to integrate the former East Germany, whose much lower productivity was a drag on the economy. However from about 2005 the costs of integrating East Germany began to diminish and Germany's true economic superiority became more obvious.

At the other end of EU's economic spectrum, Europe's Mediterranean countries - now delightfully referred to as the "PIGS" (Portugal, Italy, Greece and Spain) - turned out to have much less discipline. Even before they joined the Eurozone, these countries had relatively high interest-and-inflation rates. The advent of the euro gave them low real interest rates, particularly as their domestic inflation continued and productivity growth remained low.

The result in Spain, for example, was a gigantic housing bubble. Italy had the poorest productivity performance, falling behind Germany at a rate of almost 3% a year and so becoming hopelessly uncompetitive. On the other hand, Italy's budget discipline was fairly good - far better than that of Greece, a country whose current woes underscore the inability of the EU to adequately police the finances of its member countries.

Since it joined the EU in 1981, Greece has been much poorer than other member countries, and so has treated the EU as a never-ending source of free handouts.

That brings us back to the EMF proposal. It would be possible to design a fund that solves this problem. If you staffed it entirely with Scrooge-like bankers - the type that likes throwing foreclosed widows out in the snow on Christmas Eve - then it could achieve two things.

First, it could force Greece and any other country that needs money from the fund to reform their economies properly. This would involve cutting back the public sector, making everybody retire at ages closer to 70 than 60. It would also force down wage rates in the parts of the economy that were heavily unionized, and that had been extracting rents from their fellow citizens (or in Greece's case, from German taxpayers). Because it won't actually be a political body, an EMF of this kind would be invulnerable to the strikes, demonstrations, whining, squawking and Europe-wide lobbying which this process would undoubtedly cause.

The second achievement of such an EMF would be the creation of a bailout process that is so unpleasant and onerous that other countries end up being "scared straight" - to the point that they actually take aggressive steps to reform their own systems so as not to be subjected to the fund's sado-banking.

The precedent for such an institution would be the Bank of England of 1931, an institution led by the BOE's greatest-ever governor, Montagu Norman (in office 1920-1944).

Britain had a sloppy minority Labour government in 1929-31 that permitted public spending bloat; it was also on the "gold standard," a very deflationary monetary system at a point when the Great Depression was beginning to bite. Norman took Britain off the gold standard - but only after the Labour government had been replaced by a fiscally responsible National Government, with the flinty Neville Chamberlain as Chancellor of the Exchequer.

Sidney Webb, Lord Passfield - a Labour cabinet minister and author of "Soviet Communism: a New Civilization" - bleated: "They never told us we could do that."

Quite right, they didn't.  Norman had deliberately not given the Labour government the option of devaluing and wasting the benefit of devaluation through sloppy Keynesian spending. The result of Norman's duplicity and Chamberlain's firmness was an end to the Great Depression that involved far less pain than was experienced here in the United States - followed by an astonishing economic recovery: During the period from 1932-37, Britain enjoyed the highest economic growth rate in its history.

Alas, lost joys. An EMF with, say, Otmar Issing - the hard-money former European Central Bank (ECB) chief economist who's now advising German Chancellor Angela Merkel not to bail out Greece - might repeat Norman's success.

In the real world, however, if a European Monetary Fund does come into existence, it will be the typical sloppily statist international institution, leeching yet more money from productive taxpayers and lending it to Europe's worst-run countries, without any proper controls.

Clearly, Europe would be best served to not create it at all.


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