European Financial Crisis: Euro weakens against the dollar, what does it mean?
Solvency vs. Liquidity: Some governments–especially Greece but also Spain and Italy–are insolvent. Governments that do not collect taxes and spend money inefficiently are headed for bankruptcy. At some point banks will stop buying their sovereign debt bonds and the government will only have tax income. It can refuse to pay on its existing loans but still will not have enough tax revenue to support its budget, leaving many without the money they were expecting. At this point, the weak lose and the strong survive on less than they had before.
Liquidity: Liquidity is the funds needed for loans for business. Businesses usually borrow to conduct business. The lenders have enough security and enough interest to feel they are doing okay. Security is usually created by lending only to those who can pay the money back, although the sovereign debt crisis is raising questions about the probity of the banks in making loans to government with large deficits. Businesses like to borrow because they can usually make a higher profit on its owned assets (equity). Businesses make money on its owned plus its borrowed assets. The loan only requires the cost of interest, leaving the rest of the profits to equity. The ratio of equity to debt is called leverage, with less equity meaning higher leverage and potentially greater profits. More leverage usually means greater risk. It is common for business assets to be about half equity and half debt which generally means the banks can accept a lower interest rate. If the loan is not repaid there would be enough assets as collateral to be seized (foreclosure) and sold to cover the loan.
Business borrowing is not essential, but, like mortgage loans, it is helpful because with minimum risk, lenders can get some return and borrowers can do more business.
Insolvency of governments in Europe is threatening the liquidity needed to do the customary lending that sustains the economy. If a bank can’t get its loan back, it has less to lend out again. Its capital is reduced by the amount of non-performing debt. It can only stop lending or charge a higher rate of interest, both of which are bad for business.
The US avoids this problem because the Federal Reserve has the power to loan to the rest of the US government however much it needs to cover US sovereign debt. “The Fed” can do this because it is the monetary authority; it has to power to create money by writing a check. If the Fed stopped monetizing the debt (creating money to loan to the Treasury), interest rates would rise on Wall Street as lenders would have increasing doubts and greater concern to cover their risk. It at some point they would not lend to the US, a US version of what is happening in Europe might occur.
The Europeans have a bank like the US, but until recently it has refused to lend to insolvent governments, aggravating the liquidity problem. A few days ago, the bank announced a “back door” in Europe to do what the Fed does in the US: create money by buying bonds in the market place. In this case, the European Bank has said it will keep interest rates at 1%. If private bidders push interest over 1%, the bank will out-bid them to keep 1% interest.
The problem is that the back door policy resolves the liquidity issue but leaves the insolvency issue unaddressed. After over a year of intense negotiations, the European governments have agreed on an approach that does not quite do the job. The Fed has proven a propensity to bail out the US government no matter how irresponsible it is. Led by the influence of a responsible Germany economy, the Europeans and their bank have so far remained reluctant to follow suit. They say, why give money to Greece (i.e., buy Greek bonds) that might not be repaid when Greece is hesitant to tax and quick to over-spend?
The solution is a new European authority to discipline their member states, requiring a significant reduction in national sovereignty and some risk that the new authority would abuse its power–the same risk we run in the US (the federal government power over the states). American states can borrow like the European nations, but have been disciplined enough to stay within their borrowing capacity through huge spending cuts and some tax increases.
It seems possible to let a small economy like Greece’s go bankrupt with much more austerity than what Greeks are complaining about now. This model has helped Iceland to allow some of its banks to go bankrupt and not repay its sovereign debt. Iceland, however, was in much better shape fiscally (government taxing and spending) than Greece. A Greek default could easily precipitate the political will in Spain and Italy to implement fiscal reform which is the basis for their ability to borrow money. However, it is probably better if the European Union and the Greeks collaborate to reform taxes and spending. The banks are already losing half the money they lent to Greece, therefore it is reasonable for fiscal reform to do the rest, regardless of street protests.
The European debt crisis has pushed the value of the Euro down against the dollar, which will help lower the cost of European exports and increase the cost to Europeans of imports from the US. Unfortunately, the European crisis overshadows the US crisis from Americans. Our spending crisis has very simple causes which are ignored by the media, apparently for partisan and ideological reasons. The Republicans in the 2000’s abandoned fiscal conservatism for low tax-high debt policies. The tax cuts did not produce growth but fueled high-end consumption, overseas investment, and a speculative bubble, which caused a major recession and was exacerbated by abandoning market economics in favor of socialism for rich and capitalism for the poor. The government bailed out most of the companies responsible for the crisis. Its efforts to sustain liquidity were implemented in a way that subsidized insolvency due to the political influence of the big banks on Wall Street and AIG.
Ultimately, there is little economic difference between the hidden fiscal crisis of the unitary US government and the publicized crisis of the multi-governmental European system. Both systems are failing because of an inadequate implementation of Keynesian policies, which would require another blog to explain.
The fiscal crisis of the advanced countries is also diverting attention from a more important question: what countries, overall, are performing best, and how do they do it? For all their problems, the Western European countries within the EU are doing significantly better across a wide range of measures than the US. See www.internationalcomparison.org for details.