Europe’s Goldilocks Dilemma

Austerity is crippling the eurozone's recovery. But a straightjacket treaty and a latent banking crisis mean it's not going anywhere soon.

For those of us in the reality-based community who have been calling for an end to Europe's insistence on fiscal austerity, this month's meeting of eurozone leaders should have been a cause for celebration: Italian Prime Minister Matteo Renzi finally managed to get Brussels and Berlin to adopt a more "flexible interpretation" of rules regarding budget deficit targets. Finally, it seemed that a change of course had come after six years of disastrous budget cutting.

Not so fast. Europe's budget-enforcer-in-chief wasn't going to let that happen. Shortly after Renzi wrenched this concession, Bundesbank President Jens Wiedmann slapped him down, saying that Italy's insistence on a more flexible budget posed a threat to Europe's economic recovery.

But most of this is just posturing, anyway. Two much more important factors determine the future of Europe's budgets. The first is the fiscal straightjacket countries in the eurozone adopted in 2012 via the Treaty on Stability, Coordination and Governance, that reduces the fiscal maneuvering room from "limited" to "don't even think about it." The second is the ongoing banking crisis that really lies behind Europe's austere economics. A ministerial summit has little power to change either of them.

The policy of austerity has twin goals: reducing growth in public debt and boosting investor confidence. On both counts, the eurozone's attempts have been an unmitigated failure.

Debt levels, far from collapsing, have ballooned under austerity, with countries that have cut the most seeing shrinking economies and growing debts. Greece, the poster child for austerity, went from 105 percent of debt to GDP in 2008 to 175 percent today, despite massive bondholder haircuts and a loss of nearly 25 percent of GDP. Over the same period, Portugal doubled its debts from 62 percent to 129 percent; Spain nearly tripled its debts, from 36 percent to 93 percent; and Ireland, hailed as the eurozone's "success story" for taking the pain and getting back to the markets first, almost quintupled its debt, from 25 percent in 2008 to 123 percent today.

The confidence-inspiring powers of what was curiously called "expansionary fiscal contraction," the idea that budget cuts today make people spend more since they will have lower taxes in the future, haven't been any better. European consumer confidence dropped precipitously during the crisis and has yet to return to positive territory. Investment expectations, as measured by business confidence surveys, similarly fell as austerity took its toll and are now barely positive. Growth rates track these declines but with a North-South twist: Germany is pulling ahead, France is flat-lining, Italy is stagnating, and the periphery remains in negative territory. Unemployment rates (outside the export-driven North) are stuck at levels last seen on the eve of World War II.

Given all this, you would think a halt to such self-defeating policies would be a good idea. And indeed, it is. But that doesn't mean that Brussels and Berlin can actually stop austerity.

Few policymakers are willing to admit it, but the heart of Europe's problems is not excessive government spending or the level of government debt. Instead, politicians focus on these factors since they are easy to blame and allow them to avoid the real issue: the banking crisis. The narrative put forward by the troika of the European Commission, the European Central Bank, and (before they jumped ship last year) the International Monetary Fund -- that government spending caused the crisis -- is flatly wrong. Eurozone debt-to-GDP was going down in the years before the crisis. The real problem was overlending from Europe's big banks (going into the crisis) and how the downgrading of Europe's sovereign debt blew up their highly leveraged model of funding (as the crisis deepened).

European banks got caught short in 2011 when the sovereign debt they used to fund themselves through short-term money markets (where you pledge collateral such as sovereign bonds overnight to borrow for 24 hours and then lend for 30 years) lost value as sovereigns were downgraded. Given that these banks' balance sheets had grown to be multiples of their underlying sovereign's GDP, their ability to fund themselves fell apart as liquidity dried up through 2011 and 2012. And since the eurozone is not a country, and yet its members share a currency (and since its biggest member, Germany, was too small to eat all the bad assets involved), there was no way to print the cash to bail out the banks as Washington and London had done.

Having given away their ability to inflate or devalue their way out of trouble, the only policy option left on the table was deflation, accomplished through austerity. But austerity shrinks the economy and makes debts worse, so when bank funding dried up in late 2011, the Eurocrats realized that they needed to fix the banks before the economy could recover.

In December 2011 and March 2012, European Central Bank President Mario Draghi dumped nearly 1 trillion euros of public money into the European banking system in the form of Long-Term Refinancing Operations (LTROs). This, plus his promise to engage in outright bond purchases if needed, have kept European banks afloat. Indeed, as Oliver Wyman, leading consultant to the ECB, noted, such policies kept European banks afloat with "total state support approved for the EU financial sector total[ing] more than €5 trillion, equivalent to 40 percent of [eurozone] GDP."

When all this cash hit the banking system, banks in the periphery decided their best bet was to buy local sovereign bonds. It seemed like an obvious choice: Spanish 10-year bonds offered nearly 7 percent returns in 2012, while the ECB lent at 1 percent. The banks loaded up on these local high-yield bonds and used the profits to bury the huge amount of non-performing loans on their balance sheets. For a while, it seemed like a good idea. 

Unlimited public liquidity worked out well for the eurozone periphery countries. Despite their low growth and austerity-generated high debt levels, periphery 10-year bonds are now trading close to or below their U.S. equivalent. France, for example, which couldn't hit a deficit target if it were tied to a cow's backside, today trades nearly a full percentage point below the 10-year U.S. treasury. Investors now know that the ECB will backstop European sovereign bonds and, as a result, yields have fallen as liquidity has been restored. 

But if this is a cure, it's still a very long road to recovery. Eurozone governors, in particular the ECB, face what might be called a "Goldilocks dilemma." A strong return to growth could paradoxically undermine periphery LTRO-repaired bank balance sheets while too little could leave the eurozone stuck in the doldrums indefinitely.

If policy is loosened and growth accelerates, interest rates will have to rise. If that happens, the periphery banks holding all these now-profitable sovereign bonds will see their asset base shrink as yields go up, bond prices go down, and their balance sheets implode. Given this, the ECB needs super-low rates, more LTROs, and a host of monetary tricks to allow the banks to clean up their balance sheets, one non-performing loan at a time, in an environment of slow growth.

And here's the rub: If growth is too slow, these policies can't work. Higher growth rates are needed to allow the banks to repair their balance sheets as new, healthy loans replace the non-performing loans. The ECB's recent move to negative deposit rates for banks and the new round of targeted LTROs can be seen in this light as a way to boost lending while negotiating this dilemma. But it's not going to be easy to find a way out.

Given this constraint -- where growth can't be either too hot or too cold -- especially when the ECB is doing an Asset Quality Review (AQR) of the banking sector, any loosening up on austerity risks undermining the policies that have brought yields down and re-liquidated the banks. And while the AQR might help clean up of the worst offenders in Europe's banking sectors, it is hardly a turn against austerity. 

The institutional problem that turbocharges all this is the self-inflected wound called the Treaty on Stability, Coordination and Governance that came into effect in March 2012. This is the eurozone-wide treaty that Renzi wants some slack with -- and little wonder. It calls for national budgets to be "balanced or in surplus" in the medium term with enforcement guaranteed by "preferably constitutional" provisions in national legal frameworks. Countries that have "significant observed deviations" from the fiscal limits in the treaty will be fined. This is constraining enough, but what makes it worse is the so-called macroeconomic imbalances procedure (MIP) at the heart of the treaty, which sets the scorecard for how well countries are doing.

The MIP mandates that countries can only have a maximum current account deficit (imports over exports) of 4 percent or a surplus of 6 percent. Given that imports and exports sum to zero, that surplus of 2 percent must be offset somehow. Countries that export a lot, like Germany, could reduce their surpluses, but that's going to be a tough sell in Berlin. The other option is for deficit countries, such Spain and Portugal, to run permanently tight policies to offset Germany's surplus. That's bad news for any attempt to ease up on austerity in the periphery. And while countries must have a (near) balanced budget according to the treaty, they don't get put on the European Commission's "time out" until unemployment reaches 10 percent, which, again, suggests that permanently high unemployment will be the price paid for fiscal probity over the long term. It doesn't look like Greece is catching a break any time soon.

Between the petrified banking system and the procrustean treaty, it is hard to see how the eurozone countries can ease up on austerity even if they wanted to: Low growth isn't just legally mandated, it's needed for the banks to crawl their way back to solvency. And given that the surplus countries in the North, not just Germany, are doing just fine with the current setup, it's not clear why they would really want to ease up anyway.

So two cheers for Renzi's victory and a more flexible interpretation of the rules. But whether that's enough to end austerity and heal Europe's wounds remains very much in doubt.


Midfield General

And the Winner Is... Schland

In case you couldn’t tell, a new Germany has won the World Cup.

It is a small hut in the Chiemgau Alps, about an hour's drive east of Munich. Hikers and mountain bikers love to take a break there and have a big glass of beer or of some kind of more isotonic thirst quencher. But on Sunday, the day of Germany's final in the soccer World Cup, the hut was closed. It had a little piece of paper pinned to its door which read Geschlossen wegen Schland  -- "closed due to Schland." Passersby understood and smiled. It says a lot about Germany, or rather the very Germany that won this year's title: a Germany completely different from the ones that won the trophy in 1954, 1974, and 1990. 

When Germany holds the World Cup in its hands, it doesn't just mean that it has scored at least one more goal than the final adversary. Each of the (now four) stars the Nationalmannschaft is flashing on its jersey coincides with a different turning point in the country's history; every title stands for a new chapter in socio-economic and sometimes even in geopolitical terms.

In 1954, when Helmut Rahn fabricated the "miracle of Bern" by scoring the third goal against Hungary, the western part of the country, at least, was somebody again (Wir sind wieder wer!) on the global scene. Having started World War II and slaughtered 6 million Jews in concentration camps all over Europe, the once most-powerful country of the continent was split in two, its sovereignty handed over to the winners of the war, the cities and industrial facilities bombarded, its former intellectual and artistic elite murdered or driven into exile. But the World Cup victory allowed the country -- at least for a moment -- to forget about the horrors and the guilt. It also marked the beginning of the economic miracle (Wirtschaftswunder), Germany's comeback as a productive giant and, for the time being, a political dwarf. 

At the end of the 1960s, the German Social Democrats got to head the federal government for the first time in post war history. The restoration era of the 1950s was over, women's liberation made progress, and mass universities were being built. Willy Brandt opened up the former hard line of foreign policy and received the Nobel Peace Prize for his Ostpolitik. And in 1974, closing the World Cup final in the airy, tent-style newly built Munich Olympic stadium, Gerd Müller scored to beat the Netherlands. 

Then on the 9th of November 1989, the Berlin Wall crumbled. With the end of the Iron Curtain, a chapter in world history was closed. And a couple of months later, shortly before the formal reunification of the two Germanies, Andreas Brehme scored a highly debated penalty kick against Argentina in the World Cup final in Rome, nourishing fears of a Fourth Reich -- another attempt of German domination of the continent. 

In 2014, it's Schland.

Schland, or more correctly Schlaaaaaaand, is a somehow nonsensical, acoustical abbreviation of Deutschland that arose as a nickname during the home World Cup summer in 2006 and told the world -- and the Germans themselves -- at least three incredible things about the country. That summer can have more than two days of sunshine in a row. That Germans can create and even have fun, on and off the field. And that Podolski, Asamoah, and Odonkor are German names, at least somewhat.

Today, "Schland" is being examined as a possible entry in the Duden, the more or less official dictionary of German language. It stands for a new generation of Germans' ease with their national identity: Before the Schland World Cup, it would have been unthinkable for most Germans to wear the Nationalmannschaft jersey, to mark their cheeks with black, red, and yellow stripes, or even to put little German flags on their cars -- celebrations seen Sunday night on Munich's Leopoldstrasse and Berlin's Strasse des 17. Juni, the very normality you would see in more or less any other country in the world.

Schland, for the first time, has become a rather ordinary country.

And Schland is becoming attractive. Of all the countries in the Organizaton for Economic Cooperation and Development, only the United States has lured in more immigrants than Germany lately.

Schland is also becoming self-aware. Having been spied upon by the Americans so clumsily and so openly, even everything-is-not-so-terrible Chancellor Angela Merkel couldn't help but throw out the chief American spy in Germany -- unthinkable during the Cold War, and perhaps only possible after her predecessor Gerhard Schröder's fierce and daring opposition to George W. Bush's attack on Iraq.

Schland is becoming colorful, too. It was Schröder's overdue -- and still timid -- reform of Germanys citizenship and immigration laws that helped the nation's economy attract and retain an urgently needed workforce from abroad. Just take 2014's Internationalmannschaft with Klose and Podolski (of Polish origin), Khedira (Tunisia), Boateng (Ghana), Özil (Turkish), and Mustafi (Albanian). 

Maybe Germany has them to thank especially for not being regarded anymore as the eternal tank brigades, but rather as a more and more colorful nation that adores eating Italian pasta and drinking French wines in its increasingly cosmopolitan cities.

Of course, after getting there in a car made in Hannover, Munich, or Stuttgart.  

Clemens Bilan / AFP / Getty Images