Should Austrians Embrace the Euro?

Good as Gold?

By Pater Tenebrarum

Introductory Remarks

As we have often pointed out in these pages, to our mind the euro area crisis is not a currency crisis. It is primarily a debt crisis; a crisis of the bloated European welfare states and the fractionally reserved and way overextended   banking systems they harbor. Due to the supra-national status of the central bank it is no longer possible for member nations to simply 'paper over' their economic policy mistakes and so their errors have been revealed for all to see. Instead of being able to surreptitiously impoverish the citizenry by means of inflation and devaluation, the political classes have been forced to face facts.

In this sense, the euro is a great success: it has so far averted an inner-European outbreak of 'beggar-thy neighbor' devaluations. The usual robbing of savers had to be at least partially shelved.

It is entirely mistaken to argue that the monetary union can only work if a so-called 'fiscal union' is established. It is true that the monetary union will work better if its members were to adhere to the rules of the fiscal  pacts they have signed – be it the Maastricht treaty or the latest iteration of the 'fiscal compact'.

However, this is not the main goal of the people pushing for a full fiscal, and presumably political, union. Their aim is to abolish subsidiarity altogether in order to create a European superstate – a giant transfer union in which all tax and regulatory competition is suppressed. Moreover, they want to enable the central bank to do what it currently can not do – namely finance the deficits of governments by means of money printing.

The euro is a medium of exchange. There is no reason whatsoever that  two or more agents using a common medium of exchange need to enter into a 'fiscal union', pooling their debts in order to be able to continue to use a common medium of exchange. The gold standard worked perfectly well for a century before governments deliberately ruined it in order to finance enormous wars. No-one ever suggested at the time that the nations on a gold standard should enter into a 'fiscal union'. It would have been regarded as an utterly absurd demand.

You can review our critique of the various ideas forwarded by the 'centralizers' and our ideas regarding a free market solution to the euro area crisis in a previous article: 'The Euro Area – False Dilemmas and False Choices', where  the above points are discussed in more detail. A further addition to this discussion can be found in 'Growth versus Austerity – A Phony Debate'.

Is There 'Austerity' in Europe?

It has become fashionable among interventionists to take aim at Angela Merkel and the German Bundesbank and accuse them of forcing euro area member states into 'unbearable austerity' by continuing to refuse to bail out all and sundry without preconditions.

Among other things, commentators are lately frequently dragging up the example of Heinrich Brüning's government that was in charge of Germany just prior to the election that brought Hitler to power. A recent example is this article at Bloomberg: “Ghost of Nazi Past Haunts Austerity-Gripped Europe”. The article states: 

“Under Germany’s austerity policies in the 1930s, taxes rose, benefits and wages were reduced and unemployment soared, stoking the popular ire that Hitler harnessed. Extremists are gaining ground now as unemployment in Greece passes the 20 percent mark after five years of recession. The far-right Golden Dawn won 6.9 percent of the vote and 18 seats in the country’s most recent elections. France’s anti-immigrant, anti-euro National Front won two seats in parliamentary elections June 17.

Creditanstalt in 1931, like Spain’s Bankia now, was created by mergers with lenders weakened by toxic loans and capital shortfalls. After Creditanstalt failed, the government stepped in to prop it up, fatally hurting its own credit. A run on Austria’s bonds and the schilling ensued, according to Michael Bordo, national fellow of the Hoover Institution on campus of Stanford University in Palo Alto, California.

“Creditanstalt had been forced into a merger with an insolvent bank, which felled it,” Bordo said. “Really, Austria had a financial system set up to service an empire which was no longer there. The bank was too big.”

Austria’s 10-year yield has advanced to 2.34 percent after dipping below 2 percent to a euro-era record at the start of the month.

Six months ago, the European Central Bank supplied more than 1 trillion euros to the banking system at an interest rate of 1 percent, which banks recycled into their local government debt at higher yields as international investors bailed out.

“As a bank, if your assets are in trouble in one country, you call in your loans from the countries that are the next most vulnerable,” said James at Princeton. “Banks withdrawing credit are part of the contagion mechanism and that’s part of the current story, as well.”

In June 1931, as the German financial system teetered on the brink, the Reichsbank received a $100 million loan — equivalent to more than $5 billion today — from the central banks of France, the U.K. and U.S. The sum turned out to be insufficient to meet soaring German demand for foreign exchange. A bigger loan was blocked by France, which was concerned about plans for a customs union between Germany and Austria.

Germany’s Danatbank collapsed after one of its biggest borrowers failed. That sent capital fleeing abroad, depleting reserves, according to a 2009 paper by Martin Pontzen of the Bundesbank. By September, German banks, including Commerzbank AG and Deutsche Bank AG, were under state control.

A bank holiday and capital controls dragged in London’s merchant banks, which had guaranteed loans to German borrowers, according to Olivier Accominotti, a lecturer in economic history at the London School of Economics. A run on the pound cost Britain about 20 percent of its reserves in two weeks and ended with the nation abandoning the gold standard. The U.S. was forced to raise interest rates to defend its gold reserves. In 1933, President Franklin D. Roosevelt imposed a bank holiday and forbade citizens from hoarding gold.

“What started as a liquidity crisis became a solvency issue,” said Accominotti. “There was a major risk of a systemic crisis.”

The article mentions the 1931 loan extended to Germany, but not the conditions tied to it. The loan and concomitant attempt to restructure Germany's debt was  a result of Germany first having lost much of its wealth due to the war and the subsequent imposition of reparation demands it could not possibly fulfill. Germany's economy was wrecked. While it is clear that due to its decision to go to war the German imperial government was responsible for having brought about Germany's ruin in the first place, the treaty of Versailles compounded the economic catastrophe due to the unreasonable reparation demands it contained.

The implication of the Bloomberg article quoted above is that today's situation is somehow comparable to what the Brüning government did in the early 1930's. Is that really the case? Far from it, as Josef Joffe recently made clear in an article in the Financial Times: 

“Listening to Anglo-American über-Keynesians a first-time visitor to the eurozone might be tempted to pose three questions, in rising order of bemusement. First, what happened to the supply-side economics you tried to foist on the continentals not so long ago? Second, why did you hype Angela Merkel as Europe’s peerless leader only then to bash her as the gravedigger of the western economy? Finally, who is this Heinrich Brüning who you like to cite, and what is this “austerity” you are talking about?

Mr Brüning, chancellor from 1930 to 1932, was indeed Mr Austerity. He cut government outlays by a third, and borrowing to almost zero. That was the real thing.

Yet western governments, including Ms Merkel’s, responded to the crash of 2008 with astronomic stimuli. Whereas monetary miserliness ruled in the 1930s, the Federal Reserve and the European Central Bank galloped to the rescue. The Fed has injected about $1.3tn-worth of liquidity. The ECB is flooding the markets, buying up shaky sovereign debt and extending cheap loans to banks totalling about €1bn.

Now to deficit spending. In 2011, according to Eurostat, Ireland ran a deficit of 13 per cent of gross domestic product, Greece 9 per cent, Spain 8.5, Italy and Portugal 4 per cent each. OK, these deficits were also driven by recession, but although better off, France and the Netherlands clocked in at about 5 per cent. It is all far beyond the Maastricht limits. A new Mr Brüning would have unleashed a dozen emergency decrees against such horrendous profligacy.

Naturally, the eurozone’s public debt is rising, topping 90 per cent of GDP this year. So what exactly is this austerity everyone is berating? Unfazed, the Keynesian chorus is swelling. Never mind that gargantuan deficits in the US and UK, now four years running, have barely dented unemployment, Germany must save the western world, if not the planet.

How? “More quantitative easing by the ECB,” argue Anglo-American doomsayers, plus “fiscal stimulus”, plus “wage increases above productivity in the core”. In other words more of what has not worked in the past, and worse: wage inflation, which will do wonders for Europe’s competitiveness. Why Germany? Because, wrote Niall Ferguson and Nouriel Roubini in the FT, her “prosperity is in large measure a consequence of monetary union”, the euro having given German exporters “a more competitive exchange rate” than the Deutsche Mark would have.

Not quite. When the euro was born, it fetched $0.85; last year it climbed to $1.49. Yet German exports boomed. The moral of this tale is competitiveness was encouraged at home through labour market, tax and welfare reforms – measures that Club Med refused to implement.”  (emphasis added)

So you can see, today's so-called 'austerity' can not really be compared to Brüning's brand of austerity at all. Given the fact that budget deficits and cumulative public debts in the euro area keep rising, one can not really talk about austerity at all at this juncture.

A Brief Historical Excursion

In defense of Brüning, he really didn't have much of a choice. Less than a decade earlier Germany had suffered through the horrors of a hyperinflation, which wiped out the savings of the whole population and rendered people depending on fixed income destitute. No-one wanted to risk a repeat performance. Brüning moreover was forced by the so-called 'Young Plan', which consisted of an international loan to Germany and rearranged the reparation features of the treaty of Versailles, to make payments of two billion Reichsmark per year (roughly 7.3% of is entire annual tax revenues). He was not allowed to inflate the currency even if he had wanted to. Brüning ruled mainly by means of emergency decrees, which were tolerated by the socialist opposition in parliament because it was feared that new elections would mean the end of the Weimar Republic due to the inexorable rise of anti-democratic parties like Alfred Hugenberg's DNVP and Hitler's NSDAP (a well-founded fear as it soon turned out). Brüning was not a man without faults – although he held the Nazis at bay while he was chancellor, he later helped Hitler to attain absolute power by voting in favor of the tyrannical 'enabling law'.

If one condemns Brüning's policies, shouldn't one then laud Hitler's government  for its massive deficit spending which it achieved by creating a 'black budget' for rearmament using so-called MEFO bills? MEFO bills were an invention of Reichsbank president Hjalmar Schacht. They were promissory notes issued by a fictitious entity, the 'Metallurgische Forschungsgesellschaft' – an early version of a 'special purpose vehicle' if you will. The bills were exchangeable into Reichsmark on demand and were originally designed to mature after six months – however, this maturity date could be extended indefinitely by three months at a time. Effectively these bills represented a secondary medium of exchange and allowed the government to increase its public debt surreptitiously by more than 63%. That way the rearmament which was forbidden by the Versailles treaty could be concealed. Of course 'reflation' of an economy by means of money supply inflation – even if it is kept secret as was the case with the MEFO bills – still requires that someone  pays for it eventually. In Hitler's case it is probably reasonable to assume that he expected payment to arrive in the form of plunder once the war began.

J.H. De Soto on the Euro

Jesus Huerta de Soto has previously pointed out that the euro has a big advantage – in a certain sense, it exhibits the features of a gold standard. A detailed account of his views was recently published at the Ludwig von Mises Institute's web site, entitled “An Austrian Defense of the Euro”.

We certainly agree with many of the things he says. For instance, de Soto notes that since devaluation and inflation have become impossible to implement for member nations, they have been forced to enact economic reforms, especially with regards to the rigid labor laws that bedevil many countries in the euro area. They have also been forced to cut back their spending and their bloated welfare states to some extent.  In a word, the fixed exchange rate and the rules governing the supra-national central bank stand in the way of inflationism and deficit spending. Writes de Soto: 

“Now what interests us is to note that the different member states of the monetary union completely relinquished and lost their monetary autonomy, that is, the possibility of manipulating their local currency by placing it at the service of the political needs of the moment. In this sense, at least with respect to the countries in the eurozone, the euro began to act and continues to act very much like the gold standard did in its day. Thus, we must view the euro as a clear, true, even if imperfect, step toward the gold standard.

Moreover, the arrival of the Great Recession of 2008 has even further revealed to everyone the disciplinary nature of the euro: for the first time, the countries of the monetary union have had to face a deep economic recession without monetary-policy autonomy. Up until the adoption of the euro, when a crisis hit, governments and central banks invariably acted in the same way: they injected all the necessary liquidity, allowed the local currency to float downward and depreciated it, and indefinitely postponed the painful structural reforms that where needed and that involve economic liberalization, deregulation, increased flexibility in prices and markets (especially the labor market), a reduction in public spending, and the withdrawal and dismantling of union power and the welfare state. With the euro, despite all the errors, weaknesses, and concessions we will discuss later, this type of irresponsible behavior and forward escape has no longer been possible.

For instance, in Spain, in just one year, two consecutive governments have been forced to take a series of measures that, though still quite insufficient, up to now would have been labeled as politically impossible and utopian, even by the most optimistic observers:

1.article 135 of the Spanish Constitution has been amended to include the anti-Keynesian principle of budget stability and equilibrium for the central government, the autonomous communities, and the municipalities;

2.all of the projects that imply increases in public spending, vote purchasing, and subsidies, projects on which politicians regularly based their action and popularity, have been suddenly suspended;

3.the salaries of all public servants have been reduced by 5 percent and then frozen, while their work schedule has been expanded;

4.social-security pensions have been frozen de facto;

5.the standard retirement age has been raised across the board from 65 to 67;

6.the total budgeted public expenditure has decreased by over 15 percent; and

7.significant liberalization has occurred in the labor market, business hours, and in general, the tangle of economic regulation. […]

(…) it is hard to conceive of any of these measures being taken in a context of a national currency and flexible exchange rates: whenever they can, politicians eschew unpopular reforms, and citizens everything that involves sacrifice and discipline. Hence, in the absence of the euro, authorities would again have taken what up to now has been the usual path — i.e. a forward escape consisting of more inflation; the depreciation of the currency to recover "full employment" and gain competitiveness in the short term (covering their backs and concealing the grave responsibility of labor unions as true generators of unemployment); and, in short, the indefinite postponement of the necessary structural reforms.”  

(emphasis added)

Before the euro crisis we often mentioned in debates with friends that the euro would eventually force governments to undertake economic reforms  – we just didn't expect that it would take such an enormous crisis. So we have no quibble with the theory laid out above, but would point out that for one thing, the reforms are implemented at a snail's pace and don't go nearly far enough and secondly are becoming a hot potato politically the longer it takes for the efforts to succeed. Arguably in Spain's case, tangible success may be quite far off due to the lingering effects of the housing bubble's collapse and the decision to prop up banks and their bondholders at all cost on the back of tax payers. As Edward Hugh related to us, one must not underestimate the political forces in Spain that would likely come to the fore if the Rajoy government fails. In his opinion, Spain will never allow itself to enter a full-scale bailout program similar to those currently in place in the 'GIP' trio. In other words, it may well come to the point where Spain will rather exit the euro than letting its fiscal policy be dictated by outside lenders.

So while we agree with de Soto that the euro has forced the adoption of structural reforms, the question whether these will in the end prove 'politically doable' still remains very much an open one.

De Soto then offers an interesting theory regarding the one respect in which the euro may actually besuperior to the gold standard. What makes it superior  is its 'roach motel' quality: it was fairly easy to get in, but it is fiendishly difficult to get out of. In fact, so de Soto, it is more difficult for governments to abandon the euro than it was to abandon gold:  

“We must note that abandoning the euro is much more difficult than going off the gold standard was in its day. In fact, the currencies linked with gold kept their local denomination (the franc, the pound, etc.), and thus it was relatively easy, throughout the 1930s, to unanchor them from gold, insofar as economic agents, as indicated in the monetary-regression theorem Mises formulated in 1912 (Mises 2009 [1912], pp. 111–123 [The Theory of Money and Credit, ed.]), continued without interruption to use the national currency, which was no longer exchangeable for gold, relying on the purchasing power of the currency right before the reform. Today this possibility does not exist for those countries that wish, or are obliged, to abandon the euro.

Because the euro is the only unit of currency shared by all the countries in the monetary union, its abandonment requires the introduction of a new local currency, with unknown and much less purchasing power, and includes the emergence of the immense disturbances that the change would entail for all the economic agents in the market: debtors, creditors, investors, entrepreneurs, and workers.”  (emphasis added)

This is actually quite true. As long as national currencies retained their names and outward  appearance in the form of banknotes and coins, the populace was not inclined to take much note of their sudden irredeemability. This effect can indeed be explained by Mises' regression theorem. As Mises remarked to the process by which money substitutes were transformed into fiat money in 'Human Action':  

“Credit money evolved out of the use of money-substitutes. It was customary to use claims, payable on demand and absolutely secure, as substitutes for the sum of money to which they gave a claim. [...]

The market did not stop using such claims when one day their prompt redemption was suspended and thereby doubts about their safety and the solvency of the obligee were raised. As long as these claims had been daily maturing claims against a debtor of undisputed solvency and could be collected without notice and free of expense, their exchange value was equal to their face value; it was this perfect equivalence which assigned to them the character of money-substitutes. Now, as redemption was suspended, the maturity date postponed to an undetermined day, and consequently doubts about the solvency of the debtor or at least about his willingness to pay emerged, they lost a part of the value previously ascribed to them. They were now merely claims, which did not bear interest, against a questionable debtor and falling due on an undefined day. But as they were used as media of exchange, their exchange value did not drop to the level to which it would have dropped if they were merely claims. One can fairly assume that such credit money could remain in use as a medium of exchange even if it were to lose its character as a claim against a bank or a treasury, and thus would become fiat money.”

By contrast, if Spain were to e.g. reintroduce the Peseta, this would not only involve a logistic and legal nightmare (which of the debts previously denominated in euro would be subject to conversion and which would not?), it would also be crystal clear to all citizens that the newly issued money would suffer a sharp fall in its exchange value. The mere suspicion that the old currency might be reintroduced would immediately ignite a run on the banks (as we have just seen in Greece).  

The Role of the ECB and the Euro-System

De Soto concludes that the end of monetary nationalism in the euro area is to be welcomed, but then also notes that the ECB has allowed monetary inflation to run wild during the boom years.

We have frequently criticized this fact as well – after all, the euro is a fiat currency, and there is a fractionally reserved banking system that has been busy expanding the amount of fiduciary media (i.e., deposit money not backed by standard money) in the system at truly astonishing rates during the boom. The ECB aided and abetted this process – as de Soto inter alia points out, it has frequently tolerated a rate of money supply expansion that went well beyond its own targets (of course this is so because the entirely misguided 'price stability' criterion has always taken precedence in setting policy).

However, de Soto contrasts the ECB's handling of the bust favorably with  the actions of the BoE and the Fed:  

“In contrast with the situation of the dollar and the pound, in the euro area, fortunately, money cannot so easily be injected into the economy, nor can budget recklessness be indefinitely maintained with such impunity. At least in theory, the ECB lacks authority to monetize the European public debt, and though it has accepted it as collateral for its huge loans to the banking system, and beginning in the summer of 2010 even sporadically made direct purchases of the bonds of the most threatened periphery countries (Greece, Portugal, Ireland, Italy, and Spain), there is certainly a fundamental economic difference between the behavior of the United States and United Kingdom, and the policy continental Europe is following: while monetary aggression and budget recklessness are deliberately, unabashedly, and without reservation undertaken in the Anglo-Saxon world, in Europe such policies are carried out reluctantly, and in many cases after numerous, consecutive and endless "summits." They are the result of lengthy and difficult negotiations between many parties, negotiations in which countries with very different interests must reach an agreement.

Furthermore, what is even more important, when money is injected into the economy and support is provided to the debt of countries that are having difficulties, such actions are always balanced with, and taken in exchange for, reforms based on budget austerity (and not on fiscal stimulus packages) and on the introduction of supply-side policies that encourage market liberalization and competitiveness. Moreover, though it would have been better had it happened much sooner, the de facto suspension of payments by the Greek state, which has given a nearly 75 percent "haircut" to the private investors who mistakenly trusted in Greek sovereign debt holdings, has clearly signaled to markets that the other countries in trouble have no other alternative than to firmly, rigorously, and without delay carry out all necessary reforms.”   (emphasis in the original)

However, this glosses over another significant feature of the euro-system that clearly differentiates it from the discipline that a gold standard would enforce: namely the central bank payment system known as 'TARGET-2' and the ECB's emergency liquidity facility 'ELA'. Since there is no mechanism to automatically balance TARGET-2 claims and liabilities at set intervals, the growing imbalances  amount to a surreptitious public financing of current account deficits and capital flight. Under a true gold standard the deficit nations would lose their gold and would have to very quickly conceive of policies to regain it. In fact, the loss of gold itself would force prices and wages in the concerned nations down very fast, eventually reversing the outflow of gold. This follows from the fact that a price is the number of monetary units paid for a good or service. If the money supply shrinks, a lower money supply must do the work previously done by a greater money supply. Ceteris paribus, the purchasing power of the monetary unit will  therefore rise (and this is a case where the 'ceteris' would likely not offset this effect, as the demand for money usually increases in the face of growing economic uncertainty).

TARGET-2 is an obstacle to this process, as the loss of private capital inflows is made up by the accounting miracle enabled by this payment system sans settlement procedure. To be sure, the balance sheet of a central bank with large TARGET-2 liabilities sports assets that should in theory cover these liabilities. In practice many of these assets are probably somewhat dubious, and in the case of ELA extensions they most definitely are.

So far, the German Bundesbank's TARGET-2 claims keep growing like weeds. At last count the total amounted to €699 billion. On the other hand, the so-called 'PIIGS', especially Spain, Italy and Greece, have amassed huge TARGET-2 liabilities as foreign private sector investment in their economies has dried up.

TARGET-2 claims of the German Bundesbank have reached € 699 billion as of May 2012 (charts via German site 'Querschüsse.de') - click chart for better resolution.

The Bank of Spain's TARGET-2 liabilities have increased to € 345 billion as of May - click chart for better resolution.

The Bank of Italy's TARGET-2 liability has decreased slightly to €275 billion as of May - click chart for better resolution.

Furthermore, while the ECB is not allowed to finance government deficits directly – its fairly ineffectual and currently shelved 'SMP' bond market manipulation program has been fully sterilized – the two LTRO funding rounds have enabled banks in the countries experiencing fiscal  crises to step up as large purchasers of their governments' debt, temporarily suppressing interest rates again. While we can not prove it, there is significant circumstantial evidence that suggests that these purchases of government debt were the result of quid-pro-quo sub rosa agreements between the governments concerned and the commercial banks in these countries (especially Italy and Spain). In particular, governments helped the banks to 'prettify' certain collateral by imbuing it with government guarantees, thereby making it eligible for re-discounting with the ECB prior to the LTROs. Former French president Nicolas Sarkozy even made a thinly veiled remark to this effect, which led to this particular type of 'carry trade' being dubbed the 'Sarkozy Trade' at the time.

So while the ECB refrained from 'quantitative easing' – in spite of the fact that everybody outside the 'Northern Bloc' led by Germany would like to see it implemented (with some forwarding the argument that a little bit of legal creativity could easily be used to circumnavigate the prohibition)  – it did the next best thing. However, de Soto has a point insofar as the ECB has been using a 'carrot and stick' approach – up to now it has only tended to intervene  after new reforms have been implemented.

Germany Against the Spendthrifts

As de Soto rightly points out, the major driver in the pursuit of structural reform is the currently much-maligned government of Germany:  

“From the political standpoint, it is quite obvious that Germany (and particularly the chancellor Angela Merkel) has the leading role in urging forward this whole process of rehabilitation and austerity (and opposing all sorts of awkward proposals that, like the issuance of "European bonds," would remove the incentives the different countries now have to act with rigor). Many times Germany must swim upstream. For on the one hand, there is constant international political pressure for fiscal-stimulus measures, especially from the Obama administration, which is using the "crisis of the euro" as a smokescreen to hide the failure of its own policies. And on the other hand, Germany has to contend with rejection and a lack of understanding from all those who wish to remain in the euro solely for the advantages it offers them, while at the same time they violently rebel against the bitter discipline that the European single currency imposes on all of us, and especially on the most demagogic politicians and the most irresponsible privileged interest groups.

In any case, and as an illustration that will understandably exasperate Keynesians and monetarists, we must highlight the very unequal results that until now have been achieved with American fiscal-stimulus policies and monetary "quantitative easing," in comparison with German supply-side policies and fiscal austerity in the monetary environment of the euro: public deficit, in Germany, 1 percent, in the United States, over 8.20 percent; unemployment, in Germany, 5.9 percent, in the United States, close to 9 percent; inflation, in Germany, 2.5 percent, in the United States, over 3.17 percent; growth, in Germany, 3 percent, in the United States, 1.7 percent. (The figures for United Kingdom are even worse than those for the United States.) The clash of paradigms and the contrast in results could not be more striking.” (Emphasis added)

While it is true that Germany's economic performance has so far outdone the performance of other countries, including those that have implemented large stimulus measures, this is probably only partly due to the reforms it has undertaken. One must not forget that the extraordinarily low interest rates Germany enjoys at present are beginning to affect its previously staid economic performance with the emergence of a potentially dangerous housing boom. We would hesitate to come to conclusions on the basis of the empirical evidence available at this particular juncture (note also that Germany's economy is currently also mired in an incipient downturn).

The success of the various austerity and economic reform measures currently implemented in Europe can only be judged in the longer term, and then only if the momentum is not lost.

Unfortunately there are lately signs that some of the momentum is indeed being lost. For instance, the governments of Germany, France, Italy and Spain have just agreed to a so-called 'growth pact', which they intend to present at the upcoming euro-group summit. This involves 'stimulus spending' to the tune of €130 billion, including a capital injection into the European Investment Bank (EIB), an EU-run financing institution (which presumably is expected to leverage this capital injection via fractional reserve banking and with the help of the ECB).  Much of this will allegedly be accomplished by 'using unspent EU funds', which sounds a bit dubious to us. Does the EU really have €130 billion in unspent funds lying around somewhere? Probably the total already includes the fiduciary media the EIB will likely create.

Government directed stimulus spending will always suffer from the defect that it is not subject to profit and loss accounting. When bureaucrats are spending  funds, it is not possible to confidently state what opportunity costs arise from the projects they decide to finance. It does not matter whether a project appears 'worthy' on the surface. If for instance a new bridge is built somewhere, who can tell if the resources thus employed could not have been used to satisfy more urgent consumer wants? One must not forget that all economic activity is ultimately funded by real resources. Their most profitable allocation is hardly a job bureaucrats can be expected to accomplish. Moreover, stimulus spending is usually an open invitation to graft and corruption.

Still, at a price tag of € 130 billion, Germany may consider it a small price to pay if otherwise fiscal and monetary rectitude are properly enforced. However, the great danger is that Germany may eventually be pushed too far. While de Soto is correct that there are great disincentives to abandoning the euro on the part of the crisis countries, it cannot be ruled out that Germany one day decides to leave the currency union. It would not have to fear a collapse of its new currency – rather the opposite. Admittedly Germany is greatly interested in preserving the 'European Project' in the wider sense, and with it the euro. However, it seems certain that its willingness to do so depends mainly on the ultimate price tag. Attempts by the ECB to take things one step too far for the Bundesbank, or any moves by the other member nations to undermine the fiscal compact significantly  and repeated failures by several member nations to live up to their commitments, could eventually lead to a German exit from the euro (and Germany would then likely take the entire 'Northern Bloc' with it).  

Conclusion:

We agree with de Soto that as things stand, the euro enforces fiscal and monetary discipline to an extent that would previously have been unthinkable for many European nations. He is quite correct that politicians always look for the easy way out promised by inflation and devaluation regardless of the long term consequences and that the euro has made this very difficult. However, he may underestimate the difficulty of staying the course, especially if the process of reform continues at its current slow pace and the expected results are too long in coming. Rising political extremism and growing market pressures may combine to produce an early derailment of the currency union.

Lastly, de Soto himself admits that the euro is at best a second best solution compared with a true gold standard and a free banking system based on rigorously enforced property rights with regards to the disposition of demand deposits.

Let us say that the current 'austerity and reform' course actually succeeds in due time. What will then keep another credit boom from emerging? As soon as the good times return, many of the hard lessons of the bust are likely to be quickly forgotten again. After all, while the credit and asset boom raged, many of the governments that are now in the greatest difficulties appeared to be paragons of fiscal responsibility, as their tax revenues swelled due to the false accounting profits created by the inflationary boom. It is worth noting that there is a great reluctance among policymakers to properly diagnose the causes of the bust. The culpability of the banks and the ECB in fostering a massive credit expansion is rarely discussed. No-one wants to abandon the essential features of the current monetary system – therefore a repetition of the boom-bust sequence is practically assured should the crisis pass with the euro area intact. 

We leave you with two apposite quotes by Ludwig von Mises:  

“If it were really possible to substitute credit expansion (cheap money) for the accumulation of capital goods by saving, there would not be any poverty in the world:”

“It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights.”