Thursday, September 9, 2010

Reprint: “Systemic Contradictions”: The Eurozone De Facto Currency Peg, and the Death Spiral We Are Currently Witnessing

This originally appeared in naked capitalism on April 11, 2010—right smack in the middle of the Greek debt crisis. My basic point still stands: The euro is essentially a very complex currency peg among a group of disparate nations that happen to share a continent, but little else. And though the IMF and the EU put together a rescue package for Greece, the stresses and strains of that currency peg still remain.
Critics of free-market capitalism, especially of the Marxist persuasion, love talking about its “systemic contradictions”. Especially European critics—they adore using that steam-roller phrase: “systemic contradictions”. It sounds so thrillingly lapidary, so discussion-ending, so terminal. Nothing can escape its grasp, or the base indignity of it. “They will fail because of Systemic Contradictions!!”—like a cross between a nasty form of cancer, and some unmentionable venereal disease. And of course 100% fatal.

It’s ironic that European critics of free-market capitalism love that phrase—because it aptly describes the Europe of today, and the European monetary union that was hailed as the way of the future.

I would argue that, with the way things are going, it’s Europeans and their Eurozone which will soon be relegated to the dustbin of the past. Precisely because of its “systemic contradictions”.

The end of the Eurozone will be a tragedy—and I would argue, we are currently witnessing it.

Let’s review: 

The Eurozone was born out of the Common Market, formed back in 1958, to the west of the Iron Curtain. In 1990, the Berlin Wall collapsed, so by 1992, a reunified Germany was effectively married to France and Club Med. The rationale was, economic union would beget political union, or at least political peace. In 1999, the Euro was born—a common currency for the members of the Union. Another step in European integration.

So far, so good.

However, though a series of complicated methods were used to control the debt, deficit and inflation levels of the various Euro-economies, one fact remained: Every country of the Euro had the same currency, while every country kept the right to float its own debt.

And of course—as we now all know—each country’s debt was assumed to be backed by the rest of the Union, when in point of fact, it was not.

So what does this mean?

Well, the shadow of the Euro makes it hard to realize what we are talking about. The Euro makes it appear as if we are dealing with one very large economy—Europe—while each member state’s fiscal problems could be thought of much as we think of, say, Mississippi’s fiscal problems in relation to the United States in its entirety.

From this way of looking at the Eurozone, the natural inference is to think of Greece as a small part of a larger, healthier whole. A part that is going down the drains, true, but it won’t bring the larger whole down with it.

But this is a false inference. It’s an easy logic trap to fall into, because the Euro as a currency papers-over the differences within the Eurozone. The Euro makes the Eurozone look like one big happy family, but with a black sheep named “Greece” that has to be sorted out.

However, this is not the case. The Eurozone and the European monetary union is actually several different economies at vastly different levels of development, which so happen to have a common currency—but they have nothing else in common. Because—unlike in the US—in the Eurozone, each member state can issue its own debt. Therefore, each member state can borrow its way to equality of wealth, instead of earning it.

Looked at this way, it becomes obvious that the Euro isn’t a common currency—rather, it is a very complex fixed rate exchange system.

In other words, a currency peg.

So instead of thinking of the Euro as €, common to all Eurozone countries, it would be smarter to think of the Euro as GR-€, or FR-€, or IT-€, or SP-€, and so on—a different Euro for each member economy, all of which happen to be fixed at a one-to-one parity.

Now it becomes obvious what we’re looking at—when we look at Europe today, what we’re really seeing is Latin America circa 1980.

Thinkit: A bunch of countries in Latin America fixed their exchange rates to the US dollar; at different times and for vastly different reasons, but for the present discussion those issues don’t matter.

At first, this dollar-peg worked like a charm. The Latin American countries found themselves with a false sense of prosperity, bought and paid for with cheap dollar-denominated debt—until the inevitable crash of ’82. (In Argentina, it happened again in 2001—those gauchos never learn.)

The dollar didn’t suffer because of the fixed exchange rates—it was all the poor saps south of the border who suffered, and greatly at that. Latin American debt suddenly had no buyers, and all the previous debt had to be paid off. With no incoming dollars, that dollar-denominated debt broke the Latin American economies.

If we look at Europe with Latin American lenses, we realize that the Eurozone is in exactly the same position—it’s a bunch of over-indebted countries with their currency pegged to, of all the economies of the world, Germany. Because the role of the US dollar in this fixed-exchange rate system is today being played by the German Euro—the GR-€. And it’s the deflation of the GR-€ which is absolutely killing the Eurozone.

Going back to the Latin American example, at least those countries had the option of ending their dollar-peg and floating their currencies, once their debt levels broke them.

But the Eurozone members can’t do that! Or rather, they can break away—but they won’t break away, until it’s too late and the damage has been done. Various European-wide subsidies and programs and wealth-redistribution schemes—otherwise known as bribes—will keep the countries all tied up for a while. For quite a while, in fact, human nature being what it is, and hope always being the last thing to die.

Each day the fixed exchange rate continues, though, is one day closer to complete Eurozone collapse—which will be a tragedy. Because European prosperity insures European peace, from the Urals to the Irish Sea.

But by the time they all realize that the GR-€ is destroying their economies—much like the dollar-peg in ’82 trashed the Latin American economies—it will be too late. The European Union will be wrecked, much as Latin America was wrecked in ’82. And that crisis ushered in all sorts of foolish craziness in many many places.

God Alone knows what will happen once the Eurozone is wrecked.

We are currently watching this wreckage—we just don’t realize it. Greece is not an aberration—it’s not even the canary in the coal mine: It’s the beginning. The GR-€ is wreaking havoc on all the other countries of the Eurozone, starting of course with the weakest, Greece. But it won’t end there—far from it. The GR-€ will take out, in no particular order, Portugal, Italy, Spain, until it eventually hits France.

Then it’s over for the Eurozone. Because once France decides to break away, there’s no more Eurozone—and possibly, no more political stability.

The single most important reason for the collapse of the Eurozone is that each member state was allowed to issue its own debt. This ability, coupled with the fixed-exchange rate otherwise known as the Euro, is the core “systemic contradictions” of the Eurozone.

Right now, we are watching the Eurozone in its death spiral. And I’m afraid that all the talk of IMF bailouts of Greece and whatnot aren’t addressing the key problem: Sovereign European debt.

If somehow, all European debt could be centralized, then maybe the Eurozone would survive. But if the Europeans lack the political will to sort out Greece now, then such collectivization of European-wide sovereign debt is impossible.

So that mean, the Eurozone death spiral is inevitable. And we are now watching it unfold.


Today, Sunday, April 11, it’s just been announced that Europe has prepared a €30 billion ($40 billion) bailout of Greece.

Good for the Europeans—crisis in Greece apparently averted.

However—will the Europeans bail out Italy, Spain and Portugal, when their time comes? And if they do, how much will they shell out? Because €30 billion won’t be enough for any of those three—try €35 billion for Portugal, €50 billion for Italy, and €75 billion for Spain. At least.

I’m just wonderin’ . . .

ADDENDUM D’OH! (as Homer Simpson would call it)

Reuters is reporting that a “senior [Greek] official” said that, over the next three years, Greece will need an additional €40 billion—this is, on top of the €30 billion that were pledged today by Europe and additional €10 by the IMF.

In other words, THIS YEAR’S bailout for Greece is €40 billion, while 2011 and 2012, they’ll need an ADDITIONAL €40 billion.

That is, €80 billion ($108 billion) to tide Greece over until 2012—just Greece. Nobody else. €80 billion to salvage an economy whose nominal GDP for 2009 (according to Wikipedia) was €250 billion.

If I’m lyin’, I’m dyin’—see the Reuters article for yourself.

Of note: None of the issues affecting Europe that precipitated the Greek crisis have been repaired, or even addressed except in the most superficial of terms. We’ll have to wait and see what happens this fall, though I doubt if it will be pretty. 


  1. After reading this article I was given to wonder. What if the euro is de-valued vs. gold? Wouldn't that make the unmanagable debt of the "PIGS" nations suddenly managable? Unlike the US, the euro can devalue vs. gold without causing inflation because the euro was designed to float freely against gold. The EU central bank would need only preform open market gold purchaces untill the price appreciated enough. The "PIGS" could clear their debts without causing inflation inside the EU. Each debtor nation could then settle it's debts with gold that was more valuable in euros and this would keep the EU together.

  2. PIGS are not the end of the list. These are also small baltic countries (pegged, not in eurozone) and Belgium - not yet in debt crisis.

  3. @ Mark
    Nothigh will happen. The problem, already described by Gonzalo is the peg, wich draws poor countries into illusion of wealth. Salaries in PIGS are now only a little lower then in Germany, and should be 2 times lower. To recover an economy and ability to repay the debt there should be high salary increase in Germany or decrease in South. Both are impossible. Gonzalo is right. There will be de- pegging. Hopefully peacefull

  4. How does a currency peg force poor countries salaries to go up? In america, there are southern cities which have much lower average salaries than say New York city or Los Angeles. This happens even though all of America uses dollars. If you clear the debt via gold and then stop countries from issuing new debts in euroes, then salaries in the poorer areas should fall to reflect reality.

  5. @mark
    But in US this disparites developed "naturally" and in case of pegging peg is either below or beyond natural exchange rate. It means lowering standard of life and improwing international competivnes (as was a case of Germany) or a opposite (as a case of Greece, Spain and Portugal - buy not Italy). The second consequence - immiedatlly decreased inflation and improved credit rating of new currency means much cheaper credit - and credit consumption boom, with growing salaries and skyrocketing debt. But it all have nothing with fundametials. Some day it's time to repay- with high salaries (but with internal service and retail sector overbuilded), heavy debt and uncompetentive economy. Only solution is mass bancrutpies (including govenment) and decreasing salaries to restore international competivness or deppeging and restructurizing debt. Your proposal is a defaut - for sure inavetable solution and low fear of inflation, but reasons to go deep into debt are still in place and in few years problem will be back

  6. GR-€ should really be called DE-€ (DE = Deutschland, of course).

    One strong possibility is that the weakest members of the Eurozone (let's say Greece and Portugal, maybe even Italy and Spain) will be "spun off" and allowed their own currencies back, which they will then deflate like crazy versus the Euro. In exchange, these countries would be bailed out no more by the other Euro members.

    The rest of the "core" Euro members (Belgium, France, Netherlands, etc...) would probably be very happy with this outcome. Just a thought.

  7. Why no mention of Ireland? Isn't Ireland a PIIG?

  8. What about the political pressure to go forward with Euro. The "dreamers" that pused so far will not give up, merely to say the momentum of the system. The main question is not IF bailout, but SO WHAT. What will the pigs do after baiolut, they will continue to do the same.


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