The Euro and the Battle of Ideas

Book By Markus K. Brunnermeier, Harold James, and Jean-Pierre Landau

Review & Article by GlobalMacroForex

This book has 3 authors — one British, one French, and one German. You could tell the book had multiple authors because it was so unbiased in dealing with these issues! The book’s primary theme is there are different approaches made by the founding countries of the Eurozone that carry over into today’s discussions.

The first school of thought is the right-wing German approach of decentralized power and Austrian economics. Under its principles, the original “no bailout” clause of the European’s founding treaty must be honored religiously. (This original treaty was named the ‘Maastricht Treaty’ because it was created in Maastricht in the Netherlands.) The German’s have a long and rich history of decentralized power, preferring more autonomous federations than a bureaucratic government.

The other competing school of thought is the left wing Keynesian French side of centralized and active government. The French prefer a strong government response to a crisis and believe the priority should be on preventing it from spreading. As mentioned in the book, the difference between these schools of thought can even be seen in the respective countries’ train maps showing Germany developed in a decentralized way.

France

Centralized trains

Germany

Decentralized trains

Ironically as the authors note, this is the opposite of how the countries acted prior to World War 2. Pre-war, Germany had a very authoritarian state, and the French followed a peaceful laissez-faire economy. It was only after Germany invaded France during the War that created a reversal of these original dispositions. The French felt they should have had a stronger military to deal with these types of situations in the future, while the Germans feared the power of abusive government in the wrong hands. In addition, Germany’s experience with hyperinflation laid the foundation for its Hawkish monetary policy. This created the political climate for these two cultures to move in opposite directions.

As the book goes on, it details exactly how the United States real estate bubble served to pry open economic imbalances in the region. After the formation of the Eurozone, the yields on government bonds for all the members converged…

This lead the banks of the core countries (Germany & France) to lend money to the periphery (Greece, Portugal, & Spain), since the legislation from the Basel committee as well as their local government regulations gave an equal ranking to all types of sovereign debt. In addition, there was a lot of interbank lending. Normally lending to a bank cross-border would require large risk premiums, but since the core banks were being paid in Euros, the currency union allowed them to have the false perception of low risk.

“A large fraction of the capital flows were short-term credit flows involving cross-border wholesale funding-lending bank to bank in the interbank market.”

Interbank rates shot up:

Interbank rates are based on the yields on each country’s sovereign debt since theoretically, a government has less credit risk than a commercial bank. In Modern Financial Theory, this number is called the risk premium. By allowing all sovereign debt to be treated the same, core banks thought they could pick-up extra yield by investing in the periphery banks. This book gives a German (core bank) and Spanish (periphery bank) example:

“Spanish banks drew part of their funds from their domestic deposit base. In the years leading up to the crisis, German financial institutions (banks or money market funds) provided their Spanish counterparts with additional cheap short-term wholesale funding mostly through the interbank market. Spanish banks then duly extended more loans to domestic borrowers (in particular homeowners), usually through flexible rates (like floating LIBOR/Euribor rate plus some fixed surcharge).”

The borrowed funds were ironically recycled back to Germany to buy German products!

“Suppose the Spanish borrowers purchased, for example, German appliances such as elevators or dishwashers. The payments then went back from Spanish banks into the German financial system, ultimately to pay the wages of German worker.”

The periphery banks also used the money they received on the interbank market to make loans related to housing. In places like Spain, Ireland, and Greece, many asset-backed bonds were issued. This bond market heavily depended on rising home prices. As soon as home prices went down, the banks’ assets quickly vaporized and their Basel equity positions were compromised.

So as you can see the European Debt Crisis plagued banks with problems on both sides of their balance sheet.

The Banks’ Assets

Rapidly went down in value as home prices dropped and their holdings of periphery government bonds went up in yield.

The Banks’ Liabilities

Also became a problem as the main source of liquidity was the short-term interbank which dried up.

This created a “vicious circle,” negative feedback loop. Since banks hold government bonds, as those government bonds drop in value the banks become insolvent. As the banks come under pressure, they stop buying government bonds and the yields go even higher (i.e., prices drop). These high yields create an unsustainable situation for the periphery governments to finance their debt. Since the only way a government could get out of this situation quickly and painlessly is to print money to buy its own bonds, if the ECB fails to provide bailout relief than the government would to leave the Euro. This creates market risk where a German Euro is worth more than a Greek Euro even though it’s the same currency because of the fear Greece (or other periphery countries) will leave the monetary union.

One of the primary themes of this book is liquidity vs solvency for both governments and banks. Liquidity is a measure of how quickly a banks’ assets can be turned into cash and how well they (banks and governments) can fund their operations. Solvency is how much owner’s equity the bank or government is able to pay obligations with future tax revenue. If asset prices of a bank are dropping rapidly in value, as the bank is unable to roll over its short-term interbank loans, the line between solvency and liquidity is blurred. Since money has a value based on time preference, it’s difficult to determine if the bank is underwater due to falling asset prices or failure to roll over funding. The line is even further blurred for governments since their future tax revenues are unknown because their growth is unknown.

This book defines the difference between liquidity and solvency as

“A country is insolvent if providing an extra euro of (bailout) funds yields less than the Euro put in. When the present value of future tax revenues falls short of expenditures, the extra euro will be (partially) used up for paying off existing creditors rather than bridging a temporary funding gap.”

This book’s acid test is will a country (like Greece) will ever be able to pay off creditors with tax revenue or will it just “kick the can down the road” through a Ponzi scheme of debt that it will never be able to pay. Obviously, both the French and Germans have different views and traditions with dealing with these issues. The Germans want strict adherence to the no-bailout clause of the Maastricht Treaty (and so tend to treat these as solvency issues) while the French want to focus on dealing with the currency crisis at hand (and treating these as liquidity issues and thus allowing the ECB to print money to provide relief).

Which school of thought is correct? I’d highly recommend you to read the rest of this book and decide for yourself. =)