Bernard is an economics columnist for the NZ Herald

Bernard Hickey: Euro voters choose their own interests over creditors

A man is reflected in the chart with stock prices at the Greek Stock Exchange in Athens. Greek parties in favour of austerity measures got just 33pc of the vote. Photo / AP
A man is reflected in the chart with stock prices at the Greek Stock Exchange in Athens. Greek parties in favour of austerity measures got just 33pc of the vote. Photo / AP

Citizens in Greece and France voted over the weekend against the austerity imposed on them by their politicians, who were trying to keep bond market investors and their donors in Germany happy.

Ultimately, this was a case of voters choosing their own interests over those of creditors.

Either voters are being very short sighted in that they will eventually pay much more on their borrowings.

Or they are being very long sighted in understanding that bond investors have nowhere else to run and should have been much more careful before lending taxpayers the money.

This is a very enlarged version of the old saying about a small unpaid debt being a problem for the borrower and a really large debt being a problem for the bank. In this case huge public debts in Europe are the problem and the 'bank' is both the banks of Europe and pension funds.

Either way these sorts of voter revolts could destroy what had been an article of faith among bond investors: that modern democracies never default on their debts.

The fallout on global financial markets has already started and is likely to rumble on over the weeks and months to come as bond investors come to the ominous conclusion that taxpayers and their political representatives seem not to care about defaulting on public debts.

Greek political parties in favour of the German-driven plan for austerity got just 33 per cent of the vote. Parties of the extreme left and right who are against the plan got almost two thirds of the vote.

France's new Socialist President Francois Hollande, the first socialist in 17 years to win the Presidency the first to beat an incumbent in 31 years, has pledged to renegotiate France's commitment to the German-led plan for European-wide austerity to win back the confidence of markets and save the euro.

French and Greek voters were saying they had had enough. As did many German voters in the state elections of Schleswig Holstein. The centre-right Christian Democratic Union party of Chancellor Angela Merkel, the architect of Europe's austerity plan, received its lowest share of the vote since 1950. The Pirate Party, which is dedicated to internet freedoms, received 8 per cent of the vote and will enter the state parliament.

Revolt and default?

So what happens now? Do voters keep revolting in Europe until they eventually vote in governments that refuse to pay their debts, and therefore ultimately unravel the Euro and the European project?

This would be unprecedented. Modern democracies aren't supposed to do this. They're supposed to do the sensible thing and repay their debts. This is something that only tinpot dictatorships, monarchies and very immature (and impure) democracies do. Think Argentina, Peru, Indonesia, Angola and The Philippines.

Greece's membership of the Euro zone and the extraordinary efforts taken in recent years by its Eurozone partners to help it avoid default showed how verboten this concept is. Although it should be noted that Greece defaulted at least 5 times in the 200 years previous to its entry to the Eurozone.

The problem is now amplified by the existence of the euro, which has become a type of Gold standard of the Great Recession in the same way the actual Gold Standard of the 1930s deepened the Great Depression. Eventually Britain, America, Scandinavia and then France left the Gold Standard during the 1930s and allowed their currencies to devalue.

Ultimately, that will be the only solution for southern Europe in particular. Their economies are now contracting and both their debt loads and interest costs are rising to unsustainable levels. They have entered deleveraging-depression-death spirals. The harder they cut government spending and increase taxes, the faster their economies contract and the higher their unemployment rates rise. Spain is the biggest and most dangerous example, aside from Greece, which is well past the contractionary stage into a full blown depression.

Without the ability to allow (or to force) the devaluation of their currencies, the likes of Portugal, Italy, Ireland, Greece and Spain (PIIGS) are forced into cutting their prices and wages to make their exports more competitive. This only intensifies the death spiral because it causes deflation, which is poisonous for any economy. Deflation encourages consumers to stop spending because saving makes their money more powerful in future.

So what to do?

Most countries with control of their own monetary policies and currencies can attempt to devalue their way out and to cut interest rates. Sometimes this creates inflation, which punishes the owners of government bonds, and any devaluation certainly punishes any foreign holders of any local currency government bonds, at least in their own currency's terms.

This is usually how democracies default. They essentially impose a debt restructuring using a cut in official interest rates and/or a slump in their currency.

The problem for much of the Eurozone is they don't have control of their currencies and interest rates. So, instead, their politicians are imposing internal devaluation by cutting wages and trying to reduce unit costs to improve their export competitiveness. It is a long, grinding and politically risky path. It can only work when the population are largely behind it and are prepared to dance to the tune of bond holders.

Right now, it is the banks of Germany and France who hold many of these bonds. They are calling the shots through the politicians. But this only works in democracies as long as the politicians have the support of voters. When voters understand they are suffering fiscal pain just to keep the banks and pension funds whole (many of which may be foreign owned) then it becomes incredibly difficult.

That's why Europe is in an intractable mess

Voters in Europe have already turfed out 11 governments in reaction to this pressure. Anyone trying to understand what is happening in Europe and where it might go next therefore need to understand where the politics is headed.

Greece was the first to get into trouble and is a sign of what happens when voters lose faith in the political class. A neo-Nazi party (complete with black shirts and ominous red and black party symbol) won more than 7 per cent of the vote. It wants to close the borders to migrants and lay a minefield to stop those wanting to cross the border illegally.

Eventually the voter pressure will be too much and politicians will not be able to disguise their work in the interests of creditors rather than voters. Greece has already defaulted, but in a relatively soft way that has protected the European Central Bank, which now owns 73 per cent of Greek government debt.

In democracies, eventually voters win and creditors lose, particularly if those creditors are outside their borders and voters can't control their central banks.

Voters vs independent central bank governors

The big clashes in advanced democracies will be between voters and the independent leaders of central banks. Essentially, that has been the big politco-economic issue driving the economies of Europe and the United States for the last year or two.

Republican presidential candidates labelled US Federal Reserve Chairman Ben Bernanke as a traitor earlier this year for his money printing and bank bailouts. German politicians and central bankers are fighting hard to ensure the European Central Bank does not print money or bail out non-German banks with German money.

The results of these regular elections across Europe and America, along with the battles between voter representatives and their central bank governors will be the big themes of years to come.

Ultimately, the least disruptive way out of the massive debt burdens now stunting economic growth in Western economies is to force interest rates down and to allow inflation rates to run (slightly) higher than interest rates. This is known as financial repression and was the tactic used by the United States during the 1940s and 1950s to help pay down the real value of its own massive war and depression debts.

This is a decision to force a default on savers by stealth.

Ultimately, money printing to increase inflation and financial repression to reduce interest rates is how democracies default.

Unless, like the PIIGs, they don't control their central banks and currencies. Then hard defaults and uncontrolled exits from currency zones/gold standards are inevitable.

- Herald on Sunday

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Bernard is an economics columnist for the NZ Herald

Bernard Hickey is the publisher of Hive News, a Wellington-based political and economic subscription news email service. He also writes for and appears regularly on Radio New Zealand, Radio Live, TVNZ and TV3. He has been a financial journalist for 25 years, having worked for Reuters, the Financial Times Group and Fairfax Media.

Read more by Bernard Hickey

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