TEN
CULTURE
It was the clear but frosty evening of February 8, 1998, outside the tower of the Bank for International Settlements (BIS) in Basel, Switzerland. Inside, the tightly knit, collegial group of governors of eleven1 of the world’s largest central banks was engaged in one of our regular Sunday dinners, hosted by the general manager of the BIS. The meetings were without staff and engagingly uninhibited as we discussed the usual array of pressing international economic issues. Given that eight of the eleven governors were European, the issue of the emergence of what came to be known as the euro was a topic of increasing interest.
The BIS seemed a singularly appropriate place to ponder the awesome complexities of a merging of the seventeen separate currencies that eventually constituted the “Eurozone.” There was an explicit recognition among many of the European central bankers that the euro was the next stepping stone toward the political integration of Europe. It was the ultimate goal of some, if not most, of the Europeans sitting around the dinner table that evening. Seared into the European psyche was the devastation of two world wars in less than a third of a century; integration, it was presumed, would go a long way toward fending off future internecine conflict.
The conversations in Basel were generally directed at replicating a currency as effective as the U.S. dollar that served as legal tender across all fifty American states. From the beginning it was recognized that the merging of currencies of the European states could not be directly modeled after U.S. practice. There were more languages, less labor mobility, and less free capital flow throughout the continent than existed across the state boundaries of the United States. But there was an unwavering conviction that economic and cultural barriers would break down under the imperative of a single currency.2
Most important, the international financial markets appeared to be buying the hypothesis that the euro could change some deeply embedded cultural behavior. The presumption was that all members of the Eurozone, but especially the Italians, Spaniards, Portuguese, and Greeks, once under the cover of the discipline of the euro, would behave like Germans. In anticipation of the adoption of the new currency, yields on government debt of the prospective members of the Eurozone had been falling sharply in the years prior to our BIS dinner, dramatically closing the yield spread gap against the German bund. In the three years leading up to the introduction of the euro on January 1, 1999, yields on lira-denominated ten-year government bonds declined nearly 500 basis points (5 percentage points) relative to yields on German bunds. Yields on Spanish peso and Portuguese escudo bonds both fell close to 370 basis points against the bunds. Likewise, in the three years preceding Greece’s delayed adoption of the euro on January 1, 2001, drachma-denominated ten-year sovereign bonds fell more than 450 basis points relative to bund yields. In stark contrast, in those early years, spread changes against the bund for bonds of France, Austria, Netherlands, and Belgium were all less than 65 basis points.3
It was puzzling that the convergence of borrowing rates and corresponding dramatic narrowing of spreads was reflected entirely in the decline of southern European yields toward those of Germany rather than toward an average of all Eurozone legacy currencies, as might have been expected. That underscored the dominant role of the deutschmark (DM) as the shadow anchor of newly minted euros: Markets perceived the euro as a substitute for the DM. In retrospect, the dominance of Germany did not bode well for the working relationship within the presumably collegial group of countries.
EURO: IN WITHOUT A WHIMPER
Much to my surprise, on January 1, 1999, the merging of the currencies came off with remarkable ease. The eleven divergent floating currencies (six others would join later) effortlessly locked together and remained locked with little market tension for almost a decade. The euro seemed to belie the decidedly checkered history of past endeavors to tie exchange rates of culturally diverse countries. Many countries have, for example, succeeded in choosing the U.S. dollar as their legal tender. But these, over the years, have primarily been small Latin American and Caribbean economies. And, of course, many currencies have linked together under the gold standard. But in recent decades, success has been rare. The experience of Argentina is especially noteworthy.
The central lesson of fixed exchange rates is that when they work, they do minimize price fluctuation and render all the benefits of stability and long-term investment that attaches to it. The Bretton Woods Agreement, struck among forty-four countries as World War II was coming to a close, tied all major postwar currencies to the gold-backed4 U.S. dollar for nearly three decades. The presumption that the euro could easily withstand the internal monetary dynamics of seventeen clashing cultures, however, now seems a decided overreach.
In retrospect, the remarkably benign convergence of Eurozone currencies for nearly a decade can be explained, as best I can judge, by the global boom that funded both the creditworthy and the less so. It enabled even the increasingly uncompetitive Euro-South economies (Greece, Portugal, Spain, and Italy) to thrive as they effortlessly borrowed heavily from their northern neighbors at the low interest rates that the euro accorded them. But hidden beneath the false sense of well-being, the southern members of the Eurozone were becoming increasingly uncompetitive relative to their partners in the north, as indicated by their ever-rising unit labor costs and prices relative to those of Germany (see Exhibit 10.1).
With the collapse of Lehman Brothers in September 2008, followed by the virtual closing down of trade credit on a global scale, recognition of the starkly different international competitive capabilities of Eurozone members emerged with a vengeance after nearly a decade of golden years for the new currency. Fears of sovereign default escalated and southern euro government bond spreads against Germany blew out, after years of Euro-South being able to borrow in international markets at market rates very close to those of Germany. Spreads by late 2008 ballooned back to where they were, in general, before the euro was considered a realistic possibility.
CULTURE REIGNS
There had been a widespread notion that the Italians, once they embraced the euro, would behave like Germans. From day one of the euro, they did not. Nor did the Greek, Portuguese, or Spanish members of the European Monetary Union.5 Despite the binding restraints of the Maastricht Treaty, the Eurozone has not exhibited the ability to counter the key concern of currency unions: that the value created by a pooling arrangement tends in the end to be distributed disproportionately in favor of the financially less collegial and less prudent members of the pool. We observed this tendency as consumption growth of the south relative to Germany accelerated following the creation of the euro. Unless restrained, the less collegial members of the pool will try, and often succeed, to exploit the advantage available to all members of a pool—that which Greece in particular so brazenly exploited over the past decade.
I believe Kieran Kelly, an Australian financial adviser, captured the Greek ethos best as he noted in October 2011 that “if I lived in a country like this, I would find it hard to stir myself into a Germanic tax-paying life of capital accumulation and arduous labor. The surrounds just aren’t conducive.”6
As can be seen from Exhibit 10.1, the unit labor costs, driven by workers’ wage demands, of the countries that make up Euro-South rose persistently from the onset of the euro. In fact, from 1985 to the beginning of 1999, the legacy currencies, calculated in terms of deutschmarks, the hard currency that the creators of the euro seek to replicate, exhibited approximately the same rate of competitive erosion that was evident in unit labor costs in the years immediately following the adoption of the euro. Prior to the launch of the new currency, the Mediterranean nations were able to remain internationally competitive by allowing their currencies to weaken. That had the effect of reducing real wages and unit labor costs to internationally competitive levels, at least for a short while. No special cross-border financing was required.
ENTER THE EURO
But with devaluation no longer available after
1998, and the apparently irresistible availability of credit at the low euro interest rates, Euro-South’s consumption surged, especially in Greece and Spain. They borrowed heavily from Euro-North. The size of the buildup is best represented by the €750 billion of accumulated credits in the Eurozone central bank clearing system (TARGET2) of the Deutsche Bundesbank by August 2012, and to a lesser extent the credits of the central banks of Netherlands, Finland, and tiny Luxembourg.7 Southern Europe’s sovereign bond spreads widened back to the levels that prevailed during the financially independent pre-euro years. The central banks of Euro-South, especially Italy and Spain, were the major net debtors of TARGET2.8 Since mid-2012, the TARGET2 spread has narrowed modestly.
There is thus scant evidence that on embracing the euro, Euro-South significantly altered its behavior—behavior which had previously precipitated its chronically depreciating exchange rates against the deutschmark. From 1985 through the end of 1998, Euro-South unit labor costs and prices rose far faster than in the north, and in the years following the onset of a single currency, as I noted, that pace barely slowed. By 2008, according to OECD data, Greece, Spain, Italy, and Portugal had unit labor costs 30 percent to 40 percent higher than that of Germany.9 The underlying uptrend was stopped only by the financial crisis. Productivity in Germany, after having grown at a steady rate between 1999 and 2008, flattened and has been stagnant since the onset of the crisis. Hourly wages, however, continued their upward, fairly consistent average growth of 2.1 percent per year. The consequence, of course, has been a rise in German unit labor costs since 2008. Moving dramatically in the opposite direction were the unit labor costs of Ireland, Portugal, and Spain, which substantially improved their competitive positions relative to Germany. The unit labor costs of the other major members of the Eurozone relative to Germany since the crisis have largely maintained the ranking they exhibited through the decade prior.
Euro-North has been historically characterized by high savings rates,10 low inflation, and adherence to the rule of law (the latter can be proxied by the share of illegal activity in GDP). These are some of the metrics of a culture that determine the share of national income that is spent and the share that is saved to finance capital investment. In contrast, negative saving rates—excess consumption—have been a common feature of Greece and Portugal since 2003.
There remains the question, as this book went to press, of whether most, or all, of the south could or would ever voluntarily adopt northern prudence. A breakup of the Eurozone could leave in its wake a number of northern European countries with similar economic cultures—Germany, France,11 Netherlands, Austria, Luxembourg, and Finland, for example—still devoted to preserving a narrowed but viable Eurozone. In the end, however, a euro breakup may be perceived as too wrenching to the economic structure of Europe.
SECOND THOUGHTS
Many members of Euro-North may be harboring second thoughts about joining the Eurozone, but once there, the process of unscrambling the eggs of finance may be too daunting to contemplate. Pending further structural changes, the European Central Bank (ECB) has effectively thrown off all of the Maastricht Treaty restrictions that bound the bank to the model of the Deutsche Bundesbank. After a whole series of actions gradually loosening its Maastricht reins, the ECB employed its ultimate weapon in the fight to preserve the euro—the innocuous-sounding Outright Monetary Transactions (OMT) facility. The creation of that facility fulfilled the vow of Mario Draghi, the able and credible president of the ECB: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”12 It offered virtually unlimited access to central bank credit, a maneuver reminiscent of when banks allegedly stopped runs on their institutions literally by exposing their currency reserves in their windows for all to see. At this writing, no actual lending has been made against the OMT facility. Interest rates on sovereign ten-year notes of Greece, Portugal, Spain, and Italy nevertheless fell dramatically.13 But the deep-seated tensions of the Eurozone remain.
It may be that nothing short of a politically united Eurozone (or Europe) will be seen as the sole way to embrace the valued single currency. I do not find a fiscal union of seventeen welfare states easily sustainable, except as a way station to full political union. A welfare state without control of its budget is a nonstarter.
There is even some question of the viability of a political union with seriously divergent cultures. Germany has not fully economically consolidated East Germany into the Federal Republic. Adjusting from East Germany’s communist state to the market competition of the West has not proved as easy as most Germans at the point of consolidation (1990) thought likely. And a meaningful consolidation between Germany and, say, Greece is something else entirely.
ADDRESSING FUNDAMENTALS
Since the onset of the actual crisis in the Eurozone, a particularly distressing issue has been the unwillingness or inability of the nations of Euro-South to address their seemingly intractable budget deficits—the source of the ongoing crisis. A breakup of the Eurozone could create massive deficits and contagion. Moreover, the fear of a euro breakup for those currently heavily subsidized economies is real. No less real is the fear of a breakup to Germany, whose exports are denominated in euros, and whose global exchange rate is far lower than the rate German exporters would confront were they to export under the deutschmark currency regime.14 Germany would suffer greater unemployment, a sensitive issue for today’s narrowly divided German electorate.
Thus, when confronted with the chronic euro crisis, Euro-North has been inclined to continue bailouts, all coming directly or indirectly from central bank (ECB) money. After thirteen months and well over a €1 trillion expansion of lending to euro banks, essentially to indirectly fund the fiscal deficits of Euro-South countries, panic subsided.* This policy has been most apparent since May 2011 as European financial authorities turned to the ECB to print money to fund the persistent fiscal deficits throughout the southern Eurozone (Exhibit 10.2).
Confronted with a choice of ending deficit spending or funding it, Eurozone policy makers invariably chose the latter as the more politically attractive alternative. Such actions did, of course, resolve short-term funding crises but did little to address fundamental deficits. If the ECB—the sole source of sovereign credit in the Eurozone—will do “whatever it takes” to preserve the euro, I must assume that, if necessary, the OMT facility or any future lending vehicle will lend virtually without conditions. Between June 2011 and June 2012, assets of the ECB ballooned by more than half to €3.1 trillion.15 Such funding is, of course, in addition to the more limited direct taxpayer funding predominantly from Germany. Since mid-2011, confronted with pain-generating budgets cuts, or the ability to ostensibly fund them solely with a stroke of a pen, the choice at every point in the euro crisis has been to temporarily fund the deficit to give policy makers more time to, presumably, address the fiscal imbalances, the ultimate source of the crisis.
The propensity of policy makers to seek the least politically painful solution to a problem is, of course, not the monopoly of Europeans. We see it everywhere. As I note in Chapter 7, when confronted with the choice of solving an economic problem, policy makers most everywhere have clearly been tilting toward “painless” short-term actions rather than effective long-term solutions at a cost of short-term pain.
A BROADER PERSPECTIVE
The sorry travail of the euro at the turn of this century is only the latest evidence of the profoundly important role that culture plays in economic affairs. The key lesson of recent history is that while cultures do change over the decades and centuries, at best they do so only gradually. As the short history of the euro appears to demonstrate, culture has been far less susceptible to change than the financial markets had previously assumed. As I have noted, the markets anticipated that Spain and Italy in particular, upon adopting the euro in 1999, would alter their cultures and become more like prudent Germany.16 After a near decade of seeming validation, however,
that presumption failed under the pressure of the 2008 crisis, and the ECB had to scramble to the euro’s rescue. However, governments continue to struggle with austerity fatigue. Spending cuts are fomenting strikes and protests, which so far have been contained, but Europe is far from out of the woods.
CULTURE DEFINED
By culture, I mean the shared values of members of a society that are inculcated at an early age and that pervade all aspects of living. Culture is particularly relevant in shaping the type of economic system we choose to construct in the pursuit of material goods and services. It shapes a large body of intuitive and habitual responses to the daily challenges of life. Its embraced rules of behavior enable much of life’s complex daily decision-making processes to be carried out on autopilot, thereby removing a significant amount of the unwanted tension in our lives. It can be all encompassing, as it is in many religions, and it is rarely merely peripheral.
Aside from the compelling evidence of the history of the euro, examples of the role of economic culture are all around us. I recall a conversation I had in 2000 with Kiichi Miyazawa, the then-finance minister of Japan. I told him I thought Japan could recover more quickly from the sluggish aftermath that beset its economy following the stock market crash of 1990 by liquidating dodgy loans. Their banks had a policy of loan forbearance—that is, their banks were reluctant to call loans (especially on defaulting real estate) and liquidate the collateral, the standard procedure of most Western banks. Miyazawa responded that such provoking actions were not the “Japanese way.” Calling a loan, and propelling borrowers into bankruptcy in certain circumstances, would cause them to lose “face.” The Japanese just did not behave that way, he informed me. “Face” is a profoundly important aspect of Japanese culture.
The Map and the Territory Page 19
