Germany beat Portugal in the group stages of the Euro football championship currently underway in Poland and Ukraine.  They beat Greece in the quarter final.  They may well face Italy in the semi-final and Spain in the final.  By the end then, Germany may have beaten all four representatives of the Mediterranean’s economic basket cases and won the cup.

In the euro-zone (EZ), Germany also appears to have the upper hand.  The question not really considered, however, is whether Germany will leave the EZ before any of the Medi-debtors.  Some sort of divorce now seems inevitable.  Divorce is messy and both partners may well end up poorer as a result but, sometimes, it is better for the long run.

Germany has gained competitiveness by being tied to its EZ partners: lower transaction costs to trade.  As an exporting country, it won’t want to throw that “access to markets” away lightly.  However, if those markets stay depressed for years and it has to pay unpredictable – in quantum and over time – subsidies to countries over which it has no political control, the net benefits of the EZ may well seem less.  How long will Germany be willing to pay higher taxes and use a debased currency with higher inflation than it could have on its own to support the social welfare schemes and uncompetitive practices of other nations?

The Euro-Meds have gained lower interest rates from being tied to Germany and, over time, this could/should have allowed them to invest in productive efficiency.  But, with different fiscal and regulatory structures and cultures, that potential benefit has been squandered and led to the current financial morass.

For Germany, with strong exporting companies and reasonably low unemployment, this is as good a time as any to go its own way – get a stronger currency that means cheaper imports, lower euro-debt maintenance, and enjoy overall lower inflation whilst not paying for others’ profligacy.

There are other factors, not least the interwoven banking effects and the political will to build a deeper European family.  But, the economics could see Germany walking away with the cup.

More money has been created to support the Spanish banking system.  The immediate market reaction is positive.  This action had become inevitable but. whilst the acute symptoms are addressed, the chronic illness is not.  A succession of sticking plasters is not enough to remove the underlying uncertainty.  We also need to root out the deeper infection of debt.  At some point, the debt write-offs and interventions have to go much further.

The debate between austerity and growth continues across the continent and more allusions to the 1930s are being made.  Ultimately, debt is paid by rising incomes and taxes.  Future incomes and taxes depend on economic growth.  Economic growth comes from a combination of advances in productivity and employment.  Both are driven by businesses and consumers having the confidence to invest and spend.  That fundamental confidence is lacking.  Austerity to salve the mood of the bond markets will not build enough confidence to restore growth.  Demand is now key and, when the private sector lacks the incentive to act independently, demand must start with the state.  Once the private sector responds, the state must get out of the way.

At time like this, then, political leaders make their historic reputations – for good or ill.  We may need more sticking plasters but most of all we need more aggressive intervention to clear the infection and staunch the wounds.  Do we have the statesmen and women we need in these desperate times?

The euro-zone crisis has erupted again.  As with all Greek tragedies, there are painful lessons for us all.

Once upon a time, in a distant land of heroes and villains, a King wanted his country’s football team to play in the top league.  Taking the advice of his bigger and wealthier neighbours (and local public and private advisers), he borrowed lots of money and encouraged his citizens to do the same to buy new players.  The King proudly asserted, “By boosting investment, being innovative, acquiring skills and improving infastructure, we will be more competitive at home and abroad.  We will raise productivity and employment and generate sustainable growth.  This approach will generate the wealth we need to pay back our loans and create a positive spiral of investment, wealth creation and higher living standards.  We can match the big teams by buying the best players, scoring more goals, winning the league and becoming more popular”

Everybody wanted to lend him money for what seemed a good plan.  The problem was his people didn’t have the culture to play as well as their rivals and his rivals were not going to sit back and just let him win the league.  In the end, too much spending leaked to agents (external suppliers) and there was too much speculative consumption.  Courtiers and others diverted funds into less than worthwhile schemes and the accumulated debt became a  burden when the team stopped winning (forward economic momentum was lost).  With income less than sufficient to service the debt, a negative spiral ensued.  Poor tactics and team work meant too many own goals and losses.  Backers got restless.

Each time the King had to buy more players (borrow more), he had to pay higher wages (interest rates) to do so.  With a growing primary deficit balance, interest charges above the underlying economic growth rate and adverse valuation effects, the debt dynamics saw a ballooning of obligations to creditors – over 150% of GDP.   Soon, the King’s problems became his neighbours’ problems too as his creditors realised they were holding dodgy IOUs unsupported by real scoring (earnings) potential.

The tragedy is that, when you aren’t winning (generating the income you need) and others are no longer willing to support your team (lifestyle), everybody loses: restructuring is the only way to repair your fortunes on the pitch (finances).  One approach is to sell your best players (assets) to reduce the debt to manageable proportions but that probably means losing even more games if you haven’t got some bright, home-grown talent.  (If you lose your job and can’t pay the mortgage, you have to sell up and downsize – anybody want to buy parts of a small Mediterranean country?  You can only do that if there is  positive equity i.e. you have assets to sell and your “fire sale” generates enough money to pair down the debt.)  Unfortunately, the likelihood is that you won’t get back what you paid for your best players in the first place.

If it looks really desperate, you might just hand back the keys and walk away – the going into administration or ‘dump the currency’ option.  This doesn’t relieve the pain much in the short term but may mean you can start again sooner with a different ground in a different league.

A third option is a full take-over by a new, rich owner … again, anybody want to buy a country.  The King is dead – long live the King.  European democracies are probably no longer in the business of directly taking each other over.

Anyway, the King resigns as team manager and moves what resources he has left to the mountains of central Europe – becoming a TV pundit on the game.  His compatriots fail to form a new united team (government).  The majority of citizens are too fed up with the never ending austerity that has been imposed and vote to stay away from matches, reducing income further.

Meanwhile, the big teams (foreign powers) who should not have let them into the league in the first place, are now suffering too.  They insist, “we want you to stay in our league because, if you don’t, others might also fail and our business model (euro-zone) might collapse completely.  If our lenders lose more money with you, we will have to cut back on credit at home and the whole franchise might shrink.”

To stay in the game, however, the King’s old country needs a re-distribution of funding or talent or both.  They have to be allowed to compete and win some games.   This means a full fiscal and monetary union based on mutual self-interest.  You  can not have one team winning the league every year (Germany).  The talent and rewards has to move around through transfers of funding and investment (rebalancing of trade and public sector deficits and surpluses) .

In the near term, throwing good money after bad is never popular amongst the creditors – teams that are used to competing and not co-operating.  The risk is that the downward path to relegation continues.  The only question is whether the team goes by choice or is thrown out and, then, whether new owners can raise a phoenix from the ashes.  Bottom line – the supply chain is only as strong as its weakest link.  Break the chain or play the game -we are already in extra time and the penalties are coming thick and fast.

Early May is an election period in many European countries.  In the last few days, for example,we’ve had sub-national elections in the UK, presidential elections in France and parliamentary elections in Greece.  Whilst they have been very different in context and campaign, there have been some common themes – not least a reaction against the economic policies of austerity that are currently prevalent across Europe.  The markets may react badly to a populist shift in the short term but that just shows the narrow thinking of the model-driven financial investor…

On the one hand, the large state deficits that ballooned in the late “noughties” are clearly unsustainable for the long run.  As the supporters of austerity say “excess deficits got us into this mess, it can’t be good to add to state debts through deficit spending to get us out of it and, anyway, who is going to lend to us?  The whole point is that the flow of credit has been turned off for profligate borrowers”

On the other hand, the ‘austerity is self-defeating school’ says “you can’t grow and reduce unemployment by suppressing demand.  At a time when consumers are not spending, businesses are not investing and European trade is falling, if the government cuts back too, a downward spiral ensues.”  The recent elections show that many voters recognise and react to this downward spiral, with living standards in decline across Europe.

As is often the case, the two hands are both right.  So, let’s put them together.  First, we recognise that there has to be a period of adjustment in living standards from relative excess to relative frugality.  The question is how far should it go and for how long? The political question is also who bears the pain?  The elections suggest many people don’t think the distribution of the burden has been fair.  Second, there has to be an investment injection to trigger growth.  What better time than now, with low interest rates, untapped, unused liquidity in the private sector and spare labour to do all those productivity enhancing schemes that raise efficiency and growth potential for the long term.  Investors don’t want to lend for current spending on unemployment benefits that add little or nothing to growth potential but they will lend for real investments in infrastructure, capacity and innovation that offer the prospect of growth-driven returns in due course

Come on leaders in business and government. “Invest for tomorrow” and the growth will return.  Wait for the consumer and, at this point, you wait forever.  Bring back development.

George Osborne, the UK Chancellor of the Exchequer, partly justified a near US$15bn increase in UK contributions by asserting that no one ever lost money on loans to the IMF.  This belief rests on two things:  1) that IMF loans come with conditions that help to restore the borrower to growth, enabling repayment with interest and 2) that borrowers have to repay the IMF before they have any hope of accessing funds elsewhere.  The first may be more difficult when so many more, and economically larger, countries are potential borrowers and the second may be more vulnerable as the ‘western’ consensus of economic and political stability comes under pressure.

In essence, an IMF loan requires an acceptance on the part of the borrower that it will comply with austerity policy measures, that those measures turn the economy around, and that other creditors are willing to stand in a longer queue for repayment.  As the world goes through significant power shifts and faces the risk of potential bail outs for some major economies, the pressures on the IMF system will not get any easier, even as its potential rescue pot” grows”.  Acting as lender of last resort only works if the borrower recovers.  In response to prolonged austerity, the risk of political unrest and regime change leading to default to the IMF may seem low, but it is not zero.  No one may have yet lost money lending to the IMF but that does not necessarily mean no one ever will.

This week, 25 EU countries signed a new budget treaty, tying themselves to stricter rules on co-ordinated fiscal management.  German folk memories of inflation in the 1920s and 1930s are driving the policy makers of Europe, despite the dire impact uniform austerity may be having on many, especially the further you get from Frankfurt.

Meanwhile, the Federal Reserve Chairman signalled to Congress an end to plans for further quantitative easing (QE3) as the US recovery shows signs of life.  US memories of the Great Depression have dominated across the pond, with lots of monetary and fiscal accommodation, perhaps storing up inflation problems for later.

The policy and analytical dilemma between the Keynesian (when you are in a hole, stop making it bigger) and the Hayekian (don’t repeat what opened the hole in the first place) views goes on in the textbooks, the lecture halls, the central banks and the chancellories.

• For the former, the cure of severe austerity is worse than the disease: the resulting waste of resources, over a period of years, can not achieve positive rebalancing when all patients are on the same treatment.  Starving an economy of growth means a permanent lowering of economic well-being.
• For the latter, the economy has become a debt-addict and that addiction has to be reversed before it can achieve a sustainable recovery: fundamental resource re-allocation now (cold turkey) is a painful but a necessary step to generating efficiency and effectiveness for the mediuim term.  Keeping the economy’s temperature down (low inflation) is a prerequisite of stopping re-infection and generating a stable recovery.

These dilemmas are often with us when the economy is poorly.   The answer, in the end, is a pragmatic one: what’s needed here most, right now.  In Europe, the patient is very weak – already back in recession?  In America, the patient is out of intensive care – already heating up?.  Whatever theory they prefer, let’s hope the EU policy doctors focus more on stimulating recovery whilst the US doctors start to plan for inflation, reversing their current stances in the period ahead.

For nice reasons, I have been away from the site for a short period.  In that time, I have received many positive responses to my blogs – for which, many thanks.  It’s great to know people are finding my comments useful and interesting.  I will get round to replying individually where necessarily, in due course.

Meanwhile, recent experiences have reminded me very strongly of one proverb that sits well with the modern economics situation – don’t put all your eggs in one basket.  I will use a pastoralist economy to develop my theme.

Pastoralism depends on the availability of pasture to sustain your animals at all times.  This may imply nomadic wandering with the seasons/rainfall pattern or some other system of rotational land tenure which tends to treat the inputs (grass) as a free, though degradable, resource for all.  The problem is ‘free goods’ tend to be over-exploited and are vulnerable to shocks – adverse weather, excess population, over use of land, and/or some sort of new land access restriction (ownership/division/politics) that interferes with the established nomadic process.

In this economy, animals are wealth – an asset that retains value (as long as it retains quality).  They are a form of money: a store of value (I have 5 cows in the ‘bank’), a unit of account (my labour is worth 2 cows per annum – your corn is worth 0.25 of a cow) and a medium of exchange (I will trade you one cow for your help in building my home).

But, animals are also capital stock – they are a tool that can be used to generate future income from production over different time periods.   In normal times and any market, capital depreciates and needs to be replaced.  If a living animal is your capital, that means reproduction of new capital, which is equivalent to “saving” and “investment” for the future (saving “for a dry day”).  A bad drought affects the ability to maintain capital and owners are doubly vulnerable if the capital has been used as security for a loan.  Usually, you don’t sacrifice your capital unless you are really desperate.  Hence, pastoralists tend to hold on to livestock as long as possible.  But, this may ultimately prove futile: when a line of business stops generating useful surpluses, capital can itself become worthless.

Finally, the animals are also a flow of current income – they generate milk, meat etc and can be sold for money or bartered for other products.  So, through the health of the animals, drought-led loss of pasture not only degrades capital but it also degrades income: the whole economic chain collapses.

When the ‘business’ is losing capital and income, it is important to act early to avoid the point of no return: insolvency and famine.  So, in theory, liquidate your capital at the optimal time and re-invest the proceeds in alternative income generating capital – which can include human capital.  The problem with pastoralists is that their skill base is specialised in one area and it is not easy to switch (if only for cultural reasons) when shocks occur.  They need help to create different “baskets” of skills where wealth, capital and income are not all the same thing!

To make matters worse, the pastoralists are all in the same line of business: when one fails, they all fail because they are reliant on one income stream, one form of capital and one form of wealth.  The best insurance for their community is to have other skills and income streams to fall back on.  Even as they maintain pastoralism, some of them have to do other things to create alternative value: in good times, diversify and co-operate for the bad times.

Individual specialism is a good thing in most parts of the economy because it allows greater productivity and exchange which tends to raise living standards over time.  But, it requires two things – that your specialism is valued – (there is a market to sell into) and your specialism is sustainable.  So, we can have specialist doctors because we all value their work and are willing to pay for them (in cash or taxes) and it is sustainable because illness is endemic.  However, even here, the specialism in demand can change – a cancer that used to be treated by surgery may now be treated by drugs = fewer surgeons and more medics.

The trouble for pastoralists is the value of their activity is largely for themselves (with little external trade) and it’s not sustainable if adverse climate and/or over-exploitation of the basic resource occurs.  A sound economy cannot mean that we all specialise in the same thing.  It needs a mix of activities.  Subsistence economies are always vulnerable but a modern economy can be just as vulnerable if its foundations of assets and incomes are concentrated – ask the Greeks what happens when a financial ‘drought’ hits.

No matter how complex/inter-linked the global economy looks, there are still areas of over-dependence, over-specialisation and over-concentration in products, services or markets.  Don’t put all your eggs in one basket is as true for bankers as it is for pastoralists.

Amidst all the European gloom of sovereign downgrades, fears of default and questions about currency zones, the American economy is beginning to show some signs of life.  Whilst UK and Euro-zone consumers are under pressure, through concerns about job losses and falling real incomes, a range of numbers turned positively across the Atlantic towards the end of 2011.

First, consumer spending is increasing: retail sales were up 6.5% and auto sales were 8.4% higher year-on-year.  Second, the housing market is moving again: starts +24.9%, new home sales +9.8% and existing sales +3.6%.  Third, real industrial production grew by 3.7%, with durables +9.1%, and the survey balances healthy at 53.9 for the ISM and 62.5 for the Chicago PMI.  Fourth, the labour market had payrolls stronger (+212,000), the unemployment rate down to 8.5% and new claimants 15.2% lower.  This paints a picture of an economy reflecting a monetary stimulus with ‘normal’ cyclical responsiveness.  Moreover, with corporate earnings showing some positive growth, the US stock markets have started the year in a positive mood.

Risks remain for the United States but, if US growth reaches the 3.0-3.5% annual rates that some forecasters predict for 2012, it offers some light for the rest of us.  Europe cannot expect US growth to bail it out of its malaise.  We still need decisive and proactive action to get the economies of Europe moving again.  Nonetheless, an America comeback has got to be good news.

PM Cameron appears to have opted Britain out of any role in determining the details of the new Euro-Zone inter-governmental treaty, effectively a fiscal union to support monetary union, proposed by Germany and France.  It seems odd tactics to exclude yourself from the discussions when you can always say “no” later … but, hey, I’m no politician.

More significantly, of course, none of this euro-zone treaty stuff deals with the short term problem of credit rating downgrades, bond yield increases, risks of sovereign default and negative contagion through the whole European/global banking system.  Come on ECB/IMF, get a grip, before we slide over the edge.

At its heart, this is a balance of payments problem writ’ large.  That can only be adjusted by some combination of debt write-offs and currency adjustments and lower living standards that restores competitiveness in the deficit countries and removes structural payments imbalances.  We can inflate our way with some growth or deflate our way out with austerity… I know what I’d prefer…