walter russell mead peter berger lilia shevtsova adam garfinkle andrew a. michta
Published on: June 29, 2010
G-20 Fiddles; World Burns

The verdict on the G-20 meeting is in.  It wasn’t delivered by the spinmeisters of the global leaders hailing their bosses’ groundbreaking accomplishments.  It wasn’t delivered by the clueless journalists gravely assessing whether the summit was a win for Merkel’s message of austerity or Obama’s message of spending.  The verdict was delivered by the world’s financial markets and it can best be summed up by the Edvard Munch painting:  “The Scream.”

At first glance, the G-20 looked harmless.  As predicted, it cost much and accomplished nothing.  No decisions were taken, no minds were changed.  Politicians had their pictures taken; the press hailed mushy communiques as breakthroughs and delusional protesters played silly ‘revolutionary’ games.

That would be fine under normal circumstances; wasting taxpayer money on pointless pageantry is one of the least harmful things the world’s political leaders ever do.

But this is actually one of those times when the world needs leadership.  The European financial crisis, like a metastasizing cancer, is infecting new targets.  It is no longer a question of sovereign debt in a handful of fringe countries.  We are now looking at real threats to the financial architecture of the EU’s richest and most powerful members.

Obama and Sarkozy at G20

Obama and Sarkozy in Canada at the G8 meeting, before attending the recent G20 summit (White House).

With the adoption of the euro, southern European countries (and a few northern ones like Ireland) enjoyed a cheap credit bonanza.  Historically, interest rates in countries like Italy, Spain and Greece reflected the belief by investors that those countries would constantly depreciate their currencies in response to high deficits and the inflationary bias of their policy makers.  When those countries entered the euro, interest rates fell to near-German levels as currency and inflation risk disappeared overnight.  Those low interest rates inflated two bubbles.  In the public sector, countries with low borrowing costs started handing out cash to government workers and other well connected interest groups, pumping up economic demand overall and increasing the national debt.  In the private sector, countries like Spain saw huge real estate bubbles develop as home buyers rushed to take advantage of cheap mortgages — and developers enjoyed cheap financing as well.

Central banks are supposed to be the chaperons at parties like this, locking up the liquor cabinet when the guests start getting too happy, but the European Central Bank wasn’t paying attention.  That wasn’t a mistake; it was on purpose.  The ECB is supposed to think about the European economy as a whole, so it was watching economic conditions in the biggest economies like Germany and France.  The ECB sat in the living room, watching Mom and Dad stay sober even while the kids were whooping it up in the basement.  Mom and Dad were pretty well behaved so the bankers left the punch bowl alone — but things got a little out of hand down below and now the whole house is on fire.

As the Europeans scramble to deal with the problem, they’ve tried three things.  First, they tried to build a firewall to stop the crisis from spreading, opening up the liquidity pumps at the central bank and putting together a fund to stabilize Greece’s short term financial situation and reassure investors worried about Spain and Italy.  Second, they canceled the kids’ credit cards — Spain and Greece have both passed strict austerity programs to bring their deficits down over the next few years.  Third, they have started one of those complex, multi-stage European talking processes aimed at economic reforms to make labor markets more flexible plus the creation of new fiscal rules and procedures to provide the kind of unified economic governance that Europe needs to operate a single currency zone.

The trouble is that none of these steps seems to be working very well.  More and more investors believe that Greece will never be able to repay its debts and that sooner or later it will have to go through the international equivalence of bankruptcy proceedings.  This also means that the Greek banking system, which holds many Greek government bonds, is probably also insolvent.  If it isn’t already, it certainly will be by the time the Greek economy goes through a massive contraction as the government austerity bites — and the Greek government then declares that it cannot pay its debts in full.

This isn’t just a Greek problem.  German and French banks don’t just own a lot of Greek government debt; they have complicated relationships with the Greek banks and private sector as well.  Much of this debt may turn out to be worthless, and perhaps almost all of it is going to have to be written down.  Throwing in the problems of the Spanish banking system (and Spain’s credit problems result more from the housing bubble than from the public sector deficits), makes the problem worse.  It’s possible that some of the major European banks (especially the badly managed, politically connected Landesbanks in Germany) are also insolvent.  Reflecting these concerns, lending between banks in Europe has seized up; if the ECB stopped providing loans to banks unable to finance themselves elsewhere, a full blown financial crisis would take the European economies down overnight.

Meanwhile the political signals are flashing red.  A recent poll in Germany showed that 51 percent of Germans want to ditch the euro and go back to the deutsche mark.  It is very hard to see Germany paying billions and billions more euros on into the indefinite future to keep an unpopular currency alive.  Meanwhile Germany and France, the two countries on whose close and strategic cooperation the entire EU system depends, have opposite views about how the current crisis should be addressed.  The French think the Germans should pay through the nose to keep the euro going while increasing the German government deficit to bolster the European economy.  The Germans think the French should shut up.

Both sides have a point.  The French are right that Germany has benefited hugely from the euro.  Those Greeks, Spaniards and Italians who were wildly overspending were spending a lot of their money on German goods.  Under the old system, the franc, peseta, lira and drachma kept losing value against the deutsche mark; that limited Germany’s ability to sell products in the EU market.  From this point of view, the cost of bailing out the weak euro economies is the cost of keeping Germany’s export markets in good shape — and, at the same time, the bailouts of weak European governments and banking systems are chiefly bailing out Germany’s own banks.

On the other hand, from a German point of view it now seems clear that no matter what rules are agreed, the Mediterranean countries won’t keep them.  The Greeks systematically lied and cheated their way into the euro and continued to lie and cheat and steal until the books could no longer be cooked.  “Fool me once, shame on you” say German taxpayers.  “Fool me twice, shame on me.”  A monetary union doesn’t just need rules of the road; it needs some basic consensus about values and methods.  Lacking these, the euro area must sooner or later break down, many Germans feel.  Why not let it break down before spending billions and billions in a doomed effort to save it?  German politicians cannot avoid dealing with this popular feeling; this is a pocketbook question of vital interest to everyone in the country.  The loss of export markets in Greece and even Spain is a small matter compared to the value of your money in the bank.

In my lifetime the Europeans have solved or at least fudged many intractable problems.  Given the enormous stakes and the tremendous talent of European financiers and banking authorities, I would not advise underestimating the chances that they will figure out some ingenious way to manage the current crisis.  But they have been trying and failing to manage their euro crisis since last December and in many respects things have only gotten worse.

If this were just Europe’s problem, the rest of the world could commiserate or gloat depending on its state of mind.  But economically speaking, we live in adjoining row houses.  The fire in Europe’s basement will burn us all out of house and home if it isn’t put out.  Without a healthy European economy it is hard to see the world returning to an era of stable growth anytime soon.  President Obama’s plan to double US exports has always been a long shot and one suspects that the White House now wishes that a target this ambitious and this public had never been set.  A prolonged slowdown in Europe puts that goal totally out of reach and could even derail the US economic recovery — if the latest fall in consumer confidence doesn’t accomplish that on its own.  A full blown European banking crisis would almost certainly plunge us back into the deepest depths of recession.

China must also worry about Europe.  The EU is the largest consumer market in the world, and Chinese exports to the EU are now larger than its exports to the US.  Slow growth or recession in Europe will create more problems for a Chinese leadership already struggling to cope with labor unrest and housing bubbles.  Throw in the effects of a European crisis on Japan and the rest of Asia, and it is clear that the world’s economic leaders have plenty to think about — and they need to act fast.

Acting fast was exactly what the world’s leaders did not do in Toronto.  The stately, pointless procession of photo ops and staged conversations sent out a strong signal that the world’s leaders take after the old Mad magazine mascot Alfred E. Newman: “What, Me Worry?” was the motto du jour in Toronto.

Pointless posturing is all very well in normal times.  But these times aren’t normal and the world’s leaders don’t seem to have grasped that.  This was the message from Toronto and it is hard to think of anything more alarming.

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  • Peter

    It is not a matter of not acting fast in Toronto.

    The Europeans and the rest of the G-20 leaders literally do not know what to do so as to act.

    There is no solution which even remotely comes close to making the major players happy, let alone everyone.

    This equals paralysis which means ‘nature will take its course.’ No wonder gold is at a record high.

  • Fred from Canuckistan

    Just proving the point that socialism, Euro style or Obamassiah style fails when it runs out of other people’s money to spend.

  • Luke Lea

    Nice piece of writing, the punch bowl in the basement with parent upstairs especially.

  • WigWag

    “China must also worry about Europe. The EU is the largest consumer market in the world, and Chinese exports to the EU are now larger than its exports to the US. Slow growth or recession in Europe will create more problems for a Chinese leadership already struggling to cope with labor unrest and housing bubbles.” (WRM)

    The silver lining in all of this is that the prospect of failing markets for its export based economy may motivate the Chinese to take steps to increase domestic demand; in fact we are already seeing this. China has allowed its currency to appreciate somewhat, which increases the purchasing power of Chinese consumers. I doubt that China’s decision in this regard has anything to do with pressure from the Obama Administration and everything to do with China’s recognition that if demand in Europe and the rest of the world collapses, it’s economy will go down the tubes along with everyone else’s. China needs to be an engine that increases world demand; if nothing else, self-interest will motivate China to increasingly play that role whether it wants to or not.

    While Mead’s essay is smart and on target, I think he misses half the story. He focuses primarily on issues pertinent to monetary policy in the EU nations while only paying lip service to fiscal policy. The bottom line is that for all the historical reasons Mead has mentioned in previous posts, Germany’s fiscal policy in particular has been and continues to be abysmal. Unfortunately, Great Britain, France and even the United States seem poised to make the same mistake Germany is.

    If consumers are stretched and thus consuming less and businesses are not investing, the only remaining player which can provide the demand needed to stimulate the economy is government; if governments don’t step up to the plate it’s hard to see how recession and even deflation can be avoided.

    Unfortunately, in Germany, Great Britain, France and even the United States, foolish calls for austerity in the face of declining demand threaten to make the world economic situation far worse. Only dimwits find it too intellectually taxing to understand that just because something is counterd-intuitive it can’t be true.

    When consumer demand and business investment dry up, governments must step up to the plate and run large fiscal deficits to prop up demand, especially when interest rates are so low that monetary policy becomes useless. Even though I can’t stand Obama, his policy of stimulating the economy was precisely right; but for his approach unemployment in the US would have been far worse and our economic prospects would be even more dismal.

    The idea that if government debt in the United States or Germany increases those nations, in time, will turn into Greece is absurd. If that was true, why are the bond markets willing to lend to the U.S. and Germany at rock-bottom interest rates? In fact, those rates are so low that they are virtually unprecedented. At a time when U.S. government debt is high by historical standards (but much lower than during World War II), the U.S. spends a smaller percentage of GDP servicing its debt than it did during the Clinton Administration when deficits (and debt) were going down not up.

    This is a lose-lose situation for the Untied States, If it goes along with the Europeans (and the Republicans) and practices austerity, the world economy will inevitably collapse; hundreds of thousands of Americans who lose their jobs may never work again. Deflation (which is far more intractable than inflation) may become a long lasting feature of the American economy like it did in Japan.

    If somehow Obama finds a way to avoid austerity measures and maintains a modicum of fiscal stimulus, the U.S. will be providing the stimulus Europe needs to get out of its economic mess while we run up deficits and the Europeans don’t. When the economy eventually recovers, the Europeans will have their house in order, while the Americans (who saved the Europeans yet again) will have a much bigger clean-up to accomplish. And we will face the intolerable prospect of having to listen to the Europeans tell us how much more responsible they are than we are.

    We are damned if we do and damned if we don’t.

    None of this bodes well for Obama, for the United States, for Europe, for China or for the world.

  • http://n.a. Adam Garfinkle

    Fine analysis. All I can say is that it’s a good thing most Americans pay zero attention to what is going on in Europe, else US consumer confidence would be falling even faster than it is. Insularity and ignorance have their virtues from time to time, huh?

  • Steve

    WigWag: The problem is that the US is out of money. The nearly 862B stimulus passed in 09 has not very little to create demand, even in the aggregate. Alot of this money just kept the states in “status quo” by allowiing them to continue to operate inefficiently.

    If state employee X is employed in 07, 08 and then in 09 & 10 with stimulus money, demand has not changed from that perspective. Granted, if state employee X loses his job, demand falls. But the inefficiency of his continued employment has not changed.

    As for low interest on US 10yr debt offering: we’re basically the best of the bad at this point. With investors not investing in the market, plant or equipment but rather US treasuries (against other investment options) they have driven down the return. More and more people want US treasuries, the Gov’t can keep lowering their offering until only those who are left are willing to take the return.

    Why do you think gold is so high but reserves haven’t been tied to it for decades?

    Finally, it’s the unknowing by the Obama admin that’s causing this to extend: I’m a small business owner:

    My personal taxes are likely to rise.
    My corporate taxes are likely to rise.
    My investment taxes are likely to rise.
    My HC costs are likely to rise.
    My energy costs are likely to rise (as so stated by Obama Cap-n-Tax).

    So what’s the answer? I think I’ll go out and hire someone. NOT !!

    Business abhors uncertainty. Obama has done nothing but exacerbate it.

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  • Steve

    Extremely good article and thanks for your comments about the state of Europe’s banks. I hadn’t been paying attention.

    One of the commentators referred to nature taking its course. Individuals need to realize that nature always takes its course. At some time (either in this crisis cycle or some future one), the laws of nature will assert themselves as an unstoppable force.

  • WigWag

    Steve, you’ve answered your own question; but for the stimulus bill, thousands of state local employees would have lost their jobs, their homes, their cars and defaulted on their credit card debt. The multiplier effect that this would have had on aggregate demand is ghastly to even contemplate. Like him or not (and I don’t) Obama saved us from this fate; the problem isn’t that the stimulus was too much but too little. Neveretheless, the stimulus we got did provide significant relief; it prevented a recession from turning into a depression. Very bad things are apt to happen when true economic calamity hits; I for one am glad that Obama’s stimulus saved us from that.

    You mentioned that you are a small business person; maybe you can tell us where your customers are likely to come from if many or all of your friends and neigbors lose their jobs. Maybe you can tell us what’s likely to happen to the value of your home (which may very well have already depreciated considerably) if your newly unemployed neighbors default on their mortgage payments. Maybe you can tell us what is likely to happen to your school taxes and to the quality of the schools where your children go if the real estate tax base that your local schools depend on disintegrates.

    You point out that business investment in plant, equipment and the like are all down; true enough. What’s likely to happen to business investment if unemployment goes up even more and consumer spending becomes even more moribund? Do you think business investment is likely to shoot up under those circumstances?

    Few investors participate in the financial markets with the goal of losing money; bond investors have bid interest rates down so low because they are convinced that at current rates they will almost certainly be repaid and get an adequate return on their investment; otherwise they would put their money in the proverbial mattress. Those who champion free markets need to come to grips with the fact that the free market has spoken; what it has said with abundant clarity is that neither Germany nor the United States are Greece, Spain or Ireland. That’s why U.S. interest rates are near all-time lows and it is why the U.S. Government spends less (as a percentage of GDP) servicing its debt today than it did at a time when government debt was significantly lower and deficits were going down not up.

    Most of all, skeptics of Keynes need to explain exactly where they think the demand for goods and services is going to come from if consumers won’t spend because they are at risk of losing their jobs, busniness won’t invest because they are risk of losing their customers and the government won’t spend because it’s fiscal policies are dictated by dimwits, who, like ostriches, have their heads in the ground.

    Come to think of it, their heads may not be in the ground at all, but instead might be found firmly implanted in a particular part of their anatomy.

    Only the unsophisticated find it possible to contemplate that things that are counterintuitive might be true. Keynes proved that in times of economic distress, the government must not mimic what families do when they are in economic distress; it must do the opposite.

    Many aspects of Einstein’s Theory of Relativity are counter-intuitive also. The idea that time might flow faster or slower based on the speed of an object or that mass might increase or decrease based on the speed of that object is also counterintuitive. Certainly Einstein’s theory is far beyond what we experience in our every day lives. But despite the fact that Newton’s Laws coincide far more with our sense of reality than Einstein’s, it wasn’t Newton who was correct; Einstein was.

    If austerity is likely to lead to enhanced economic prospects including greater employment, increased economic growth and the avoidance of a ruinous deflation than the proponents of austerity should explain to us exactly what the mechanisms are that make austerity an appropriate tool to use during an economic downturn.

    If they can’t do that, what are they contributing other than hot air?

  • Mike M.

    It would certainly be reassuring if we here in the U.S. had wise and responsible leadership at this time that could be counted on to help steer the ship and lead the world once again through its latest crisis.

    Sadly, we in America have made the incredibly foolish mistake of electing an unaccomplished, irresponsible, aimless know-nothing Chicago hack to lead civilization during these dark and depressing hours. It is a mistake for which we and much of the world are going to pay dearly for many years to come.

  • Jules Mopper

    Shorter Mead: Krugman was and is right.

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  • K2K

    I do not believe in WRM’s sole correlation between the G20 and the selloffs in world financial markets this week. U.S. financial markets are responding more to the dismal economic data on industrial production and jobs as well as the pending Financial Reform legislation, and whatever triggered the Asian market selloffs first.

    Financial markets hate uncertainty. The news media over-emphasizes daily and weekly and even monthly stock market fluctuations.

    Historical notes: “The Greeks systematically lied and cheated their way into the” Marshall Plan first, so why did anyone believe the Greeks had discovered the merits of truth when the Euro came along?

    And, Spain’s housing bubble due to over-production was focussed on the fantasy of demand for second homes from Germans and Brits. Are there enough empty Spanish houses to relocate Gaza? Two problems solved :)

    Obama had his chance with the first stimulus, and blew it by outsourcing the details to House Democrats who think it is still 1964. There was a better way to jumpstart REAL job creation while preserving public employee jobs with that 800+ billion.

  • Leading Edge Boomer

    Wigwag and Jules Mopper (above comments) speak the truth.

  • BT

    A note from Australia (where we are said to have ridden out the initial onslaught of the GFC quite well, from a combination of luck and good judgement).

    I went shopping last week, for the first time in many months. The shops are full of well-designed, appealing consumer goods; mostly manufactured in China, many heavily discounted. The assistants in our up-market department store (usually snooty and off-hand) gave me big genuine smiles when I purchased. There were only a few other serious customers in the store.

    Where are the customers? If I wanted to start a small business, what would I sell and to whom? All the current niches seem full, and consumers have their wallets zipped shut and credit cards maxed out.

    Coffee shops, electronic appliances and home repair goods seem to be happening: but clothing and lifestyle items are just not moving at the moment. Hard to see how this is going to change in the short term.

  • Foobarista

    The problem with Keynesianism is it’s basically an attempt to “signal” a good economy. This may have worked occasionally in the past, but people who see massive deficits and future tax increases ignore the “signal”. Instead, they’ll pocket whatever they get from whatever Keynesian stimulus so they’re better positioned to ride out the even darker times that come when the debt comes due.

    The only way out of it is to grasp the nettle now with credible action to reduce the cost of government and increase business activity. But as long as the Keynesian Kool-aid is being passed around by Krugman et al, far too many pols will drink it, because it fits their dreams: increase government power and look like Santa Clauses by handing out money borrowed from the Chinese. Reducing government means reducing their power, so they’ll only do it if the only choice left is the gallows.

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