On Our Periphery

Disturbances in global financial markets, in the banking sector, as well as the troubles of the eurozone and the persistently low growth rates of developed countries constitute what for the past 5 years has been dubbed “the global financial crisis.” We can take as its starting point the run on the British bank Northern Rock, which was caught up in the American subprime mortgage market. The bank lost its financial liquidity in September 2007 and was nationalized two months later. In March 2008, the Federal Reserve in New York saved a huge investment bank, Bear Stearns, from bankruptcy. The estimated numbers of toxic loans in the banks’ portfolios was rising every week but there was still no mention of the global crisis.

It was the Lehman Brothers’ bankruptcy in September 2008 that caused a wave of panic on the markets. As a first consequence, it brought lending between banks to a standstill. The crisis quickly shifted towards the eurozone, where the banks had financial instruments issued by the American banks in their portfolios.

We are confident today that we are facing the deepest structural changes in the global economy since World War II, accompanied by transformations in economic policy. The debate on the reasons and consequences of the crisis is still open. It is worth remembering that the reasons for the Great Depression of the 1930s have not been explained up to today. Therefore we should not expect the economists to reach consensus on the current crisis, which is still far from over, and which rouses emotions and carries various political implications.

Who is Guilty, the Market or the State?

The first assessment concerning the reasons for the crisis focused on improprieties in financial practices and on irresponsibility and immorality of bankers. The main explanation was that the introduction of overly complicated financial instruments created inestimable risk. The ambiguous role of rating agencies is often emphasized. Some commentators have highlighted improper incentive schemes for motivating financial managers, who were rewarded for risky operations and were not symmetrically made responsible for losses incurred by them.

The free market and liberalization of financial flows at the end of the 20th century were commonly held responsible for the emergence of the crisis. The pendulum of public feeling has shifted towards the champions of the more restrictive state control of the private sector, particularly of finance, as well as deepened state intervention in the economy.

Taking a 5-year-perspective, it is now easier to tell the superficial events from the root causes of the crisis. If the crisis was generated by a lack of regulation, excessive liberty in the field of financial flows, the recklessness of bank managers and the market orientation of the policies, the recently introduced regulations, severe intervention of governments and central banks into the market economy should have ended it. But that did not happen. On the contrary, the interventions that went still further, including unconventional monetary policy of central banks as well as maintaining interest rates close to zero, have caused imbalances in the financial markets. For example, we can take the negative interest rate for some instruments such as short-term bonds in Denmark, Switzerland and Germany. Despite the fact that the central banks have pumped hundreds of billions of dollars and euros into the economies, developed countries are not able to return to a level of steady growth.

In fact, the excessive debt, caused by monetary policy of some central banks, particularly of the American Federal Reserve, is the fundamental reason for the crisis. Cheap loans, made available by the Fed, raised stock and real estate prices. Suddenly the bubble came to an abrupt end, causing a series of disasters that the world has been coping with up till now.

In recent years it has become fashionable to state that the financial crisis proves the bankruptcy of economic theories. Nevertheless some of them accurately explain the background. Hyman Minsky, an American economist who died in 1996, asserted that long-term economic stability establishes the conditions for financial instability. If we believe that tomorrow will be as good as today, we are disposed to indebt ourselves, instead of saving money. Thus, longterm stability produces a higher risk of potential instability. The recent financial crisis, like that of the 1930s, appeared after a long era of prosperity.

According to Professor Erich Streissler, who follows the economic theory of the Austrian School, “the 2001 crisis was postponed because the monetary and fiscal policy was loosened, and then it burst in 2008” (cited in “W irtschaftsBlatt” from September 2011). Professor Streissler claims, in accordance with many economists, that American growth of 2002–2007 was artificially sustained by the economic policies of the government and the Fed. If the crisis had broken out six years earlier, we would have witnessed a series of lesser shocks that would, as Minsky and the Austrians believe, have restored the balance.

A Debt and a Deleveraging

The debt of developed economies began to increase promptly between 2000 and 2008. In that time, the private and public debt of Great Britain rose by 157 percentage points (as a relation to GDP), while in Japan it increased by 19 percentage points, in Spain—150, in Korea—93, France— 83, Italy—64, Switzerland—17 points, in the USA—70, in Germany—7 and in Canada—28 percentage points (according to the McKinsey Global Institute). Both debt and its dynamics had different structures in each of those countries. In the USA, Great Britain and in Spain, its main component was real estate and mortgages, while in Japan it was government debt. The real estate market in the USA and several other countries was supported not only by mortgages, but also by complex financial instruments, secured by credits. The consequence was a huge level of indebtedness throughout the financial sector, which was no longer able to finance loans with deposits. A compound pyramid emerged, the collapse of which was a direct trigger at the outbreak of the crisis.

Between 2000 and 2008 US debt was growing at 3.5 per cent a year, with British at 5.2 per cent and Spanish at 7.4. Due to such an increase, demand was also rising so the economy gained an “additional motor” and was flourishing.

Professor Kenneth Rogoff, a historian and an economist, author of the book “This time is different,” which provided an analysis of historical financial crises, realized that the crisis of the debt produced a deeper fall in GDP, a longer period of stagnation and a higher unemployment rate than a “normal” recession, which occurs every several years in market economies. The economic growth was held by debts in both the private and public sectors. So, it was necessary to lower the debt levels of enterprises, households and the public sector, in order to increase growth and lessen the risk of another recession.

The statistics showed that the reduction of debt (also called deleveraging) has occurred only in a few countries. Others have increased their debt, although at a slower pace than before the crisis.

Since summer of 2008, American debt has begun to diminish in relation to both the previous years and to GPD. It is now 12 percentage points less than in the critical moment of 2008.

The only component of debt that actually rose is the indebtedness of the public sector. Its increase is partly generated by the adoption of debt from the other sectors (by bailing out banks and helping out those caught in the mortgage crisis). The other cause of the increase was the stimulation of the economy issued for fear of recession and deflation.

Since 2009, the joint debt of the US private and public sector has fallen from 375 per cent of GDP to 353 per cent. In 2000, this debt was only 250 per cent of GDP, so there is still a huge gap between those numbers and therefore deleveraging will continue.

The bright side is that deleveraging has led to an improvement in bank balances. The American program of bank reform, introduced in autumn 2008, has proven successful. Big banks that were consolidated by public capital have returned to the hands of private shareholders.

The eurozone has not begun to deleverage yet, although some of the debt load has already lessened. The German economy’s debt continues to be low-level. According to McKinsey Global Institute, French debt grew between 2008 and 2011 by 35 percentage points (in relation to the GDP), whereas in Italy it was 12 points and in Germany one point.

The Eurozone Crisis

The global financial crisis became a debt crisis in the winter of 2009/2010. In 2009, all European countries abruptly increased their deficits in order to stimulate economic growth and counteract recession. Some of the countries, particularly Ireland and Spain, had relatively low public debt, but their banks were deeply indebted, so in order to save them, the state had to indebt itself. The result was an increase of public debt in most of the 27 EU countries. In 2008, it was 62.5 per cent in relation to GDP, whereas in 2009 it rose to 74.8 per cent and in 2010, 80 per cent. The total debt of the eurozone members rose from 70.2 per cent in 2008 to 85.4 per cent in 2010.

By the end of 2009 a newly formed Greek government under Jorgos Papandreu (he won the elections in October 2009) revealed that Greek finances were worse than what the previous governments had maintained. Part of the debt was kept secret. The profitability, i.e. the market cost for Greek bonds began to rise. In October 2009, 10-year-bonds had a yield of 4.4 per cent which was only 1 per cent higher than German bonds. But by the end of 2009 it grew to 6 per cent and in April 2010 reached 10 per cent.

Greece and Italy were the most indebted countries in the eurozone. When they adopted the euro as their currency, the cost of loans significantly fell but the savings that were produced on that occasion were not allocated for the consolidation of public finances, they covered an increase in spending. Consequently, the debt remained high. These countries were only able to finance it because the eurozone was keeping interest rates low. But the panic on the markets, catalyzed by the crisis in the American mortgage market, raised the debt burden in the most indebted European countries to a level, at which they could no longer sustain it.

The second reason for the crisis, the one that sometimes is unperceived by the public, is the deep variety in competitiveness within the eurozone. In 2007–2008, the cost of labour in Germany grew only one per cent, while in Greece it grew 37 per cent, in Italy—31, in Spain—29 and in Portugal—25 per cent. The German economy, which even before the emergence of the common currency was more competitive than the economies of the South, has in the last decade maintained its supremacy.

Lack of competitiveness is one of the main causes for the deep recession that is occurring in Southern Europe. Between 2008 and 2011, the Italian economy shrank by 5 per cent, the Greek—13 per cent, the Portuguese—3 and Spanish—over 2 per cent.

Restraining the eurozone crisis means:

• maintaining solvency for indebted countries;
• lowering the debt level;
• improving competitiveness in SoutherncEuropean countries;
• launching growth mechanisms in thoseccountries.

The first task is the most pressing, but relatively simple. In May 2010 the European Financial Stability Facility (EFSF) was introduced with license to incur debt up to 440 billion euro. European Financial Stabilization Mechanism (EFSM), in which all the EU countries participate, can dispose of an additional 60 billion euro. In 2013 the European Financial Stability Facility fund will be substituted by a permanent institution called the European Stability Mechanism, centered in Luxemburg, with as much as 700 billion euro where one fourth will be given by Germany.

Four countries have received financial support from the above-mentioned funds. Greece received it twice: 110 billion euro in May 2010 and 130 billion euro in 2011. Ireland received 85 billion euro in October 2010, Portugal 78 billion in April 2011 and Spain 100 billion in financial help for its banks in June 2012. The International Monetary Fund also supports these indebted countries. The IMF provides experts and oversight to make sure that their loans are well controlled.

An increase of GDP in 2008–2011.

2007=100

EU 27 countries	99.4
EU 15 countries	99.0
Eurozone 17 countries	99.3
Belgium	102.3
Bulgaria	102.5
Czech Republic	102.7
Denmark	95.6
Germany	102.5
Estonia	90.8
Ireland	90.7
Greece	86.7
Spain	97.7
France	100.3
Italy	95.4
Cyprus	103.3
Latvia	83.7
Lithuania	94.1
Luxemburg	99.1
Hungary	96.9
Malta	105.8
The Netherlands	101.1
Austria	102.9
Poland	115.7
Portugal	96.9
Romania	101.1
Slovenia	96.5
Slovakia	108.3
Finland	98.1
Sweden	104.1
Great Britain	97.3

For maintaining the liquidity of EU member states, the European Central Bank has taken up Long Term Refinancing Operations (LTRO) twice, granting low-interest loans to commercial banks. This was in 2011 and 2012. The total amount of these loans exceeded 1 trillion euro. In a large part, it was used to purchase bonds, which for some time lowered the profitability of Italian and Spanish issues. In September, 2012 Mario Draghi, CEO of the ECB, declared that the Bank would have to purchase short-term bonds of indebted countries on the market but those countries would have to ask for help themselves. This declaration led immediately to a decrease in the profitability of 3-year Italian, Portuguese and Spanish bonds. The problem of liquidity in peripheral countries was solved for a time. More difficult and time consuming was the task of diminishing the imbalance between the countries of the European South and North and the revitalization of economic growth.

Many economists did not believe that it would be successful. But statistics for Greece, Spain and Italy demonstrate that those economies are reforming and being restructured, although gradually. In Greece, falling wages in both the public and private sector have caused a significant reduction in labour cost: 11.1 per cent in 2011 in relation to 2010. In relation to 2009 this reduction reached 17.4 per cent. The improvement in competitiveness is already evident in statistics for foreign trade. In 2011, Greek exports increased 39 per cent, while in 2010 it was only 11 per cent. Export to countries outside the EU grew faster than exports within the Union. The deficit in transactions lessened between 2008 and 2011 by over 10 per cent of GDP, or 24 billion euro. The forecasts say that in 2012, the growth in exports will significantly alleviate the decrease in Greek GDP. The data confirm that the inner devaluation (price reduction of production components) in Greece has proven to be efficient.

Similar processes have occurred in other peripheral countries. If reforms and a reduction of labour cost led the Southern countries on a path of steady growth, a gradual lessening of debt and self-contained financing of public needs will be possible without resorting to emergency funds.

Where does Europe go?

Crisis means deep structural changes in the global economy. Their consequences consist of:

• reduction of the imbalance between exporters and importers (the Chinese trade surplus is diminishing, China will soon face negative trade balance);
• a change in lifestyle of the inhabitants of the developed countries: American families will raise their savings; Europe will dismantle some of the institutions of the welfare state;
• a change in business models: the real economy will be less dependent on financial institutions;
• a change in the specific gravity of the global economy (probably towards Asia, particularly China, but some other complex moves are also possible);

The crisis constitutes not only economic but also political challenges for the EU. The European Commission proved its helplessness as far as the crisis is concerned. The key decisions were made by the European Council at gatherings of the countries’ leaders: the leaders of the strongest eurozone states. The importance of Germany rose decidedly. They have relatively strengthened their economic position in relation to other big countries like France, Italy, Great Britain and Spain.

The European Central Bank has also gained significance, not only economically, but also politically. Its decision to purchase short-term bonds was made against the wishes of the Bundesbank. If the ECB engages more deeply in financing the debts of the eurozone countries, it will inevitably lead to greater politicization of the Bank. The ECB CEO’s and the board’s stance became an object of intense political debate.

The main problems and decisions focus on the eurozone itself. The countries that do not belong to it are less impacted by the peripheral countries crisis on one hand and on the other, they are marginalized in the decision making processes.

The answer to the EU debt crisis and a political crisis is the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union, also called the Fiscal Stability Treaty, and

the banking union. The Fiscal Stability Treaty was enforced mostly by Germany. They wanted to introduce more strict rules for debt incurrence in other EU countries. Europe is convinced that it is Angela Merkel who needs such a treaty in order to appease her constituency (not willing to pay their own money to help the Greeks or the Portuguese). In the meantime, many European countries hope that the Treaty will persuade Germany to be more generous to indebted states and to open capital flows from the European Central Bank as well.

The further step would be to initiate a banking union. The joint supervision of the banks, mutual insurance of deposits and uniform procedures of a so-called “resolution” (that is restructuring and controlled bankruptcy for the banks) will be introduced. The general idea is to recover the banks without spending money from state budgets. The outcome of such a union would also be a further harmonization of eurozone domestic economic policies. It is not yet determined how the decision making procedures would look. Probably, the importance of the European Commission would lessen and the decision making role would shift to a new international organ whose competences would be limited to the eurozone.

The Polish Dilemma

Every couple of years, the European Union undergoes reforms by introducing new treaties. It is a complex, time-consuming and uncertain procedure. The politicians decided hence to shortcut it and introduced the Fiscal Stability Treaty as an intergovernmental agreement. Signing this treaty is a matter of will, not duty.

This treaty does not reinforce any EU institutions. On the contrary, it reduces the importance of the European Commission, the EU Council and the European Parliament. Meetings of those who joined the treaty became a new organ within the EU. Thus 25 or 17 countries will, from now on, make decisions for introduction later in the whole EU.

The banking union would also put Poland on the margins of the integration processes. If the financial supervision rules differ within the EU, another category of country will emerge: those that are not trustworthy enough for the market. In addition, those countries may afterward fall into the margins of the European financial system harmonization.

This would constitute an appalling scenario for Poland. As former Prime Minister Leszek Miller once said: if we are not a part of the eurozone, we are second class passengers.

But Poland needs to pay a lot to join the “first class” EU, the eurozone. For the time being, Poland does not fulfill any of the Maastricht criteria. The government has to limit the deficit first while the Polish National Bank needs to stabilize prices and inflation.

Tusk’s government is too cautious, so it will not decide on joining the eurozone that quickly. It wants to avoid risks and political consequences. So it plays along cautiously, hoping that the eurozone will sooner or later stabilize. The Polish government is not willing to facilitate a preliminary date on the introduction of the euro. It hopes that Fiscal Stability Treaty will fulfill its mission rapidly and leave the scene. Due to a special relationship with German politicians, Poland authorities expect to find their country in a beneficial position between West and East. Such calculations are rational but not at all ambitious, whereas the government does not seem to have any ideas for a European policy, especially in case the situation gets more complicated.