Cyprus Bailout Shows Why Paul Krugman is Wrong About Europe


Two articles in the New York Times speak to the foolhardiness of unregulated Keynesian stimulus programs for the Economic Union. The nations that are requesting bailout money (there are now five) are experiencing varying degrees of systemic problems. Before money for infrastructure projects is allocated to EU members, plans to rectify systemic issues must be in place. 

The first article indicates that Spain and Cyprus are seeking rescue money for their banks. Stock markets in Europe plunged and the euro dropped on this news, as investors are growing pessimistic about long-term gains emanating from the impending Euro Summit. Changing levels of expectations are one of the primary causes of volatility in the financial markets around the world. 

In Spain, banks have been hard hit by real estate loan defaults. The country is seeking another 100 billion plus euro bailout for its banks. Even the method of disbursement has become an issue. Spain wants assistance to flow directly to its banks, and not through the government, to avoid increasing Spain’s sovereign debt total. This is an obvious ploy that will not fool investors, as Spain will still be responsible for the loans. 

The intention of the EU is to establish a banking union, which would need the financial backing of Germany. It would be responsible for winding down failing banks and guarantee deposits across the continent. The latter would be an attempt to stem the movement of deposits from weak countries to stronger ones, a situation that has further sapped the strength of some European banks. None of this will ever come to pass unless a supervisory group with real clout is formed, this being an important issue for the Germans. 

As an aside, the Spanish government will be going to market to raise 3 billion euros today. The rating agencies cut Spain’s debt rating down to near “junk” status (BBB3 by Moody's Investor Service) along with the ratings of 28 of its banks. This will make the transaction difficult and also increase the borrowing rate. Relating to the banks, they are heavily exposed to the sovereign debt of Spain further fueling the situation. 

Cyprus has also requested a bailout in an effort to recapitalize its banks. The crisis in Greece has had a direct impact on Cyprus banks, which have a huge exposure to the Greek economy. The country is seeking 10 billion euros of support. In total, Cyprus has total loans of 152 billion euros, or eight times its gross national product. 

The second article relates to Italy. It is experiencing a recession, a shrinking economy, unemployment over 10 percent and poor prospects for the foreseeable future. The Italian government hopes to spur growth by changing some aspects of its labor arrangements. 

Currently, labor laws are very restrictive and costly. The proposed changes are meant to rebalance the labor market for the benefit of new workers at the expense of old workers. The package provides incentives for employers to hire new workers and to make it possible to fire employees, even for economic reasons. Most experts think the labor initiatives are inadequate. 

The point to be made is that calls for economic stimulus from people like Paul Krugman are not appropriate for the EU until systemic problems are addressed. These problems relate to the sheer amount of debt of the EU members, bank issues, unsustainable labor arrangements among other things. Moreover, support from Germany is critical, and it will not be forthcoming without monetary, fiscal and political reform. Austerity plans must be in place before any large stimulus is provided.