The Europe Crisis from a European Perspective

[This week, we introduce a new contributing editor to, Alasdair Macleod. He will mostly be contributing commentary focused on the situation in Europe, where he's located. The credit crisis underway there is not Europe's problem alone; it has the potential to send crippling financial shockwaves to the US and elsewhere around the world. Please join us in extending a warm welcome to Alasdair. -- Adam] 

The purpose of this report is to give readers the essential background to the economic problems in Europe and to bring you up-to-date in what has become a fast-moving situation. At the time of writing, there has been a lull in the news flow, but that does not mean the problems are under control. Far from it.

Flawed from the Start

When we talk about Europe today in an economic context, we really mean the Eurozone, whose seventeen members are the core of Europe and share a common currency, the euro. The euro first came into existence thirteen years ago, on January 1, 1999, replacing national currencies for eleven states; Greece joined two years later. In theory, the idea of a common currency for European nations with common borders is logical, and it was Canadian economist Robert Mundell's work on optimum currency areas that provided much of the theoretical cover.

However, the concept was flawed from the start.

The euro would have made sense if the economies of the member states had been allowed to converge -- that is, evolve -- so that they had similar characteristics. While this was the intention from the outset, the mistake was to put convergence in the hands of politicians and their economic advisers, who (if not representing socialist parties) were and still are all interventionists. This meant that they pursued their own national agendas by intervening in their respective economies while paying lip-service to the greater European ideal. Therefore, convergence was never going to happen.

The point everyone missed is that the only way convergence could occur is if all member states relinquished government planning and control of their individual economies, so that an undistorted free market across national boundaries could have developed. Instead, central planning by individual member states was the order of the day. Control mechanisms, such as limits on government borrowing as a proportion of GDP and permitted budget deficits, were breached with impunity, and the fines that should have been imposed under the Stability and Growth Pact of 1997 were never implemented. Today all Eurozone members are in breach, with the minor exceptions of Finland, Estonia, and Luxembourg.

The naïve ambitions behind the Maastricht Treaty were only the start of the euro-fudge. The whole point of the euro, so far as France and the Mediterranean countries were concerned, was to escape the monetary straitjacket of the deutschemark, with which their individual currencies were unfavourably compared in the foreign exchange markets. The Bundesbank, Germany’s central bank, was truly independent of government, and operated with the single mandate of price stability, while the other national central banks were extensions of high-spending governments. It was to de-politicise note issuance that, based on the Bundesbank model, the European Central Bank (ECB) was created to be independent of all governments.

Looser Standards, Easier Money

However, while the Bundesbank was focused only on price stability, the ECB relies on a wide range of indicators to guide monetary policy. So where the Bundesbank was single-mindedly objective in its approach, the ECB has become variously subjective, being able to choose its statistical indicators at will. While the ECB is regarded by most commentators as following restrictive monetary policies, they are considerably more expansionary than the old Bundesbank.

Anyway, the result was that borrowing costs for France and the Mediterranean countries fell rapidly to a significantly lower margin over Germany’s, which was taken as the “risk-free” rate. European banks geared up their lending to benefit from the spread, locking in a one or two percent differential between German bond yields compared with, for example, Italian government bonds. Gearing (i.e., levering up with further debt) this differential ten or twenty times was a no-brainer, particularly when it was backed by the implicit guarantee of the whole system. This was party-time for banks, and amounted to ready finance for profligate governments, which was the underlying reason that Greece joined -- to benefit -- two years after the start of the Eurozone.

In order to be eligible for monetary union in the first place, the future Eurozone members had to put their houses in order to meet the convergence criteria. For those with unacceptable debt-to-GDP ratios, this meant shifting debt “off balance sheet,” typically by dropping nationalised industries from the national accounts. Various other fudges were devised to make appearances acceptable for the target year of proof of convergence: 1997.

This means that even today, declared government debt is only part of the whole government debt story, with government guarantees, actual and implied, giving a far greater potential problem than headline debt figures suggest.

The Party Kicks into High Gear

Greece was a special case, joining the Eurozone two years after the start. She had so mismanaged her affairs before entering the euro that membership in the Eurozone amounted to a rescue of Greece’s finances. Interest rates for government borrowing in drachmas had been over 20% for much of the 1990s. By 1999, when her plans to join the Eurozone began to be discounted, Greece's short-term government debt yields had fallen to 7.25%. By 2005 they had fallen to only 2.5%, and even 10-year government bonds yielded less than 3.5%. At the same time, Greece’s official central government debt rose from €83.22bn in 1999 to €175bn in 2006, rising further to €264bn by 2010.  

Bank lending was expanding rapidly in other countries as well, particularly Ireland, Portugal, and Spain. And it wasn’t only government: The private sectors of these latter three countries experienced property bubbles on the back of easy credit that sooner or later were certain to burst.

When things are booming, politicians take the glory and revel in their supposed success. At the domestic level, they loosen constraints on spending. They delude themselves that the boom is the result of their economic policies, so they extend planning and controls over the private sector at the behest of favoured pressure groups. Most European parliaments are coalitions, whose cohesions are bought through favours and money, corrupting the whole political system. And at the pan-European level, boom-times also encouraged politicians to grab their share of glory on the bigger stage by trying to outdo each other in their support of a common European ideal. Theirs is still a world of imagined power and uncontrolled spending. The EU budget, an expense on top of national accounts, is seen as a source of funds for everyone to grab before the annual budget allocations are used up. The result is that the EU budget has been unable to pass an audit by its own auditors for the last seventeen years.

With this gravy-train in operation, it is hardly surprising that the politicians and their favoured appointees lost touch with economic reality. The extraordinary lack of humility from European leaders is evidence of this, and entirely human.

Reality Intervenes

Economic conditions have now changed, with fear of deflation replacing easy money from before the credit-crunch and the Lehman crisis. From then onwards, banking changed from a world of expansion, of using all devices, including off-balance sheet vehicles, and hypothecation of collateral, to expand their lending. It was replaced with a sudden awareness of risk, of falling property prices and over-extended construction businesses.

This rude shock was a global phenomenon, affecting the US and the UK as well as mainland Europe. To stop the global banking system from going into a systemic melt-down, Sovereign states agreed to stand behind their commercial banks, guaranteeing all deposits. In effect, they were committed to underwriting balance sheets that totalled multiples of their own GDPs, turning a banking crisis into a sovereign debt crisis.

This was bad enough for countries with their own currencies, but Eurozone governments cannot support themselves with monetary printing, control of this function having been passed to the ECB (the exception is the TARGET settlement facility, which is described below). So while the US and UK were able to print dollars and sterling respectively via quantitative easing (QE), Eurozone governments were unable to do so.

The Importance of TARGET

The reason quantitative easing has been so useful to governments elsewhere is that it allows government deficits to be funded without paying interest rates demanded by bond markets. For that reason, interest rates in US dollars, pounds sterling, and Japanese yen can be held artificially low despite government guarantees to underwrite their banks’ liabilities. The further advantage of QE is that it provides commercial banks themselves with liquidity to offset contracting balance sheets. In the absence of QE, Eurozone governments cannot so easily address their immediate financial and economic obligations, and so they face the scrutiny of risk-averse bond investors.

Of course, central banks are careful to de-emphasise the reasons for QE stated above. But the publicly stated reason, which is to help kick-start an economy, is obviously relevant where economic recovery is prevented by the actions of banks worried about deposits walking out of the door. This problem and that of capital flight are generally avoided in the EU periphery countries by the smoothing operations of the national central banks, which control the cross-border settlement system known as TARGET (an acronym for the Trans-European Automated Real-time Gross-settlement Express Transfer System).

Money flowing, say, from Greece to Germany is replaced by the Bank of Greece issuing euros to leave the quantity of money in Greece unchanged, and the inflow into Germany is neutralised by the Bundesbank withdrawing euros from circulation for the same reason. Both trade imbalances and capital flight are accommodated by these means, and there is therefore no net currency issuance to accommodate them. By this mechanism, local banks facing depositor withdrawals in favour of stronger banks in other jurisdictions are kept solvent without recourse to the ECB.

If it wasn’t for TARGET, the ECB would have had to step in to stop banks in the periphery countries from collapsing. Instead, TARGET has bought time by smoothing capital imbalances and can be expected to continue to do so. The effect has been for national central banks in the periphery nations to operate their own, hidden version of QE, concealed from public scrutiny because it is offset by money being drained elsewhere from the system, mostly by the Bundesbank in Germany. 

Dangerous Imbalances Are Building

In the accounts of the central banks, the withdrawal of money in Germany by the Bundesbank is balanced in this example by a loan to the Bank of Greece, and since the Bank of Greece is guaranteed by the Greek Government, this is an extra, hidden government debt of which bond markets are generally unaware. Loans under TARGET by the Bundesbank and other national central banks to the Bank of Greece at end-2011 stood at about €100bn, which is a combination of Greece’s cumulative trade balance with Eurozone partners and capital flight. To put this in context, Greece’s GDP is estimated to be about €220bn, so the other national central banks are stuck with unsecured loans on their books that amount to 45% of Greek GDP. And remember, this does not include capital flight over the last three months, which in all probability will have accelerated.

Other TARGET “assets” in the system at year-end were €195bn owed by Bank of Italy (11.7% of GDP), €170bn owed by Bank of Spain (12% of GDP), about €120bn owed by Bank of Ireland (75% of GDP), and €55bn owed by Bank of Portugal (30% of GDP). Exposures in the form of loans are over €500bn to the Bundesbank, and a further €370 to the Netherlands, Luxembourg, Finland and the ECB itself.

These are serious imbalances, particularly for the smaller countries, and without them not only would their commercial banks have already folded, but asset prices would also be considerably lower. While these outcomes have been avoided so far, growing imbalances (if left unchecked) can only result in the eventual collapse of the TARGET system. 

Conclusion of Part I

The above summarizes the essential background to the problems faced by the Eurozone.

In Part II: What Lies in Store for Europe, we address the logical next question: How will the tragedy play out from here? 

We look at the critical roles played by Germany and the ECB, the only two entities with enough clout to determine a permanent outcome for the current Eurozone. And we examine the fast-eroding fundamentals for Spain, Italy, and France that will soon force a decision on the euro's fate.

Lastly, we recognize that the European credit crisis offers a rare opportunity for investors: a near-certain bet. 

Click here to access Part II of this report (free executive summary; paid enrollment required for full access)

This is a companion discussion topic for the original entry at

A hearty welcome Alasdair. This is an excellent report. The part about TARGET was fascinating and completely new to me. The collapse of the Euro seems inevitable, and will have global repercussions, so we are fortunate to have you reporting from the scene.


Clarity and precision in a sea of confusion and opaqueness.

This description of TARGET is fascinating.  One wonders why Germany isn’t in the grips of severe deflation given the amounts of the money the Bundesbank is taking out of the economy.

 Hi DebuThe money being withdrawn from circulation merely balances euro inflows from elsewhere, so there is no deflation. The trouble is what is not seen, i.e. the money that ends up owed to the Bundesbank by the Bank of Greece et al.

 I, too, extend you welcome to  I was completely unaware of TARGET.  It helps explain the imbalances between Eurozone countries that have had some of us scratching our heads.

 Are these hidden imbalances due to TARGET a reason why countries like Greece are not being allowed to fail?