George Soros: New Year, Same Crisis

30.01.2012, 16:21

George Soros, Chairman of Soros Fund Management and of the Open Society Institute, writes that with the euro crisis still acute, the prospect of a global financial meltdown remains very much alive.

I have proposed a plan that would bring immediate relief to global financial markets, by using the European Financial Stability Facility (EFSF) to guarantee newly issued Italian and Spanish sovereign debt. Banks could then hold those bonds as the equivalent of cash, enabling Italy and Spain to refinance their debt at close to 1%. This would put their debt on a sustainable course and ring-fence them against the threat of an impending Greek default. 

I call this the Padoa-Schioppa plan, in memory of my friend Tommaso Padoa-Schioppa, who helped to stabilize Italy’s finances in the 1990’s. The plan is rather complicated, but it is both legally and technically sound. I describe it in detail in my new book Financial Turmoil in Europe and the United States.

The authorities rejected this plan in favor of the European Central Bank’s current long-term refinancing operation (LTRO), which provides unlimited liquidity to the banking system for up to three years. It allows Italian and Spanish banks to buy their own governments’ bonds and engage in a profitable carry trade at practically no risk, because, if the country defaulted, the banks would become insolvent in any case.

The difference between the two schemes is that mine would provide instant relief, while the LTRO has kept countries and banks hovering on the edge of default. I am not sure whether the authorities deliberately prolonged the crisis atmosphere in order to maintain pressure on the eurozone’s heavily indebted countries to adopt fiscal discipline, or were driven to this course by irreconcilably different views. Which interpretation is correct is not inconsequential, because the Padoa-Schioppa plan could be implemented at any time, as long as the EFSF’s available funds are not otherwise committed.

Either way, Germany dictates European policy, because, in times of crisis, creditors are in the driver’s seat. The trouble is that the austerity that Germany wants to impose on the eurozone will push Europe into a deflationary debt trap. Reducing budget deficits will put both wages and profits under downward pressure, economies will contract, and tax revenues will fall. So the debt burden – the ratio of accumulated debt to annual GDP – will actually rise, requiring further budget cuts and creating a vicious circle.

I am not accusing Germany of acting in bad faith. The Germans genuinely believe in the policies that they are advocating, and theirs is the most successful economy in Europe. So why should the rest of Europe not emulate them?

The answer is simple: the Germans are pursuing something impossible. In a closed system like the euro-clearing system, everybody cannot be a creditor simultaneously.

The fact that a counterproductive policy is being imposed creates a dangerous political dynamic. Instead of bringing eurozone countries closer together, it will incite mutual recrimination, with a real danger of undermining the European Union’s political cohesion.

The EU is following a course that resembles a boom-bust sequence or financial bubble. That is no accident. Both processes are reflexive and largely driven by mistakes and misconceptions.

In the boom phase, the EU was what David Tuckett, who applies psychoanalytical insights to financial markets, calls a “fantastic object” – an unreal but attractive object of desire. To my mind, the EU was the embodiment of an open society – an association of nation-states founded on the principles of democracy, human rights, and rule of law, and not dominated by any nation or nationality.

The EU’s creation was a feat of piecemeal social engineering, led by a group of far-sighted statesmen who understood that the fantastic object was not within their reach. They set limited objectives and firm timelines, and then mobilized the political will for a small step forward, knowing full well that when they accomplished it, its inadequacy would become apparent, requiring a further step. That is how the coal and steel community was gradually transformed into the EU

During the boom period, Germany was the main driving force of integration. When the Soviet empire began to fall apart, Germany’s leaders recognized that reunification was possible only in the context of a more united Europe, and they were willing to sacrifice to achieve it. When it came to bargaining, they were willing to contribute a little more and take a little less than others, thereby facilitating agreement.

The boom phase culminated with the Maastricht Treaty’s entry into force in 1993, and the introduction of the euro at the end of the decade. Then followed a period of stagnation, which turned into a process of disintegration after the crash of 2008.

The euro was an incomplete currency, and its architects knew it. The Maastricht Treaty established a monetary union without a political union. The euro boasted a common central bank, but lacked a common treasury. The architects had good reason to believe, however, that when the time came, further steps would be taken towards a political union.

But the euro had other defects of which the architects were unaware – and which are not fully understood even today. And it was these defects that helped to set in motion the process of disintegration that we see today.

The euro’s founders relied on an outdated theory of financial markets. They believed that all imbalances originated in the public sector, because the invisible hand corrected market excesses. In addition, they believed that they had introduced adequate safeguards. Consequently, they treated government bonds as riskless assets that banks could hold without allocating capital reserves against them.

When the euro was introduced, the ECB accepted all government bonds at its discount window on equal terms. This gave banks an incentive to gorge themselves on the weaker countries’ bonds in order to earn a few extra basis points, while causing interest rates to converge. That, in turn, caused economic performance to diverge.

Germany, struggling with the burdens of reunification, undertook structural reforms and became more competitive. Other countries, benefiting from lower interest rates, enjoyed a housing boom that made them less competitive. That is how the euro’s introduction caused the discrepancy in competitiveness that is now so difficult to correct.

The tipping point was reached when a new Greek government revealed that the fiscal deficit was much larger than the previous government had announced. The Greek crisis revealed the Maastricht Treaty’s gravest defect: the absence of provisions for correcting errors in the euro’s design. There is neither an enforcement mechanism nor an exit mechanism, and member countries cannot resort to printing money. The ECB’s statutes strictly prohibit lending to member states. So it was left to the other member states to come to Greece’s rescue.

Unfortunately, the European authorities had little understanding of how financial markets really work. Far from combining all available knowledge, as economic theory claims, financial markets are ruled by impressions and emotions, and they abhor uncertainty. To bring a financial crisis under control requires firm leadership and ample financial resources. But Germany did not want to become bad debtors’ deep pocket.

Consequently, Europe always did too little too late, and the Greek crisis snowballed. Other heavily indebted countries’ bonds were hit by contagion, as were the European banks that had loaded up on them.

Germany aggravated the situation by imposing Draconian conditions and insisting that Greece pay penalty rates on its rescue package. The Greek economy collapsed, capital fled, and Greece repeatedly failed to meet the conditions. Eventually, Greece became patently insolvent. Germany then further destabilized the situation by insisting on private-sector participation.

This pushed risk premiums on Italian and Spanish bonds through the roof, and endangered the banking system’s solvency. The authorities then ordered the European banking system to be recapitalized. This was the coup de grâce, for it gave banks a powerful incentive to reduce their balance sheets by calling in loans, and to rid themselves of risky government bonds.

That is where we stand today. The credit crunch started to affect the real economy in the last quarter of 2011. The ECB then began to reduce interest rates and aggressively expand its balance sheet. The LTRO provided some relief to the banking system, but left Italian and Spanish bonds precariously balanced between a sustainable path and a Greek-style abyss.

The ever-deepening financial crisis is interlinked with a process of political and social disintegration. During the EU’s boom phase, political leaders were in the forefront of further integration; now they are trying to prevent disintegration by protecting a status quo that is clearly untenable.

Treaties, statutes, and laws that were meant to be stepping-stones have turned into immovable boulders. The German authorities, notably the country’s constitutional court and the Bundesbank, are dead set on enforcing rules that have proved to be unworkable. This is bound to lead to further deterioration. Those who find the status quo intolerable and are actively looking for change are driven to anti-European and xenophobic extremist movements. Hungary today augurs what is in store elsewhere.

The outlook is dismaying but there must be a way to avoid it. After all, history is not predetermined.

The only way out is to rediscover the “fantastic object” that used to be so alluring when it was only an idea. That vision of the EU was almost within our reach, until we lost our way. The authorities lost sight of their own fallibility, and started to cling to the status quo as if it were sacrosanct.

Today, the EU bears little resemblance to the fantastic object. It is undemocratic to the point that the European electorate is disaffected, and it is ungovernable to the point that it cannot cope with the crisis that it has created. These are the defects that need to be fixed.

That should not be impossible. But it does require that we reassert the principles of open society, which means recognizing that the prevailing order is not cast in stone, and that rules are in need of improvement. We need a European solution for the euro crisis, because national solutions would lead to catastrophic dissolution; but we must also change the status quo in order to inspire the silent majority that is disaffected and disoriented but probably still pro-European.

Around the world, people are aspiring to an open society. We see it in the Arab spring, in various African countries, in Russia, in Myanmar (Burma), and in Malaysia. Why not in Europe?

To be more specific, a European solution to the euro crisis involves a delicate two-phase maneuver, similar to the one that got us out of the crash of 2008.

When a car is skidding, you first have to turn the steering wheel in the direction of the skid. Only after you have regained control can you correct your direction. In the eurozone’s case, governments must first impose strict fiscal discipline on deficit countries and encourage structural reforms. Then stimulus is needed, because structural reforms alone will not suffice to escape the vicious deflationary circle.

The stimulus will have to come from the EU, and it will have to be guaranteed jointly and severally. It is likely to involve Eurobonds in one guise or another. It is important, however, to spell out the solution in advance. Without a clear game plan, Europe will remain locked in a spiral of mutually reinforcing economic decline and political disintegration.

George Soros is Chairman of Soros Fund Management and of the Open Society Institute.

Copyright: Project Syndicate, 2012.