Transcript | 3. lecture: About the causes of the debt crisis in the Euro-zone (Vladimír Vaňo) - University for modern Slovakia

Explosion in the underdeck and a small leak in the dam.

• Can the people at the captain lounge pretend that it’s none of their business when there’s a threat of an explosion on the fifth underdeck or damage to the body of the ship?
• Can an operator ignore even a tiny little hole in a water dam while claiming that despite of the tiny leak the rest of the construction is build of tens of tons quality concrete?
• Probably very few are in doubts about the correct answers to these questions. Those are given not only by the laws of physics, but mainly the knowledge of the irreversible chain of consequences, that could be caused by what appeared to be a small problem.
• And despite of that we are during a public discussion about the causes and effects of the so called debt crisis in the Euro-zone witnesses of a misleading decontextualization of some events, or a carefree ignorance of the laws of the economy and finance market.
• Also on the basis of what we already talked about in the previous lectures, let’s take a closer look not only at the causes, but mainly potential consequences of the so called debt crisis in the Euro-zone.

Why is the debt crisis in the Euro-zone affecting us too?

• Why is the independent Slovakia, during its time also called the Tatra tiger of Europe, dealing with the situation of the weak peripheral economies, or the European currency union at all?
• Since 1. January 2009 Slovakia introduced euro as its domestic currency. With a fully-fledged membership in the Euro-zone, besides the use of a common currency, comes for example a fully-fledged vote in the steering committee of the European central bank. From Frankfurt, where it resides, was before the introduction of euro the management of the German mark (DEM), which was more than 23 years ago not only a symbol of a strong currency, business prosperity, but also freedom. After two decades since the fall of the iron wall was the vote of the Slovak governor of NBS in the management of ECB rightfully participating on the decisions about the monetary policy of euro, the second most important reserve currency after dollar.
• Why did we even introduce euro? The obligation to accept euro was signed by Slovakia together with becoming a member of the European union in year 2004. After fulfilling the requirements we were the first in the middle Europe region to introduce euro in 2009 and thereby completing the commitment accepted in the entry contract with the European union.
• So is the introduction of euro a political matter? Not necessarily, even thought concrete decisions and commitments are in the end effect accepted and signed by the political representatives of a country.
• The introduction of euro in Slovakia was only the conclusion to the process of business integration, which was started by radical economical reforms after 1998. The vision of the integration to the EU attracted to Slovakia direct foreign investment that increased the export efficiency of the Slovak business (and radically decreased unemployment from nearly 20% to 7.36% in august 2008).
• The private businessmen (and employers) in Slovakia were asking themselves during the first decade of economical reforms a basic business question: where will they find a better market for their production (and so the work for Slovak employers).
• The answer to this question of the private businessmen in Slovakia is the fact that more than one fifth of the Slovak export is going to Germany, more than half to the countries of the Euro-zone and more than 85% to the member countries of the European union.
• The independent decisions of hundreds of Slovak exporters, motivated by the trading politics, led to an exceptional extend of the business integration, which together with the small domestic market (and the dependency of the industry on export) significantly increased the correlation of the Slovak business cycle with the business cycles of Germany and the Euro-zone in the last decade.

What is this common currency for?

• What do we need this common currency for, when many neighbors didn’t introduce it? The same commitment to accept euro (after fulfilling the requirements) was signed when becoming a member of the EU by the neighboring countries of the region. Lagging being in the economical reforms, a missing long term strategy of the euro implementation, but mainly not fulfilling the requirements has made it not possible. When before 2008 was the implementation of euro in the new member countries of the EU considered to be a matter of time, after the most serious after-war global recession it’s obvious, that the fulfillment of the pre-membership criteria won’t be as fast nor simple. Besides that, the consequences of the recession exposed the other countries of the region to more acute business problems, that have a higher priority.
• What do we in Slovakia have from the implementation of euro?

1. Elimination of the risk of bidirectional fluctuations of the exchange rates.
2. Lower transactional expenses in the foreign trade.
3. More stable inflation development, contributed to by the elimination of the exchange fluctuations.
4. More stable development of the interest rates, that are noticeably better compared to the countries from the regions with a higher inflation (Hungary, Poland, Romania).
5. A higher rating and lower expenses for the refinancing of the public debt, also thanks to the introduction of euro (increased rating from S&P in December 2008).

• Thanks to the above stated is Slovakia, as an economy dependent on export, looking forward to a stronger competitiveness.
  • After the recovery of the growth of our outlets has the industry growth in Slovakia in 2010 grown approximately twice as fast (20%) than compared to the export orientated economies of Hungary and Czech republic. A faster renewal of the production means also a quicker production of new work places.
  • So in 2010 the Slovak exporters provably demonstrated that the advantages of the euro introduction strengthened their competitiveness, compared to comparable neighbors.
  • At the same time the comparably deep sink of the industrial activity in 2009 demonstrated a textbook difference between the shift along a stable curve of demand and fall of the whole curve of demand.
  • The development at the neighbors with their own currencies demonstrated, why the weakening of the exchange rate (and an exchange rate reduction) doesn’t necessarily mean a better demand, when the key outlets suffers from a massive decrease of economic activity and number of orders.
• Even households noticed a well timed introduction of euro (literally five minutes to twelve: the decision about the acceptance into the Euro-zone came a few weeks before the start of the rapid turbulences in the economy and the finance market in fall 2008):

1. Thanks to this good timing, Slovakia evaded rapid exchange rates turbulences that noticeably weakened the neighboring exchange rates between September 2008 and March 2009.
2. As proven by the decline in industry production, which copied the development from the export partners, in time of a recession is a weaker currency not necessarily a good remedy for the export efficiency.
3. On the contrary, especially in the case of small and open economies is the rapid weakening of the exchange rate caused by the higher prices of import, which contributes to inflation.
4. In Slovakia were we thanks to the recession and decrease of the domestic demand, similar to the rest of the Euro-zone, looking forward to a record-breaking low inflation in 2009 and 2010, so in the post-revolution history a record-breaking slow devaluation of the purchasing power of salaries and savings.
5. Despite that the neighbors in the region were facing a recession, the more expensive import caused by the exchange rates fluctuations contributed to a much faster inflation (especially in Poland, Hungary and Romania), so to a faster devaluation of the purchasing power of salaries and savings.
6. If it wasn’t for the introduction of euro, Slovakia would be definitely facing (as well as in the history of the Slovak crown a number of times) a pressure to a similar weakening of the exchange rate like the other currencies of the region. If it wasn’t for euro, even in Slovakia would the inflation in 2009 and 2010 increase through the more expensive import.
7. If we assume, that the inflation in Slovakia was only by a few per cent points higher due to the currency turbulences (similar to the region), it means that during the first two years since the introduction brought euro to every Slovak person with an average salary a few hundred (euro) from the saved devaluation of the purchasing power (which would be higher without euro). And we’re not even talking about the savings in relation to the purchasing power of the past savings....
8. In contrast to numerous other countries of the region were the Slovak households and companies in the first years after the introduction of euro looking forward to a disproportionately lower interest rates of loans.
9. Thanks to the status of euro as the second most important reserve currency of the world, the Slovak national bonds appeared within a broader circle of investors (including foreign central banks) and the Slovak government could thanks to this refinance old debts and can borrow cheaper.

• So already during the first years after the introduction of euro, Slovakia (export employers, the purchasing power of households, but also the national budget) tasted the substantial (and measurable) advantages that came with being a member of the Euro-zone.

Unconventional currency union: one currency, single interest rates, many budgets.

• The membership in the club doesn’t only bring advantages, but in hard times also the need to cooperate on the common solution of challenges.
• Before we get to the debt crisis in the Euro-zone, we have to remember some basic principles of the functioning of large-scale currency blocs, using a common currency. And that’s not always in an economically homogenous area.
• As we already mentioned, the two basic parts of a business policy of a state are budget and monetary policy, which in the world of fiat money have to be independent in order to balance each other. But mainly, they have to be clearly identifiable.
• The United States of America (USA):
  • Use 1 currency (simplifying the trade within the union).
  • Has one monetary policy (common interest rates setting decided by the central bank, FED- Federal reserve system).
  • They have one federal budget policy (the federal ministry of finance, which besides other budget transfers helps weaker regions to balance temporary problems).
  • Compared to the European business and monetary union (EMU), Euro-zone for short:
    • Uses 1 currency (which simplifies the trade within the union)
    • Has 1 monetary policy (common interest rate settings decided by our European central bank).
    • Has 17 independent budget policies that stayed under the competency of the member countries.
    • During the first decade of its functioning was the Euro-zone working in a rare combination of a common monetary policy and 17 independent budget policies.
    • The central bankers of the euro-zone agreed to such a unique combination only under the condition, that the member countries will commit to coordinate their own budget policies in such way, that they will behave as a one unit club and by this make it possible for the united anti-inflation monetary policy of ECB to function effectively.

The stability and growth pact: attempt to coordinate and a spirit for limit of deficit in bad times.

• The key instrument for the coordination of the joint budget policies is the stability and growth pact.
• For us the most known (but not the only) requirement is a 3 per cent limit for the deficit of the public funds (step between income and expenses of the budget at most 3 per cent of the yearly GDP of a country).
• The central bankers asked the member countries during the creation of euro, to commit to a management with balanced, eventually surplus national budgets and in times of a business weakening to upkeep the deficit up to 3% of GDP.
• Why 3% GDP? Such a maximal yearly increase of the debt makes it theoretically possible, assuming a long term potential for the growth of developed businesses by a real achievable tempo of about 3%, that it doesn’t come an inadequate increase of the overall debt.
• What for 3% GDP? So that the country has a deficit pillow accessible, thanks to which it could overcome those regularly recurring recessions on its own, even without the need for fiscal transfers as it’s known in the USA.
• The Devil lies in the details: the original spirit of the stability and growth pact required a responsible budget management, so a balanced or surplus budget in times of business growth and in times of the weakening of the economy a deficit within 3% of the GDP.
• A number of the member countries of the Euro-zone (including Spain, Ireland, Finland and others) really kept this spirit of the pact and in times of expansion were their national budgets managing with surpluses.
• In many however, overtook the political interpretation of the pact as a 3 per cent limit for the deficit without any regard to weather and phase of the business cycle. Slow and ineffective sanction mechanisms didn’t allow for a timely and point-blank intervention towards the members that didn’t keep to the rules.
• This dis-interpretation of the original spirit of the coordination rules for the budget policy and an insufficient and slow enforceability of their compliance belong to long term seeds of the problems in the current situation.

Recession in the Euro-zone: causes and consequences for the public funds.

• The regularly recurring recessions as if by textbook open the scissors between the budget incomes and expenses: the weakened economic activity decreases the amount of taxed income, on the other hand some budget expenses grow more in times of recession (i.e. social expenses).
• A rapid fall of the business activity in the USA, where the recession started already at the end of 2007, was through the foreign trade in 2008 brought over into the recession in Europe.
• The lifeline of the foreign trade that brought over the recession weakened the budged incomes and deepened the budged deficits practically in all member countries (the overall deficit of the member countries of the Euro-zone was with this in year 2009 deepened to 6.3% GDP).
• Especially in the case of the countries with a high public debts (inherited from the past before euro) the deepening of the deficits to levels multiple times higher than it was assumed at the creation of the Euro-zone by the agreed terms, discouraged the bond investors.
• The increase of risk surcharges of the weakest members and an increase of the interest rates required for the refinancing of their debts gradually led Greece, Ireland and Poland to ask for cheaper bridge loans from other members.

Did the tough winter weaken only the sick ones?

• Did the most serious after-war crisis cause budget problems only in the weakened countries, that already before the recession neglected the prevention and preparation to the cyclically recurring recessions?
• That’s not all there is to it: a serious deepening of the deficits was also noted by many countries that were in years of a business growth ideal examples of a surplus budget management (for example Spain or Ireland).
• The negligence of prevention (violation of the spirit of the stability and growth pact) created a living ground for the current situation: in times of recession is also the surplus budget in a deficit due to the fall of incomes: the budget, which is deficit in times of growth will during the times of a recession fall even deeper, often an unsustainable step.
• Direct and most important cause of the current situation is the most serious after-war global recession. It worsened the management of the budgets in the unprepared countries (Greece), but also in the ideal ones (i.e. Ireland).

How does the refinancing of the public debt work.

• One of the popular, and a common disinterpretation of the functioning of the public debt, is linked to the means by which these public debts are refinanced at the bond market (a so called roll-over):
  • The debt increases of the national budgets of the past years, which accumulated represent a public debt, are financed by emissions of national bonds with a definite date of expiry.
  • Similar to the theory of business finances, which is concerned about solvency rating of a company that takes into account besides the optimal debt burden also whether it can make enough to pay for the interest rates, it is also assumed in the case of public funds that the responsibly managing countries with growing economies will in times of the bonds expiry manage to borrow on the trade market again for the payment of principal by the emission of new bonds.
  • Through such a system of from time to time emitted national bonds of various expiry are practically all public funds being refinanced (with the exception of national bonds, that are promised only as a pay for interest rates, but don’t have any set date of the principal expiry).

When do we pay for this and how? The basic assumption for the decrease of the debt.

• How do countries in this regime decrease their debt burden?

1. In times of business growth to manage with surpluses, from which they pay a part of the gradually maturing national bonds (USA at the end of the 90’s, Spain, Ireland or Finland before the recession).
2. In times of business growth is the growth of the public debt (yearly deficit) slower than the growth of business efficiency. The faster growth of GDP than the public debt leads to a decrease of the relative statement of the public debt in proportion to the efficiency of the economy. (example of Slovakia in years 2001-2008, more countries after the 2^nd world war).
3. From the point of the sustainability of the public debt is the economy efficiency, trend in the development of the relative debt in proportion to GDP and the ability to duly and in time pay their interest crucial for the investors.

• Alpha and omega of the long term sustainability of the public funds is the business growth and the creation of the best investment and business environment for its strengthening.

National bonds as speculation?

• Where does the money for national bonds come from?
  • Emitted national bonds are bought by private investors as a tool of the most conservative and least risky savings valorization.
  • The private investors require for the difference in riskiness of eminents a different risk surcharge for undergoing a credit risk.
  • Is the purchase of the national bonds a speculative investment?
    • From the definition is a loan to the government on a given market considered to be a less risky loan: the country sets themselves the price for its services (taxes) and has a monopole for the use of power for its enforcement (tax office, police, etc.). That’s why is on the given market by definition any private debtor more risky (the price of goods of the private companies is created on the market, the private businesses face an insecurity of competition, or changing consumer preferences).
    • On the given market is therefore a loan to the government – national bond, considered to be the most conservative accessible investment (we shouldn’t forget, that the private businessmen on the given market belong under the jurisdiction, but also under the taxation powers of the government).
    • Are the national bonds without any risks?
      • The global bond market has a rich and long history of national defaults (for example Argentina or Austria not too long ago). But at the same time it has an elephant’s memory.
      • The bond market penalizes the debtors for such credit “accidents” by making the next access to the bonds market harder and more expensive (even after a default of a country there is public debt, even if smaller).
      • The status of a reserve currency has USA gained exactly through its spotless credit loan. The foreign central banks assume, that thanks to the advantages, which brings the use of the reserve currency, has the Euro-zone the ambition to keep a comparable credit, as a 331 million currency bloc of the second most important reserve currency of the world.

Protection of the private property and the enforcement of voluntary commitments.

• Modern countries are in the market economy considered to be guaranty of basic pliers on which the market system is based:
  • Protection of the private property
  • Securing of the enforcement of voluntarily accepted commitments.
  • National loan (bond) belongs to voluntarily accepted commitments from the country towards the private investors, investing their private savings.
  • Carefree experimenting with the violation of the commitments of the country, as from the definition of the least risky debtor,  is why they can undermine the trust of the investors and businessmen comparably to, for example an expropriation of private property.

Basic principles of external help: a whip hitting every trimester

• Countries, of which the public financing worsened to such a degree that the private investors require inadequately high interest rates, reach after the bridging loans of the transnational lenders instead of the refinancing at the bond market.
• Those are for example International Monetary Fund (IMF), or the nascent European stability mechanism.
• IMF was created after the second world war as a safety net for the countries in temporary budget problems. It was the message from the interwar development, which showed that leaving a country in problems to help itself can in extreme cases lead to events that are for all others (international community) much more expensive, than a timely sympathetic help.
• In the recent past was the safety net IMF activated in case of Hungary, but the bridging help was also given to Romania or Serbia. Slovakia is also a financial contributor of the IMF.
• External bridging loan, whether from the IMF or from the European stability mechanism, isn’t an expense, but a loan so an asset which brings interest revenue. Besides that the transnational lenders have, compared to the private investors, during such bridging loan set requirements for the renewal of the public funds and economy, regular and detailed valorizations, but also enforcement of compliance.
• Not only Ireland, Portugal and Greece, but also Hungary during the electoral year 2009 got convinced that the transnational bridging loans are besides interest rates (even if lower) accompanied by a strict whip of painful requirements.
• Considering the regular assessment and a strict observation by the transnational lenders it’s in the interest of the country to do the best they can to evade a dependency on the international safety net, which is linked with a notable weakening of the sovereignty of the decision making about their own public funds.

Euro bailout funds: the European version of IMF, respectively a seed of the federal debt agency.

• The biggest contributor of the IMF is the USA. That’s why when the activation of this proven safety net threatened in case of the country within the Euro-zone, as a currency block using the competitors currency against dollar, strong votes, according to which Europe should solve its own problems, were voiced.
• The IMF also contributed to the loan of Greece, also to the European stability mechanism, but only financially and with professional help, as a major “shareholder”, the European countries hold the most important discretionary powers.
• The European stability mechanism can be compared to either the European version of the IMF, or to a seed of the European federal debt agency (one of the currently non-existent parts of the closer fiscal integration).

Targeting of the external bridging help: time for healing and reforms

• The bridging loan from the transnational lenders (whether its the IMF or the European stability mechanism) isn’t and shouldn’t be on its own a remedy for the problems of the weakened economies.
• The international bridging loan is only one of the parts of a more complex solution for the situation of countries, that ended up in this “intensive care unit”:

1. Liquidity: the bridging loan gives limited time of liquidity in order for the country to manage the refinancing of the due public funds also without the bond market and private lenders.
2. Interest expenses: after the in advance limited time the bridging help makes the interest expenses for the refinancing of the public debt cheaper against what the country would have to pay to the private lenders.
3. Time for healing: the supply of a cheaper liquidity for the refinancing of the due public funds creates for the weakened countries space in time for the realization of the necessary healing measurements in the field of the public funds as well as in the area of structural economic reforms, which support the business efficiency and create conditions for a long term growth of the economy (the economy is crucial for the support of sustainable public funds).

• The compliance to the terms of the bridging international help is painful and unpopular (see Hungary in 2009), however for the weakened countries it’s less painful than the consequences of the worst case scenario.

A loan isn’t an expense, but an asset that brings revenue.

• Bridging help isn’t an expense for the help of the concerned countries, but a duly credited loan, so an asset that brings revenue.
• Where does the money for the international bridging help come from? In principle, from the same private investors, who would borrow to the concerned countries more expensive.
• The loan mediated by the stronger and healthier members (whether IMF or the Euro-zone) is cheaper, but mainly compared to the loan from private lenders it’s linked with strict, regularly evaluated and enforced terms of the renewal of the concerned country.
• A proven effective tool of enforcement is the drawing of the bridging help in quarterly installments, while every new one is conditioned by the fulfillment of the agreed terms and by the setting of new “homework”.

What helps the situation? What worsens and deepens the debt crisis?

• The safety net of the international bridging help is therefore supposed to help the country to bridge the swampy terrain and create conditions for the decrease of the imbalances in the public funds and a realization of structural reforms necessary for the renewal of the business growth.
• As we already mentioned, in the case of the countries using a common currency it is expected by the foreign central banks that the credibility of commitments will be diametrically higher, similarly the solidarity while defending the credibility of the common currency and its member countries.
• A slow and hesitant setting of the required safety net supports speculations of the sharks, who reach in the finance market for the short term revenues of the worst case scenario of the debt crisis.
• The worst case scenario, which is linked to serious shocks of the finance market and a fall of the real economy (and a fall of the taxed incomes), is not a sustainable solution of the public funds state, but a way to its serious worsening (higher deficit and a faster increase of the public debt).

Where did the shares of the bridging loan come from?

• During the entrance to the European union all member countries agreed a share of the basic capital of the European central bank. The shares were created as a combination of the rating of the business efficiency and the size of the country within the EU.
• “Shareholdings” in the ECB are, besides other, crucial for the pay of dividend from the income of ECB.
• This key was used during the creation of the shares in the European stability mechanism.
• Slovakia is a 0.69 percent shareholder of the ECB. 17 member countries using euro take part on the basic capital of the ECB by 70%.

The consequences of the worst case scenario of the debt crisis:

• Three member countries are currently in the state of dependence on the international bridging help: Ireland, Portugal and Greece.
• The worst scenario would under extreme pressure of the finance market with a high probability affect all of them together.
• What would be the consequences of the worst case scenario of the debt crisis in the euro-zone:

1. Serious deepening of the economy weakening. A domino effect, which would affect the real economy and employment, would similarly to September 2008 cause a worsening of the accessibility of the capital to finance the real assets of businesses (fixed investment).
2. Serious damage to the credibility of euro as the second most important reserve currency of the world. The foreign central banks assume, that the credibility and solidarity of the Euro-zone is comparable to the USA, not to the countries of South America, or east Europe. The shock that would come with the negation of this assumption of the global finance market would overshadow September 2008.
3. The restrain of the interest expenses of all members of the Euro-zone, even though to a different extent. The weakening of the demand from the foreign central banks would increase the interest expenses for the refinancing of the public debt, which in case of the countries of the Euro-zone already exceeds 85% of GDP.
4. The worst case scenario in case of the Euro-zone could undermine the process of the political integration of the EU, as the chief of the American Fed, Ben Bernanke, warned in summer of 2011. The common European currency is not only a project of the 17 countries using euro, but a flagship project of the whole EU (that’s also why the new member countries agreed to the commitment to accept euro after meeting the criteria).

• The severity of the consequences of the worst case scenario of the debt crisis in the Euro-zone for all participants (countries with problems as well as other members) expressly leads to the conclusion, that it is in the interest of all concerned to make the best effort to avoid the worst case scenario in the Euro-zone.
• The solidarity in case of the European stability mechanism isn’t only a solidarity of the healthy towards the sick, but also a solidarity of the healthy towards each other, in order to together evade the scenario, which would in the end effect damage them irreversibly (i.e. the loss of the status of a reserve currency and the related advantages).

Is the situation of the Euro-zone felt only by its members?

• The tension within the Euro-zone is not hermetically sealed by its boundaries.
• The risk of serious turbulences on the finance market, as a threat of the weakening of the demand from the main export market is felt also by the countries of the region behind the boundaries of the Euro-zone in the form of the increase of risk surcharges as well as through the rapid weakening of its exchange rates, by means which similarly to years 2008/2009 represents a risk of the inflation development of the consumer prices.
• The countries of the middle and east Europe aren’t an island for themselves and as for the export dependent economies that they are, the worst case scenario of the debt crisis in the Euro-zone isn’t in their interest, whether they use their own currency or euro.