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He Who Says No To Austerity And Global Imbalances Must Say Yes To The Northern Euro

Contributed by George Dorgan, a macro-based fixed-income and currency overlay portfolio manager based in Switzerland, and the main editor of the blog SNB & CHF.

Recent European austerity has only led to stagflation in Southern Europe: increasing unemployment and higher inflation than in Germany. Many economists call for an end of austerity, but they do not understand that allowing the PIIGS to consume more, means that Germany must pay for it.

Fearing their own economic principles like Robert Mundell’s optimum currency area, leading economists and politicians drive Europe into years and maybe decades of austerity, transfers from the north to the south and economic uncertainty. This uncertainty, however, is the worst thing for business leaders and the European economy.

In the first part of our essay, we will discuss the results of recent European policy: austerity and global imbalances. In a second part we will present an alternative solution, a strategy for the introduction of a Northern Euro.

Part one: Austerity and weak euro worsens European and global imbalances


We admit that an exit of a weak euro member might trigger irrational behaviors and bank-runs, clearly explained here:

One weekend we will just find that the Greeks have done [the Greek euro exit]. But now suppose Greece does pull this trick. The day after we have a Drachma – deposits are in Drachma. We might print a single 10 drachma note and allow it to settle against the Euro – then over time print more. This should work for Greece.

Now if you are Irish or Italian or Portuguese (or even Spanish) you know the rules. You get to get your Euro out of the PIGS and into the core (Germany) as fast as possible. So max all your credit cards (for cash), draw all your bank deposits and load them in the boot of your car and make the drive to Switzerland or Germany. Somewhere safe. Otherwise you are going to lose half the value the day that the rest of the PIGS do a Greece.

And this bank run – a run including tens of thousands of Italians driving their Fiats – will surely blow apart every Italian bank. And their Euro-skeloritic compatriots will sign the death knell for all their banks too.

Target2 balances and rising German house prices versus falling peripheral ones show that this bank-run scenario already happens today, inside the common euro zone, just a bit more slowly.

Instead of kicking the periphery out of the euro zone and risking a bank run, we should go for a different approach, namely that the Northern countries leave the euro zone. 

Austerity and kick-the-can approach


David Koo, the economist, who propagated the “balance sheet recession theory“ thinks that only fiscal spending will rescue the PIIGS and austerity will do just the opposite. Most recently a group of economists called for the end of US and global austerity.

We are of the strong belief that Germany will not (be able to) pay this big bill for many years and decade. And if it does, it should do it once-off and not in an endless delirium, that eventually costs ten times more than a simple clean and clear cut, with the Northern euro introduction.  

The potential official sector loss participation for Greece is only the very first example of the explosion of costs caused by the kick-the-can approach. Fiscal spending and stimulus in the PIIGS is only possible with fiscal and monetary independence, which is not the case inside the euro zone. It also requires a currency that can devalue. 

Turkey does a lot better than Greece with its own currency


Turkey, the biggest Greek competitor in holiday destinations, is currently booming, last but not least thanks to a cheap currency. At the time when Greece was to join the euro, Turkey had big issues with hyper-inflation, but overcame the problems with the time.

Euro against New Turkish Lira since 1999

Turkish Lira depreciation helps to keep holidays in Turkey cheap


Southern European states have no chance in the long-term


Italy, Spain, Portugal, Cyprus and Greece did not use their historical chance to improve their economies via long-term factors like technology or better infrastructure between 1999 and 2008, but much of the money flowed into real-estate and consumption.  As opposed to the previously, when cheap money was easily available, funding for Italian and other peripheral companies has dried up now. Salaries are downwards sticky, so that the only way out is a strong devaluation of the Euro and higher wages in the Northern and Eastern European countries over many years.

A quick look at economic theory shows that the southern states have no chance to stay in the euro in the long-term. Between 1999 and 2008 they were able to compete with the Northern countries in terms of GDP only thanks to cheap debt, a construction bubble and a consumption run.

Production factor labour


The southern countries have seen a loss of labour-intensive work such as textiles due to globalization since the euro’s introduction.

Industrial Production Italy

Italian Industrial Production YoY (source Istat)


They see labour competition from the former communist countries and the advanced German export model. Italian labour costs are close to Germany’s, but they are four times higher than the ones in Slovakia or Estonia. Slovakian industrial production is rising at more than 10% per year, while those from the periphery have fallen strongly and are still sinking.


Southern European countries cannot devalue any more to become competitive. Before the euro era, Italian labour was competitive only thanks to an always weaker Lira, as the following graph from Commerzbank shows.


Cheap Italian Labor Costs before euro

Cheap Italian Labor Costs before the euro era (source Commerzbank)


Production factor capital


The following graph shows the net international investment position (NIIP) of the euro countries, one indicator of availability of capital. It shows that Greece, Portugal, Spain and Ireland desperately need foreign capital.


The ongoing capital crunch makes everything worse, we see huge capital outflows (see video). Due to missing capital, production costs in the PIGS are rising more quickly than in Germany. This despite falling or slowly rising labour costs. But only a return to really cheap labour and a cheaper currency would attract foreign capital again.

As Goldman’S Huw Pill explains, relying on labour costs reduction is not sufficient: 50% lower Greek and Portuguese and 30% Spanish or French labor costs would be needed.

We view relative wage cuts of this magnitude as unfeasible: it is difficult to imagine France accepting a one-third fall in living standards relative to Germany. Of course, one could rely on Germany to raise wages, so as to redress the competitiveness gap from the other side. But ultimately such an approach would imply Germany accepting much higher rates of inflation, say above 4% pa for a decade or more, assuming the ECB met its target of keeping area-wide inflation close to 2%. We doubt the German public would countenance such an eventuality…. Source Goldman Sachs via Zerohedge

Other factors


  • Technology

The periphery is far behind in technology. Their expenditure on R&D is less than half that of the Northern states. Latest Greek data  showed 0.6% R&D of GDP, Italy has 1.3%, but France or Germany close to 3% and Finland 4%. More R&D like the Euro Plus Pact wants, is restricted by the lack of capital and the Fiscal Compact, the implementation of European austerity.

  • Human capital and worker’s mobility
The human capital flight from Greece is obvious. Portuguese seek jobs in Germany, but since most of them do not speak German, the efforts do not succeed. The euro zone is too far from an optimum currency area.
  • Overall competitiveness (taxes, debt, etc.)

The southern states are behind countries like Poland or Estonia.


The euro will destroy the public-sector, but first the welfare state in the periphery


If, on the contrary, the euro remains, then free-market forces will reduce the public-sector share and destroy the southern European and the French welfare states as Robert Mundell said:

 ”It puts monetary policy out of the reach of politicians,” he said.  ”[And] without fiscal policy, the only way nations can keep jobs is by the competitive reduction of rules on business.”

But unfortunately the first thing that is destroyed is the welfare state, but bureaucracy and the public sector remains. Spain has 60000 more public employees than in 2007 and so many labour laws to remove; the way to an efficient economy is still very very long.

Government Spending Eurozone

Austerity means welfare state cuts, but less public-sector (source Mercatus Center)


A more competitive exchange rate is a help to help yourself


Currently German tax-payers just finance the ever rising unemployment rates in the periphery and send always new “care packages” down to them. Yes “care packages” is the right word – our Italian, Greek, Portuguese and Spanish friends may forgive us. It is like the life aid for Africa in the 1970s. At the end of that decade aid organizations finally discovered that  ”help to help yourself” is the solution and not just sending food packages to survive. The Africans needed to have also machinery to be able to produce their own food.

We identify with this “help to help yourself” a competitive exchange rate, that is at least 20% weaker than the German currency. We do not see the point to go to an Italian supermarket and to see more German and Austrian dairy products than Italian ones. Dairy products that are carried in trucks over the once so beautiful alps. In the 1990s, however, Parmalat, an Italian dairy products company, dominated the market, at the times of a weak Lira. With the euro introduction and rising Italian salaries the competition was too big. After a series of frauds they went bankrupt.

The strongest and most efficient weapon against such environmental excesses in a free market like the European one, are exchange rates. They are far quicker than adjustments of labour costs, especially when capital is missing.


The euro increases global and European imbalances and prevents German consumers from spending


The following graph shows that the Northern Euro is a necessity to eliminate the increasing growth divergences in the euro zone.

Divergence of European Growth Northern Euro

Divergence of European Growth

Leading American Keynesians like Barry Eichengreen want to provoke German inflation of 4% and more, in order to force Germans to consume. They do not understand the German mentality and the historical fear of inflation. They do not understand that Germans are very price-sensitive and spend more when they think that prices are cheap. All Germans still remember the “Geiz ist geil”, “Penny-pinching is cool” of the early 2000s. A weak euro does not help them to consume, they need a strong Northern euro with strong purchasing power. Like they lived in the 1970s when always weaker dollar did not harm the German competitiveness.

Inflation and the pure fear of tax rises to finance the potential German losses on the Greek bailout, the ESM and Target2 will do the contrary: Germans will not increase spending as much as recent salary improvements and a potential cost-push inflation might suggest.

But the cheap euro helps that the German trade surplus with the US, France and Asia is rising more and more, even if a brutal reduction in consumer spending in the PIIGS cut the German trade surplus with these countries.

Global trade imbalances become bigger and bigger thanks to the world biggest currency manipulator, Germany.

Deutschlands Salden im Außenhandel mit den USA, Frankreich und Asien

Rising German trade surplus with USA,France, Asia

Deutschlands Salden im Außenhandel mit Portugal/Griechenland, ...

Falling German trade surplus with periphery


Nigel Farage puts it in simple words:


Northern Euro: Once-off write-offs instead an endless delirium


In 1982 Paul Volcker stopped the vicious inflationary cycle, reduced uncertainty and stabilized the American and European economies. Only Latin America went for a lost decade due to lower commodity prices, high interest rates and high debt. One reason was that Wall-street did not want to accept a final hair-cut until 1989. Read why Southern Europe will live the same lost decade as Latin America, if nothing changes.


Spanish Public DebtThe Greek example has shown that delaying write-offs leads to more and more debt. The same will happen for Spain, Portugal, Cyprus, Slovenia and partially Italy. These countries might be able to reduce debt, but with falling GDP, the debt to GDP ratio will rise.

With a 20% higher Northern Euro exchange rate, German and other Northern European leaders should accept 20% private and official sector write-offs for assets of the other peripheral countries.

The 20% price advantage will make the peripheral economies competitive again, far more quickly than it will do with gradual (real) wage cuts and negative or slow GDP growth for many years. At the same time, cheaper import prices will help the Northern Europeans to spend more. Admittedly, the Northern Euro creation is a step, that implies big German sacrifices and a once-off uncertainty,  but it avoids an uncertainty that lasts for years and decades.

We think that eventually the Northern Euro will be introduced: politicians and their economic advisors might just be waiting for a calm and secure moment, especially when confronted with Northern European inflation that could become a problem in 5 to 7 years, see the retrospective of the Northern Euro introduction from the year 2030.

In a forthcoming second part of this essay, we will present details on the strategy for the Northern Euro introduction that includes currency depreciation-related haircuts on Northern official sectors and banks, a certain amount of capital controls and stabilizing monetary policy and currency purchases, similar to the ones of the Swiss National Bank. Cross-posted from SNB & CHF.

Also by George Dorgan: Who’s the Next Downgrade Domino to Fall?…The UK? 

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Reader Comments (9)

Two questions:

1.What does "skeloritic" mean?

2. Did Volcker break US inflation or was it just the decline in oil prices?
December 8, 2012 | Unregistered CommenterJB McMunn
The game was lost when we exited the Gold standar and when politicians such as Reagan and Thatcher ''released'' the beast, aka the Financial - Banking Sector. We are heading to a global turmoil not seen before for thousands of years. The politicians must act before its too late..
December 8, 2012 | Unregistered CommenterMike
It's not clear how Reagan and Thatcher are responsible. Neither of them approved of a European Union. Could it be that the real culprit is Big Government and out of control spending? Reagan strongly believed that government was the problem, not the solution. Evidently, he was right.
December 8, 2012 | Unregistered CommenterPavan
Imho much too little red line in the essay. Very (too) difficult to catch that. Try with the headings first and link the different parts better. Probably solved that way. And mention in the beginning that it is in 2 parts.
Looks also overall a bit messy (too many styles, lettertypes, underlining etc).
December 9, 2012 | Unregistered CommenterRik
1.What does "skeloritic" mean?

My guess is that the word should be sclerotic:,or.r_gc.r_pw.r_qf.&fp=46524d946814aef7&bpcl=39650382&biw=1360&bih=650
December 9, 2012 | Unregistered CommenterHaralambos
Rik - I apologize for the "look" of the article. Formatting on George's site is different; headings, some larger images (those that are over 580 px wide), captions, and image alignment don't transfer well from his site to mine. I tried to fix some of it. But obviously..... ;-)
December 9, 2012 | Registered CommenterWolf Richter
The Club Med countries are less competitive because they tend to have more controlled media, less transparent public sector institutions, and a bit more compromised justice systems than their northern counter parties. I tend to believe Niall Ferguson when he claims that it is such fundamental, institutional features of a country that determine the country's productivity. And more concretely in this discussion, whether the wages of a given country are sticky or not. It is my impression that Germany's wages have not been as sticky as the wages of Club Med countries.

In a socialist/large public sector/welfare state the wages tend to be fairly sticky and the traditional mechanism to reach a labor market equilibrium is through collective bargaining and subsequent large amounts of regulation and required inflation to wrap it all in a comprehensive package. It truly is a package, a local optimum, and one cannot change just one part, say sticky wages, without changing other parts as well.

It probably takes a crisis to compell the welfare state to change such institutions. And the country has to actively use the opportunity. Without a widespread discussion and recognition for a need for change, the country is likely to lose its opportunity.

If the EU political leaders had stood strong and had not bailed out Greece the first time, the citizens of Greece would have had a democratic chance to evict their old elite and reshape their institutions. But because EU rushed in to prop up the old elite and institutions, the opportunity for the healthy renewal was lost.

Of course, the reason the other EU countries decided to rush in was that they were also lacking in their own institutions, allowing the byrocratic and political leaders to overstep their legal powers and fudge the information presented to the electorates.
December 9, 2012 | Unregistered CommenterCool river
No problem but it is a rather long and technical (and interesting) article and it will be a bit difficult to grasp.

Problem I see is merely political. They set the thing up as a political statement. They are trying to save it in its current form mainly for political reasons. Merkel's new set up looks to suck nearly as much as the old one because it is a political compromise.
Which makes it very likley that the end game will be mainly political as well. The core can from a political pov difficult split off as it is the core of the EU (the holy shrine of European politics for more than half a century now).
Which means that the German-French axis plays an important role. They will try to keep them together. While pure on economics they should split.
With as additional problem that The North will get back to the Mark anyway (as they basically had before) and the South will most likely fall apart anyway. They are too different from each other. Meaning nothing of the European project would be left. Which would be hard to digest for Europe's burocrats.

With the receivers they are likely pushed by their voters, which is nearly impossible to time. So difficult to form a block, as the aprts of the block will move independently from each other. Mainly when a country has a primary deficit and when there are elections.
December 9, 2012 | Unregistered CommenterRik
My idea is that we will see two sorts of pressure.
A Northern one, basically voters demanding a stop to the transfers down South. Directly via new governments in but more likley indirectly by putting via polls the pressure in the existing ones. Especially relevant is Germany, but also say Holland could kill the beast as the other ones are really small and Germany would lose by far its main supporter. Or a smaller one by contagion.
But here it would not necessarily mean an EZ-exit. It could be more likely simply stop the transfers or put extremely strict conditions to them.

A Southern, also by voter pressure. Austerity fatigue, imho they donot have much choice but that might not stop them. Time will make it worse (as history in other places shows). And Northern vorters demanding a tougher line even more. Anyway it is hard to see that all 7,8,9 problem countries will go for a decade long run of austerity.
At least one will pull the plug during that process and subsequently we have a whole new ballgame.
basically when they are in primary surplus (plus to cover loss of interst income and consumption financed with that; possible uncertainties, supplier shortening payment term (cash on delivery); deferment possibilities running out). At that point do an exit when forced by say an election or more indirectly an election not to far in the future.
Subsequently the whole ballgame is changed, also for the other PIIGS.
In countries like Greece there could even be a not-rational variant. Simply have enough never mind the costs and leave (and create a terrible mess, but that would be typical Greek or Cypriotic. Get in a few Arabs they would be great at that as well).

So my gues is we see first 'knife on the throat conditions', but if PIIGS and Co get into primary surplus the gane changes and countries most likley will be forced to leave by their voters.

@Cool river
Fully agree. The EU is simply helping the dodgy Greek (and other) elite to stay in power. And it is hardly helpful.
They need real change:
-you cannot have a welfarestate and nobody paying for it. It is one or the other.
-with economic basis eg technical and education level like an EM long term you will have an EM standard of living not a Western world one.
-having a 3rd world government unlikely give you longer term a Western style income, especially if you combine it with high taxes (except for the ruling elite).

Problem being this is not about Greece or its people. This is more about what is still acceptable at home up North, a EU-religion, saving French and German banks, being afraid for big (but necessary as you indicate) steps (and only looking as far as the next election).

So as they say:' Let the games begin', as this is simply a small step in a large process and definitely not an endstation. The situation remains as unstable and unsustainable as it was. Just waiting for the next shockevent and if that doesnot do the job the one after that.
December 9, 2012 | Unregistered CommenterRik

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