The European Financial Crisis revisited: the Germanification of Southern Europe.

It has been an interesting few months in Europe. The Greeks have just had their first round of parliamentary elections and need at least another round before a government can be formed. The French have just elected a new president on an anti-austerity platform, making it a clean sweep around Europe: in every country populations have punished their government for the recession following the GFC. Meanwhile the Germans are being their obstinate selves, clinging to a fiscal treaty no-one else has any intention of sticking to.

The main mistake being made by European politicians, and in particular the German ones, has been to prevent countries going bankrupt that have no hope of balancing their books without radical reforms. The temporary bailouts allow those countries to avoid truly reforming, completely paralysing those countries and exasperating underlying problems (As the ECB bank-president said just yesterday!).

The mistake of getting involved in bailouts was made early on, but reached its crescendo with the 130 billion euro gift to Greece in March 2012. It was an act of gross folly but there simply was no mechanism at the time to avoid agreeing to the bailout; the Greek politicians were signing every insane promise asked of them and Germany ran out of excuses not to agree to the bailout. That generosity helped the Greek politicians to keep buying off their domestic supporters but is proving the old adage that there is little people resent more than charity, and it will in the medium run achieve the opposite to the financial stability some hoped to gain from it.

To start with the ingratitude, Germany is now depicted once again as the evil man of Europe in popular media in Greece, Ireland, Spain, and Portugal. Rioting protesters in Athens burned German flags and newspapers carried pictures of Angela Merkel wearing  a Nazi uniform. Cartoons in Greek newspapers depicted Merkel and the Finance Minister Schaeuble as running concentration camps for Greeks.

This despite the fact that the Germans not just directly sent huge amounts of money to the governments of these countries, but even allowed the European Central Bank to send more money to their troubled banks in the order of a trillion euros in total, which in effect is printed money and thus a form of tax on the whole of Europe. These populations should be thanking the Germans on their bare knees, but the reality is the opposite. Why and where is this going to?

For one, opportunistic politicians in all these countries have caught onto the trick of blaming the Germans and other European countries for the problems of their own making. They make ludicrous public demands for the rest of Europe to bail them out, or even blame them for the housing booms that preceded and worsened the financial crisis. And populations, with their exceptionally limited understanding of how financial matters go, lap it up and increasingly vote for anti-European political parties.

So far, German politicians seem to be oblivious of the damage that their generosity is doing. Instead of realising that they are setting themselves up for trouble, they insist other countries abide by Stability Pacts and austerity measures. They send financial experts to come and check the books, of course finding one discrepancy after the other. This makes it simpler for politicians elsewhere to pretend that the Germans are to blame for their problems and thus allows them to shirk their own responsibility.

A good example of irresponsible posturing in France is all the talk of using the European Structural Funds to give the European economy a boost. It sounds reasonable to call for the freeing up of money that is being idle, but a quick look at what these funds actually do and their size is sobering. For one, there are few funds in the world which do more useless and corruption-inviting projects than the ESF (see here for a nice discussion): lots of tunnels and roads that have only sheep as regular users. The idea that building some more concrete goat tracks will save France is fanciful, to say the least. More importantly, there is just not all that much money being idle in these funds. The European Social fund has no more than about 15 billion to spend per year and the European Regional Development Funds have a budget of about 35 billion a year. You thus need 3 years of their total just to cover the Greek deficit for 2012 and it’s not even a whole percent of European GDP. Add to that the dry realisation that the money ultimately of course comes from tax-payers and it should be clear that the call from some Southern European politicians and economists to raid these funds in a Keynesian gesture is a rent-seeking distraction from the main game.

Why do national politicians not get much more serious about internal reforms and instead blame others for their problems? Because it would cost them the next election and probably the one after that. It is in this regard handy to remind ourselves that the Germans themselves punished the last German leader who instigated serious reforms (the Hartz reforms, politically pushed through by Schroeder). It costs the German social democratic party ten years of being out of power, a clear deterrent for any other politician in Europe to be serious about reform.  So the governments of the countries in trouble don’t reform. Even a technocratic government, like that led by Mario Monti in Italy, has found it too hard to push the unpopular reforms necessary and has instead opted for symbolic tinkering, like handing out 500 taxi permits or allowing shops to open on Sundays. As if 500 taxis are going to make much of a dent on the millions out of work!

Which brings us to the nub of why the financial crisis will not go away in Europe: because there is no serious reform in Southern Europe, growth there will remain negative and non-existent for quite a while. That in turn appears to be leading its smart young people to go to the North of Europe or emigrate outside of Europe. So the future hope and tax-base of these countries is being eroded as we speak which further aggravates the paralysis inside these countries and strengthens the interest groups that prevent real reforms. Only in the North of Europe are real reforms on the table, such as the UK where real banking reform and health service reform is being instigated.

I have in the past prophesised that the ECB would bail out the weaker countries in return for a weak financial stability pact. That political deal has indeed been made and is being implemented, complete with the immediate realisation amongst the big players that the stability pact is not worth the paper it is written on. However, the ECB bailout cannot solve the underlying problems of a Southern Europe that is in political and economic paralysis, with politicians who cannot afford to instigate real reforms and are instead merely posturing. As a result, the countries will keep coming back for bailouts from either the Northern European governments or from the ECB. Only very slowly are the leaders in Northern Europe starting to wizen up to the fact that their generosity will not keep the place together but will tear the European Union apart.

Hence the European financial crisis is on hold until several countries are allowed to go bankrupt: Greece, Ireland, Portugal, and maybe even Spain and Italy. Once these countries go bankrupt there will be a much greater internal political will to push through real reforms, simply because the governments won’t have the means to pay off the interest groups and will thus have to offend most of them anyway. And those who fear some kind of fascist resurgence or extremely xenophobic nationalism to arise in these countries are mistaken: these are relatively small countries kept afloat by international trade and wealthy foreigners who can leave in a heartbeat, so there is basically no-one rich and foreign they can lay their hands on and threaten. Yes, nationalism will rise as populations try to regain some sense of self-worth, but the only hope for these countries is to remain integrated in the European and world economy and that reality limits the degree of fascism and xenophobia these countries can slide into.

Who will lose out in the end? It will be the politically weak inside the Southern European countries, including pensioners, welfare recipients, minorities, migrants, the unhealthy, and the unskilled. And who will be amongst the surprise winners? The Northern Europeans because they will be the beneficiaries of a large brain gain from the South and it will be their companies that are best poised to take advantage of the eventual resurrection of the Southern European economies.

As to the long-run, the Portuguese, Spanish, Greek, and Italian scholars I talk to all agree: the way out for their countrymen is to become German, either by moving to Germany or by adopting similar institutions and policies inside their own countries. But current institutions and attitudes cannot change so quickly. It is a fascinating question of societal transformation whether the road of least resistance actually does indeed lead to a slow Germanification of Southern Europe or whether it leads somewhere else. I am inclined to trust greed and ambition and thus would put my money on slow Germanification.