Saturday, August 04, 2012

Letter to a Friend: Socialism and the European Financial Crisis

Recently someone I've been corresponding with implied a connection between Europe's socialist tendencies and the current European financial crisis. I wrote this letter as a response, but thought it would be of general interest here.

The thing to know about the European financial crisis is that, except for Greece (which has an economy approximately the size of greater Miami's and can be dismissed as largely irrelevant), the current problems were not caused by excessive public sector debt. The two countries having the greatest difficulty, Ireland and Spain, were actually running budget surpluses before the crisis hit. Ireland was considered a model economy. Italy's debt was trending lower as well.

So what caused the European crisis? Spain is instructive. Spain had its own real estate bubble, and a big one. Spain's was caused by a huge influx of capital from "northern" European countries like Germany. (The European countries with relatively healthy economies are sometimes referred to as the north, and those in distress are called the south.) The influx was largely because the advent of the common currency, the euro, caused the owners of capital to incorrectly upgrade their assessment of risk in southern countries like Spain and Greece. Over the bubble years large economic and trade imbalances formed between Spain and the north. When the real estate bubble popped, Spain was quickly in big trouble. Interest on Spanish government bonds soared, so suddenly a private sector bubble became a public sector fiscal and debt crisis. Spain's creditors in the north demanded fiscal austerity, causing further contraction of the economy—a vicious cycle.

Problems like Spain's would normally be resolved, in a country with its own currency, by devaluing that currency (as did Iceland), but Spain is on the euro so that isn't an option. That leaves Spain with the prospect of "internal devaluation," which means deflation, massive contraction of the economy, massive unemployment (currently 25%), and much misery. Higher inflation and a hotter economy in Germany could help Spain a lot, by reversing the imbalances that have formed over the past decade and blunting the deflationary forces in Spain. Germany, however, isn't interested in that—even though German capital was a substantial player in Spain's bubble, and German creditors will be severely hurt in a European meltdown.

In sum, Europe's problem is very much a consequence of the fact that the countries in the euro zone have disparate and uncoordinated fiscal policies but use a common currency. It turns but that partial economic integration is pretty unstable. (There was also an element of contagion caused by the problems in the U.S., and the fact that international financial institutions were all loaded up with the same toxic assets such as mortgage backed securities.) The flawed economic structure created private—not public!—sector financial imbalances which are at the root of the current situation. Europe's problems are largely a result not of public sector policy, spending or debt, but of private sector financial markets, trade, and capital flows. It certainly isn't about anything you could characterize as socialism.

Copyright (C) 2012 James Michael Brennan, All Rights Reserved