George Soros and the two choices facing Europe
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There’s a good reason why the likes of Paul Krugman, Joe Weisenthal (twice), Cullen Roche, Ezra Klein, and everybody else are raving about George Soros’s analysis of what went wrong in the Eurozone: it’s really good. The big theme is that the European-unity project is a bubble, which could burst at any minute. But it’s the granular analysis in this 4,400-word speech which really makes it worth reading.
Essentially, Soros characterizes the European project as being a bit like a runner, moving at a steady clip in the direction of greater unity. Running is a weird thing: it’s basically the art of falling over continuously in a particular direction. So long as you keep on moving forwards, you can maintain a dynamic equilibrium. But stopping is really hard, because whenever you try to do that, you’re out of balance:
The process of integration was spearheaded by a small group of far sighted statesmen who practiced what Karl Popper called piecemeal social engineering. They recognized that perfection is unattainable; so they set limited objectives and firm timelines and then mobilized the political will for a small step forward, knowing full well that when they achieved it, its inadequacy would become apparent and require a further step. The process fed on its own success, very much like a financial bubble.
The problem here is that the statesmen didn’t understand that they were running: they thought they were walking. They thought that while forward momentum was a good thing and maybe even necessary, ever-greater union was in and of itself a good thing, which would bring the continent closer together and make it stronger. With hindsight, by contrast, we can see that it was a way of turbo-charging the European bubble, and setting it up for a catastrophic pop if and when the process of integration didn’t continue far beyond what was politically feasible circa Maastricht.
The bubble was a consequence of the convergence trade, which in turn, says Soros, was a function of BIS risk weightings:
When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank accepted all government bonds at its discount window on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker euro members in order to earn a few extra basis points. That is what caused interest rates to converge which in turn caused competitiveness to diverge. Germany, struggling with the burdens of reunification, undertook structural reforms and became more competitive. Other countries enjoyed housing and consumption booms on the back of cheap credit, making them less competitive. Then came the crash.
The problem here is that the convergence trade could probably have been better described as a divergence trade: it created a two-tier Europe, with a strong creditor-filled center funding a weak debtor-filled periphery. And as a result the political union — which had always been the necessary other shoe to drop — became impossible, rather than inevitable.
At this point, says Soros, optimistically, Europe still has three months to pull together a comprehensive package to save the union — a package which is just as economically necessary for Germany as it is for Spain. But politically, getting this done is going to be incredibly hard: “the disintegration of the European Union,” says Soros, is “just as self-reinforcing as its creation”.
The economic necessity for Germany, here, is a product of Target 2, the mechanism by which the Bundesbank’s balance sheet now holds €660 billion in peripheral-country claims. Germany needs to throw money, more or less continuously, at the European periphery at this point, because if it doesn’t, its central bank will suddenly find itself insolvent to the tune of roughly €1 trillion. That wouldn’t be the end of the world: if Germany got its Deutschmark back, then the Bundesbank could simply print €1 trillion worth of Deutschmarks to fill that hole. But a world where the Bundesbank is willing to print €1 trillion worth of Deutschmarks is simply not the world we’re living in, and the Germans will do pretty much anything to avoid that outcome.
Which leaves us with the only alternative:
Germany is likely to do what is necessary to preserve the euro – but nothing more. That would result in a eurozone dominated by Germany in which the divergence between the creditor and debtor countries would continue to widen and the periphery would turn into permanently depressed areas in need of constant transfer of payments. That would turn the European Union into something very different from what it was when it was a “fantastic object” that fired peoples imagination. It would be a German empire with the periphery as the hinterland.
This is, in a nutshell, the bet I have with Joe Weisenthal. He, like Soros, says that Europe — including Greece — will become a German empire, where the Germans reluctantly dole out a stream of transfer payments to a resentful periphery. I’m taking the other side of that bet, because I think it’s politically impossible, in a union of democratic nations. And also because I think that even if perpetual transfer payments to Spain are justifiable, perpetual transfer payments to Greece are not. Either way, here’s the video.