A Central Banker Utters The Truth

On July 1, the Republic of Cyprus, a tiny country on a divided Mediterranean island, will rotate into the Presidency of the Council of the European Union—one of those bitter European ironies because Cyprus will likely have to be bailed out, according to Central Bank governor Panicos Demetriades. It adopted the euro in 2008 and is already in a heap of trouble. Last year’s loan from Russia has kept it afloat, but now it’s bailout and haircut time.

And reality is now even staining the Teflon economy of Germany with a daily litany of suddenly awful data points:

New vehicle registrations, which had been holding up well, fell in May by 4.8% compared to prior year. Commercial vehicles spiraled down by 13%, and heavy trucks crashed by 32%.

The KfW business climate index for small and medium size companies dropped by 5.7 points, to 12.9, three times the normal monthly variation; for large firms, it dropped 5.8 points, to 12.3. In its explanatory statement, the KfW banking group, a government-owned development bank, used the terms “recession fear” and “panic attack.” A “clear warning that has to be taken very seriously” where “the risk of a downward spiral … rose enormously.”

April industrial orders dropped 1.9%, the worst decline in six months—with export orders down 2.6%. The wobbly economies in Europe and elsewhere are finally catching up with the export powerhouse.

And Spain is begging desperately for a massive bailout of its banks, after claiming for years that they wouldn’t need one. But it doesn’t have the money, and “the door of the markets isn’t open to Spain,” explained Budget Minister Cristobal Montoro. So taxpayers in other countries should fork over the money, via the EFSF bailout fund, and pay it directly to the banks. Which is against the rules. Germany, insisting that rules be adhered to, opposes that scheme whose purpose it is to bail out Spain via its banks to avoid otherwise obligatory structural reforms. With these issues mucking up the predictions of growth in the US, CNBC’s pundit called on the US to bail out Europe.

What a relief then to hear a voice of reason. Even if it’s from a central banker, Jörg Asmussen, Member of the Executive Board of the ECB and a German politician in the opposition SPD. In articulating hard truths and an uplifting message, he followed in the footsteps of Jens Weidmann, President of the German Bundesbank and Member of the ECB Council who’d given an awesome interview in the lion’s den.

Asmussen was speaking in Riga about Latvia’s problems, its astonishing rise from the ashes, and its lessons for the Eurozone. In 2008, Latvia’s debt-fueled economy collapsed with a cumulative GDP decline of 24%, the worst in the world. Its currency peg to the euro came under sharp criticism. Pundits pressured it to devalue. Paul Krugman called it “the new Argentina.” But instead of going for the “quick fix,” Asmussen said, Latvia implemented tough “fiscal consolidation and structural reforms.” In 2009 alone, it cut its budget by 9%—far beyond any EU country. Harshest austerity, instead of spending and borrowing its way out of trouble. In the middle of a gigantic crisis!

Against everything Krugman holds so dear, the economy stabilized in 2010, and in 2011, GDP jumped 5.5%, the fastest in the EU. Cut off from the financial markets, Latvia had received emergency loans from the IMF and the EU, but its stunning fiscal and economic performance allowed it to return to the financial markets far faster than projected. Its competitiveness improved. And its currency peg to the euro remained intact.

Despite unmitigated austerity, the Prime Minister was reelected twice, while all those in the Eurozone who tried to reform anything at all were kicked out of office. Latvia had accomplished in the shortest time an “internal devaluation” rather than choosing an “external devaluation” via its currency.

“Speed is of the essence,” Asmussen said. The government attacked the deteriorating public finances, got the people to take ownership of the reforms, and “frontloaded” the toughest measures, rather than dragging things out and implementing half-measures. And it got them passed before “adjustment fatigue” wore people down.

“The bottom line is this: when adjustment is inevitable, it is better to take the medicine right away than to let the fever rise for months,” Asmussen said. Latvia demonstrated that an “expansionary contraction” isn’t an oxymoron. “Even if fiscal consolidation weighs on the growth prospects in the short term, it has sizeable positive effects in the medium to long term.”

Austerity alone wouldn’t have been enough. The government also implemented “growth-enhancing structural reforms” to foster a policy environment favorable to “growth and wealth creation.” A bit tricky in face of vested interests. But critical mass overpowered them. “Education, health care, central administration: hardly any public sector category was spared by the reforms,” he said. People weren’t left to twist in the wind. Social safety measures were put in place, which helped gain support for the measures. So what made all this possible? A “broad consensus in society,” he said, “the key difference” between Latvia and Greece.

Latvia is scheduled to adopt the euro on January 1, 2014, despite the mayhem in the Eurozone. For the former member of the USSR, the euro has a “geostrategic dimension, namely completing their firm anchoring in a Union based on freedom, democracy and human rights.”

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