The European Situation

I thought I would make a brief return again, as I have been watching the slide of Europe into a morass with that feeling of watching a slow motion car crash. I am writing this as a very general post, without referring to the specifics of individual countries, but highlighting the principles of why the European financial crisis just will not go away. There are differences in detail and circumstance, but I think that the general principles will hold. As a light introduction, I just saw an amusing Youtube clip, which seems (in a simlistic but effective way) to sum up the madness that is facing the EU.




Since the alarm bells about the debt of Greece, Ireland, Italy, Portugal and Spain were first rung, there have been a series of deals, bailouts, negotiations, austerity measures, and on and on...but still the crisis pops back into life. The problem is something I have long discussed, which is that you cannot easily reverse the direction of an economy. In all of the above cases, the economies were living on too much borrowed money, and that borrowed money shaped the structure of the economies. The direction of that money was into consumption, and the consumption beyond the actual income was unsustainable. However, a county that has lived on borrowed money has developed an economic structure to support the consumption of the wealth creation of other countries.

In simplistic terms, this translates into the means of importing and distributing goods and services paid for by the wealth creation of other countries. In practical terms this means the over-development of retail, the restaurant and entertainment sectors, the government services, and all of the infrastructure that supports these. In a madly self-destructive cycle, the more the country borrowed, the more the activity in the economy, the higher the employment and the higher the reports of GDP, and the greater the confidence of lenders to keep on lending. The problem with the cycle is that it keeps feeding on itself right up to the point that it does not. It does not even matter what finally triggers the loss of confidence by creditors, as at some point there must be a moment of realisation of the inherent unsustainability of the cycle.

The problem with the policy actions of all of the parties seeking to save Europe from the crisis is that, once the cycle breaks, the real underlying economy emerges. As the flood of borrowed money diminishes, all of the activities that were supported by borrowed money go into reverse, unemployment rises, GDP sinks, and government revenues fall. The debt to GDP ratio starts spiralling, and fresh borrowing comes at an ever greater cost as the weakness of the economy becomes apparent. The ability to service existing debt dimimishes, and the crisis emerges once again in full force, as the downward spiral continues. Even as bailouts are calculated and handed over, the ability for the country in question to support the existing debt (let alone the new debt) is diminishing. The bailouts are chasing a downwards moving target.

In the end, the only answer is austerity. Somehow, it is necessary for consumption within a crisis country to come back into balance with the wealth creating capacity of the country. The problem is that, the deeper and longer the debt accumulation, the more the structure of the economy will have been distorted towards the consumption of debt. The real income per capita, without the addition of debt into the economy, is much, much lower than people had come to believe. It is as if the entire country has been spending their salary X, but were unkowingly supplementing their income with a slowly rising credit card debt of Y.

When the credit stops flowing into the country, and the supplement of the borrowing disappears, it is apparent what the actual income is. It is far lower than everyone thought. As it is, there are large numbers of people who are actually supplementing their income with debt, but they were unaware of how much additional debt they were personally liable for when their government borrowed. They were also unaware of how much of the whole economy was reliant on the continual debt accumulation, and can not understand why their job has evaporated. And that of their neighbour. And their brother. It is no surprise that they feel angy. They just did not realise that the promises made by their governments were not built upon sound foundations, and that the shiny new businesses making so much money were reliant upon borrowing for their survival. That is, the aggregate borrowing over the whole economy was supporting so many businesses, so much employment.

It is quite understandable that people were deceived. When all around you, you see the signs of growing wealth, it seems only natural that it must be built upon real wealth creation. It is the great illusion that debt equals wealth. The reality is that debt for consumption equals a higher quality of life, right up to the point that the debt becomes due. Then, as has always been the case, ruin follows. What we are watching in the ongoing European crisis is the slow and painful emergence of the real size of the economies in question. The problem is that, when looking at many of the non-crisis economies, they also look to be troublingly reliant upon debt.