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Urgent Stock Market Message

Europe Chooses Economic Depression 

Economics / Great Depression II Jun 08, 2010 - 04:25 AM GMT

By: Mike_Whitney


Best Financial Markets Analysis ArticleForget about a smooth recovery. Finance ministers and central bank governors of the G-20, met this weekend in Busan, South Korea and decided to abandon "tried and true" expansionary fiscal policies for their own strange brew of belt-tightening policies and austerity measures. 

The EU members are eager to restore the illusory "confidence of the markets", something that will surely be lost when the eurozone slides back into recession and the hobbled banking sector begins hemorrhaging red ink. Trimming deficits while the economy is still on the mend will weaken demand and force businesses to lay off more workers. That will decrease economic activity and slow growth. It's a prescription for disaster.

Here's an excerpt from Paul Krugman's blog:   "Slashing spending while the economy is still deeply depressed is both an extremely costly and quite ineffective way to reduce future debt. Costly, because it depresses the economy further; ineffective, because by depressing the economy, fiscal contraction now reduces tax receipts....

The right thing, overwhelmingly, is to do things that will reduce spending and/or raise revenue after the economy has recovered — specifically, wait until after the economy is strong enough that monetary policy can offset the contractionary effects of fiscal austerity. But no: the deficit hawks want their cuts while unemployment rates are still at near-record highs and monetary policy is still hard up against the zero bound." ("lost Decade, Here We Come", Paul Krugman, New York Times)

Europe is marching headlong into a depression. The attachment to stone age economics is shocking.  It is as if John Maynard Keynes never lived. When GDP shrinks--as it inevitably will--the deficits will grow and bond yields will widen making it more expensive to fund business. Public confidence will wane, relations between member states will sour, and cities will fill with angry demonstrators. Fiscal consolidation will rip the 16-state EU apart and trigger a crisis bigger than Lehman Bros. The ECB needs to support demand by encouraging government spending while  households patch their tattered  balance sheets and regulators take over underwater banks. Any deviation from this plan will only exacerbate the problems.

How sick is the EU banking system? Here's an excerpt from the New York Times:

"It's a $2.6 trillion mystery. That’s the amount that foreign banks and other financial companies have lent to public and private institutions in Greece, Spain and Portugal, three countries so mired in economic troubles that analysts and investors assume that a significant portion of that mountain of debt may never be repaid.

The problem is, alas, that no one — not investors, not regulators, not even bankers themselves — knows exactly which banks are sitting on the biggest stockpiles of rotting loans within that pile. And doubt, as it always does during economic crises, has made Europe’s already vulnerable financial system occasionally appear to seize up. Early last month, in an indication of just how dangerous the situation had become, European banks — which appear to hold more than half of that $2.6 trillion in debt — nearly stopped lending money to one another...."

Analysts at the Royal Bank of Scotland estimate that of the 2.2 trillion euros that European banks and other institutions outside Greece, Spain and Portugal may have lent to those countries, about 567 billion euros is government debt, about 534 billion euros are loans to nonbanking companies in the private sector, and about 1 trillion euros are loans to other banks. While the crisis originated in Greece, much more was borrowed by Spain and its private sector — 1.5 trillion euros, compared with Greece’s 338 billion. ("Debtors’ Prism: Who Has Europe’s Loans?", Jack Ewing, New York Times)

This proves that the real problem is the banks, not "sovereign debt". (which is only 567 billion of the 2.2 trillion euros total) The EU is faced with the same problem as the US; either take over insolvent banks and restructure their debt--making bondholders and equity holders take a haircut--or endure years of hellish subpar economic performance with high unemployment, dwindling investment, grinding deflation and social unrest. The EU has chosen the latter, and for reasons which may not be that clear at first glance. A cheaper euro makes EU exports more competitive, which will keep the EU's most powerful member (Germany)  happy. Also, deflationary policies protect the interests of bondholders who are heavily invested in financial institutions whose asset values are grossly inflated by cheap money and massive leverage. Finally, austerity measures transfer the losses from banks and shadow banks onto the backs of workers, consumers and retirees. Screwing workers to enrich bondholders and bankers is a political calculation. It makes no economic sense.

Belt-tightening in the EU means that the world will (again) have to rely on the US consumer to bounce back, shrug off his historic burden of personal debt, and resume spending like a madman. With unemployment hovering at 10%, credit lines being slashed by the day, and retirement just around the corner (for many baby boomers); that looks like an unlikely prospect. 

By Mike Whitney


Mike is a well respected freelance writer living in Washington state, interested in politics and economics from a libertarian perspective.

© 2010 Copyright Mike Whitney - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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© 2005-2018 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


09 Jun 10, 05:36

This article and your argument are fallacies.

If European governments had decided to stop spending if for a reason:

They can't get more in debt!(unless they print money and hiperinflate). Easy.

Your fallacy: there is no recovery like you suppose if we continue spending because debt will grow exponentially. The same way a drug addict won't recover if continues taking more and more drugs.

09 Jun 10, 10:20
europe depression

Yes It may make puritan Austrian school happy but is a surefire prescription for depression. Europe is ruled by a bunch of vacillating dunce-heads who will eventually realize their mistake & try to reverse policy, but buy then it'll be too late.

Don Borden
12 Jun 10, 10:53
Europe Chooses Economic Depression

The problem is the grasshopper and the ant syndrome. During good times most governments (with Germany as a notable exception) spent as though there were no tomorrow, even becoming heavily indebted to do so. Now that bad times prevail, the ants, e.g., Germany, France and certain other N. European EU nations, are being asked to sacrifice to bail out the grasshoppers.

Not only is there reluctance by the ants, this economic downturn is largely credit-bubble-burst based, unlike past post-WWII recessions Because there is limited “rainy day” savings available, the printing of new monies has the potential for creating inflation and even hyperinflation. Further, this socialistic application of new monies is inefficiently applied and quite disruptive. The gold bugs are seeing this. Germany and evidently the UK are also and have decided to pursue a restrictive monetary route.

If we want to look at recent experience with Keynesianism, there is the notable example of Japan. Right now they have the highest government debt-to-GDP ratio of the world’s major nations. They’ve been experiencing low growth coupled with disinflation, and in some cases, deflation, for some 25 years! Ironically this deflation may morph into inflation, according to knowledgeable Nippon-area analysts (e.g., Koo from Nomura), if Japan continues its profligate monetary ways.

Even China, which does have rainy day monies, is blowing them on creating a vast amount of overcapacity in manufacturing and real estate. The economic numbers coming out now are no longer believable. Take for example the reported 47+ percent gain in exports for May. While China’s customers have moderately recovered, now fading, due to government stimulation, we’re talking a few percentage points here.

The debt–Piper has to be paid, either with some pain now or with inordinate pain later if more Keynesianism based indebtedness is added. The most governments can and should do is to alleviate the pain until individuals and private sectors recover from their massive debt binges.

When you’re in an indebtedness hole you don't dig deeper with even more debt. Even Bernanke, in a kettle calling the pot black move, is warning the U.S. government to restrain its fiscal borrowings.

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