Europe’s Economic Struggle

Listener: 22 December, 2011.

Keywords: Macroeconomics & Money;

It has been another difficult year for the world economy. Longstanding problems that were incrementally addressed include population growth, the depletion of limited resources like oil, the exploitation of free resources that threaten to make fish extinct and warm the planet, and the rebalancing of global power. The urgent one – the unsteady global financial system – remains unresolved.

This goes back to the boom of the 2000s, which left the financial system riddled with overvalued assets. Until these fictitious values are eliminated, the world economy will struggle. That may mean your house is not worth what you thought, so you feel poorer. For some, their houses – or in the case of the finance companies, their properties – may be worth less than the mortgages and other debts on them, so the lenders, including depositors in finance companies, lose out too.

These homely examples apply equally to sovereign nations, global financial enterprises (more fell over in the past year) and multinational companies (which, on the whole, have survived – so far). The recent experience of Greece is by no means unique in the history of the world: over 100 economies have gone through similar crises in the past 150 years, some more than once (New Zealand is not one of them).

Greece reached the stage where it was unable to service its debt, having to borrow more to fund public spending because taxation and other revenue was insufficient. Projections suggested its government debt would soon be twice the annual GDP. (New Zealand is desperate to keep its level down to below 40%.)

You might say the remedy is in the Greeks’ own hands: by raising (and collecting) taxation and cutting spending. Well, yes, but the people will only take so much fiscal pressure before they revolt; Greece’s last civil war ended less than three decades ago.

The typical Greek will say, “It is not me who is overspending; I was not a beneficiary of the profligate borrowing.” We can argue over this, but remember the average annual (public and private) net borrowing per New Zealander is around $55 a week; you may insist it is not you, so who is overspending and who is benefiting?

The response of countries in the European Monetary Union was to give the Greeks debt relief by – roughly – halving what their government owes to the banks. Easier said than done. Even allowing for shareholders losing their equity, reducing the banks’ assets in this way would mean cutting back on their lending to others, with fewer advances to businesses and for home purchase. Credit would contract. Meanwhile, European banks are being required to increase their capital reserves to make them less likely to fail – and therefore less likely to need a bailout from taxpayers. There may be a widespread credit squeeze across all the European banks, worsening Europe’s economic downturn.

If Greece goes bankrupt, the banks holding the debt will lose even more of their money and will ask governments for help, which comes (I simplify) by governments taking over some of the debt reduction. That means higher taxes or lower government spending; hence their reluctance to bail anyone out.

The good news is that the reductions are spread over a wider group, so individuals don’t suffer as much. The bad news is that there are other economies – like Italy – that may have to be bailed out; the total cost to the world’s taxpayers is likely to be much higher.

In the meantime, those who hold the overvalued assets – shareholders, depositors and all – try to avoid a loss by getting taxpayers to pay for the write-down of the inflated values. No wonder the public is getting grumpy. The political gridlock may mean the world won’t do enough, or can’t do enough, or does it too late – in which case the world economy may collapse into another great depression with severe unemployment.

It’s a bit like watching a motorway pile-up in slow motion. The roads are wet, the vehicles too close, no one is giving way and – egged on by their passengers – the drivers are being irresponsible.