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<nettime> Michael Pettis: Syriza and the French Indemnity of 1871-73
nettime's_deep_diver on Mon, 9 Feb 2015 04:43:01 +0100 (CET)

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<nettime> Michael Pettis: Syriza and the French Indemnity of 1871-73


Michael Pettis: Syriza and the French Indemnity of 1871-73

Posted on February 7, 2015 by Yves Smith

Yves here. Get a cup of coffee. This is a fabulous, readable but
nevertheless carefully argued and therefore long post on the drivers of
the Eurzone crisis and what the parameters for a sensible resolutions
are. Or you can read an FT Alphaville post (hat tip Jeffrey C)
that hits some of the high points from this insightful article and adds
some data and news tidbits.

By Michael Pettis, a Senior Associate at the Carnegie Endowment for
International Peace and a finance professor at Peking University's
Guanghua School of Management. Cross posted from China Financial

European nationalists have successfully convinced us, against all
logic, that the European crisis is a conflict among nations, and not
among economic sectors. Today's Financial Times has an article
discussing the travails of Greece's new Finance Minister, Yanis
Varoufakis as he takes on Germany:

In a small but telling sign of the frosty relations between Berlin
and the new Greek government, the German finance ministry last week
criticised Mr Varoufakis for failing to follow through with a
customary courtesy call following his appointment. Mr Schäuble,
meanwhile, has warned Greece not to attempt to "blackmail" Berlin
with demands for debt relief.

This is absurd. The European debt crisis is not a conflict among
nations. All economic systems-- and certainly an entity as large and
diverse as Europe-- generate volatility whose balance sheet impacts are
mediated through different political and economic institutions, among
which usually are domestic monetary policy and the currency regime.
With the creation of the euro as the common currency among a group of
European countries, monetary policy and the currency regime could no
longer play their traditional roles in absorbing economic volatility.
As a result, for much of the euro's first decade, a series of deep
imbalances developed among various sectors of the European economy.
Because Europe's existing economic and political institutions had
largely evolved around the national sovereignty of individual
countries, and also because the inflation and monetary histories of
individual countries varied tremendously before the creation of the
euro, it was probably almost inevitable that these imbalances would
manifest themselves in the form of trade and capital flow imbalances
between countries.(1)

We have a great deal of experience in modern history with the kinds of
imbalances from which Europe suffered and continues to suffer, and from
the historical precedents three things are clear. First, the imbalances
that led eventually to the current crisis had their roots in
hidden transfers between different economic sectors within Europe,
and not between countries. It is only because of deep institutional
differences among the member countries that these imbalances manifested
themselves largely in the form of trade imbalances between the
different countries in Europe. These hidden transfers artificially
forced up the savings rates in some countries and, for reasons that I
have discussed elsewhere, it is a matter of necessity, well
understood in economics (although too often forgotten by economists),
that artificially high savings rates in one part of an economic system
must result in higher productive or non-productive investment (in
advanced countries usually the latter) or artificially low savings in
another part of that system.

Second, deep distortions in savings and investment historically have
almost always led to an unsustainable increase in debt, and Europe was
no exception. For many years European debt has risen faster than
European debt-servicing capacity, but the gap between the two has not
been recognized and written down, and instead manifests itself in the
form of excessively high and rising debt burdens whose costs have
eventually to be assigned.

Third, and most worryingly, it has always been easy for extremists and
nationalists to exploit the grievances of the various economic groups
to distort the meaning of the crisis. One way is to transform it into a
class conflict and another way is to transform it into a conflict among
member states. Resolving a debt crisis involves nothing more than
assigning the losses. In the current crisis these costs have to be
assigned to different economic sectors within Europe, but to the extent
that the assignation of costs can be characterized as exercises in
national cost allocation, it is easy to turn an economic conflict into
a national conflict.

Most currency and sovereign debt crises in modern history ultimately
represent a conflict over how the costs are to be assigned among two
different groups. On the one hand are creditors, owners of real estate
and other assets, and the businesses who benefit from the existing
currency distortions. One the other hand are workers who pay in the
form of low wages and unemployment and, eventually, middle class
household savers and taxpayers who pay in the form of a gradual erosion
of their income or of the value of their savings. Historically during
currency and sovereign debt crises political parties have come to
represent one or the other of these groups, and whether they are of the
left or the right, they are able to capture the allegiance of these

Except for Greece, in Europe the main political parties on both sides
of the political spectrum have until now chosen to maintain the value
of the currency and protect the interests of the creditors. It has been
the extremist parties, either on the right or the left, who have
attacked the currency union and the interests of the creditors. In many
cases these parties are extreme nationalists and oppose the existence
of the European Union. If they succeed in taking control of the debate,
the European experiment will almost certainly collapse, and it will
take decades, if ever, for a European union to revive.

But while distortions in the savings rate are at the root of the
European crisis, many if not most analysts have failed to understand
why. Until now, an awful lot of Europeans have understood the crisis
primarily in terms of differences in national character, economic
virtue, and as a moral struggle between prudence and irresponsibility.
This interpretation is intuitively appealing but it is almost wholly
incorrect, and because the cost of saving Europe is debt forgiveness,
and Europe must decide if this is a cost worth paying (I think it is),
to the extent that the European crisis is seen as a struggle between
the prudent countries and the irresponsible countries, it is extremely
unlikely that Europeans will be willing to pay the cost. As my regular
readers know, I generally refer to the two different groups of creditor
and debtor countries as "Germany" and "Spain", the former for obvious
reasons and the latter because I was born and grew up there, and it is
the country I know best. I will continue to do so in this blog entry.

It is a horrible irony that while the view that the European crisis is
a conflict between prudent Germany and irresponsible Spain could easily
tear apart the European experiment, it terribly muddles Europe's actual
experience and may create a false impression of irresponsibility. To
see why, it is useful to start with a little history. Nearly 150 years
ago Spain's "Glorious Revolution" of 1868 saw the deposition of
Isabella II and the collapse of the first Spanish Republic. More
importantly for our purposes it also unleashed within continental
Europe a conflict over the succession to the Spanish throne which
ultimately, through a series of circuitous events, resulted in France's
declaration of war on Prussia in July 1870. This was widely seen in
France as a chance partially to even the score over Prussia's victory
during the Napoleonic wars, but in the end France's revanchist
fantasies were frustrated. By early 1871, the French army was roundly
defeated by Prussia, which during that time had unified the various
German states as the German Empire under the Prussian king.

There were at least two important results of France's military defeat.
Of minor importance for the purpose of my blog entry, but interesting
nonetheless for those obsessed with modernism and with France's late
19th Century cultural history, like me, the Franco-Prussian War will
always be remembered for its role in the subsequent creation and
collapse of the Paris Commune. This event left its mark on the thinking
of many cherished artists and intellectuals, from Manet and Rimbaud to
Proudhon and Haussman.

But the other, to me, very interesting and far more relevant
consequence was the French indemnity. As part of the privilege of
conquest and as a condition for ending the occupation of much of
northern France, Berlin demanded war reparation payments originally
proposed at 1 billion gold francs but which eventually grew to an
astonishing 5 billion, at least in part because of an explicit decision
by Berlin to impose a high enough burden permanently to cripple any
possible French economic recovery.

To give a sense of the sheer size of this payment, usually referred to
in the literature as the French indemnity, this was equal to nearly 23%
of France's 1870 GDP.(2) Germany's economy at the time, according to
Angus Maddison, was only a little larger than that of France, so
Germany was the beneficiary of a transfer over three years equal to
around 20% of its annual GDP. This is an extraordinarily large
transfer. I believe the French indemnity was the largest reparations
payment in history -- German reparations after WWI were in principle
larger but I don't think Germany actually paid an amount close to this
size, and certainly not relative to its GDP.

Transfer Beneficiary

Astonishingly enough France was able to raise the money very quickly,
mostly in the form of two domestic bond issues in 1871 and 1872, which
were heavily over-subscribed. One of the most complete studies of the
French indemnity, I think, is a booklet by Arthur Monroe published
in 1919.(3) According to Monroe, the first issue of 2 billion in
perpetual rentes was issued in June 1871, a mere 48 days after the
treaty was signed, and was heavily oversubscribed. The second issue was
even more successful:

Thirteen months after announcing the first loan the government
opened subscriptions for a second, this time for three billions,
again in 5 per cent rentes, but issued at 842. The response to this
was astounding, for more than twelve times the amount desired was
subscribed, more than half of the offers coming from foreign

Monroe goes on to note that "it is no small compliment to the credit of
France at this time to note that about one-third of the foreign
subscriptions were from Germany," so when we think about the net
transfer to Germany, it was less than 5 billion francs. Although Monroe
says that more than half the subscriptions came from outside France,
and one-third of those were German, with twelve times oversubscription
there is no way for me to estimate how much was actually allocated to
German purchasers so I have no estimate for the amount by which the 5
billion should be adjusted.

The payments were made in the form of bills of exchange and to a lesser
extent gold, silver, and bank notes, and Berlin received the full
payment in 1873, two years before schedule. It was during this time
that Germany went fully onto the gold standard, and obviously enough
the massive indemnity made this not only possible but even easy. It
also guaranteed currency credibility almost from the start, and it may
jolt modern readers to know that at the time monetary credibility was
not assumed to be part of the German DNA, so the additional credibility
was welcome.

What does all of this have to do with Syriza? A few weeks ago I was
discussing with a group of my Peking University students Charles
Kindleberger's idea of a "displacement", and I proposed, as does
Kindleberger, that the 1871-73 French indemnity is an especially useful
example of a displacement from which we can learn a great deal about
how financial crises can be generated.(4) It then occurred to me that
the French reparations and their impact on Europe could also tell us a
great deal about the euro crisis and, more specifically, why by
distorting the savings rate wage policies in Germany in the first half
of the last decade would have led almost inexorably to the balance of
payments distortions that may eventually wreck the euro.

It is a nice accident that the French indemnity accelerated Germany's
adoption of the gold standard, because massive transfer payments from
Germany to peripheral Europe were probably necessary for many of these
countries to adopt the euro, in some ways their own version of the gold
standard. Before jumping into why I think the French indemnity is
relevant to the Greek crisis, I want to make three quick points:

1. I went into more detail on how France raised the money than might
at first seem necessary for the purpose of this blog entry because
it actually illustrates a potentially useful point. In the first
third of my 2001 book,(5) I discussed extensively the historical
role of global liquidity on the evolution of national balance sheets
and sovereign debt crises. One important point is to distinguish
between financial crises that occur within a globalization cycle and
those that end a globalization cycle. Whereas the latter are often
devastating and mark the end for many years of economic growth, the
former -- like the 1994 Tequila crisis or the 1997 Asian crisis, or
even the 1866 Overend Gurney crisis -- may seem overwhelming at
first, but markets always recover far more quickly than most
participants expect. When markets are very liquid, and in their
leveraging-up stage, they can absorb large debt obligations easily,
and because they can even turn these obligations into "money", they
almost seem to be self-financing.

The 1858-73 period was one such "globalization period", with typical
"globalization" characteristics: explosive growth in high-tech
communications and transportation (mainly railways), soaring
domestic stock and real estate markets, booming international trade,
and a surge in outflows of capital from the UK, France, the
Netherlands and other parts of Europe to the United States, Latin
America, the Far East, the Ottoman Empire, and other financial
"frontiers". I would argue that this is why, despite Berlin's
expectation that the indemnity would cripple the French economy, it
was surprisingly easy for France to raise the money and for its
economy to continue functioning. Germany, similarly, struggled over
many aspects of the WWI reparations, but after 1921-22, when global
markets began their decade-long globalization boom, driven by
extraordinarily high US savings (and characterized by the familiar
globalization sequence: electrification of American industry, the
spread of telephones, automobiles, radios, cinema, and other
communications and transportation technologies, booming
international trade and capital flows, the Florida real estate
mania, stock market booms, and, of course, the rise to fame of one
Charles Ponzi), Germany found it relatively easy to raise the money
that famously became part of the reparations recycling process --
until, of course, the 1930-31 global banking crisis, after which
Germany was forced into default. This may be relevant as we think
about any possible future European sovereign bond restructuring. Any
attempts to assess their impacts based on historical precedents must
distinguish between periods of ample liquidity and the radically
different periods of capital scarcity. Once the liquidity
contraction begins, every debt restructuring will be brutally
painful, unlike now when they are absorbed almost without a thought.

2. I explain in my book that the French indemnity actually increased
global liquidity by expanding the global supply of highly liquid
"money-like" assets. Of course Germany's money supply increased by
the amount of the transfer (not the full amount, because part of the
subscriptions actually came from Germany), but this was not offset
by an equal reduction in France's money supply. The creation of a
huge, highly liquid, and highly credible instrument, the two French
bond issues, involved the creation of "money" in the Mundellian
sense. While the transfer of money from France to Germany might have
seemed systemically neutral, in fact it resulted in a systemic
increase in global "money".

3. From an "asset-side" analysis, as I discuss in my January 21
blog entry, the transfer of capital over three years from
France to Germany equal to more than 20% of either country's annual
GDP would have had very predictable impacts -- they should have been
very negative for France, as Berlin expected, and very positive for
German. In fact the actual results were very different. This is
because there are monetary and economic conditions under which
liability structure matters much more, and conditions under which it
matters much less. Economists and the policymakers they advise are
too quick to ignore these differences, perhaps because there is not
as well-formulated an understanding of balance sheets in economics
theory as in finance theory, so that when someone like Yanis
Varoufakis proposes that there are ways in which partial debt
forgiveness increases overall economic value, instead of merely
creating moral hazard, worried economists often recoil in horror,
while finance or bankruptcy specialists (and an awful lot of hedge
fund managers) shrug their shoulders at such an obvious statement.

It is mainly the third of the above three points that is relevant for
the current discussion about European sovereign obligations. One might
at first think that France's indemnity, at nearly 23% of GDP over three
years, might have been devastating to the economy. It certainly left
France with a heavy debt burden, but its immediate economic impact was
not nearly as bad as might have been expected. Wikipedia's
assessment is pretty close to the consensus among historians:

It was generally assumed at the time that the indemnity would
cripple France for thirty or fifty years. However the Third Republic
that emerged after the war embarked on an ambitious programme of
reforms, introduced banks, built schools (reducing illiteracy),
improved roads, spreading railways into rural areas, encouraged
industry and promoted French national identity rather than regional
identities. France also reformed the army, adopting conscription.

Far more interesting to me is the impact of the indemnity on Germany.
>From 1871 to 1873 huge amounts of capital flowed from France to
Germany. The inflow of course drove the obverse current account
deficits for Germany, and Germany's manufacturing sector struggled
somewhat as an increasing share of rising domestic demand was supplied
by French, British and American manufacturers. But there was a lot more
to it than mild unpleasantness for the tradable goods sector. The
overall impact in Germany was very negative. In fact economists have
long argued that the German economy was badly affected by the indemnity
payment both because of its impact on the terms of trade, which
undermined German's manufacturing industry, and its role in setting off
the speculative stock market bubble of 1871-73, which among other
things unleashed an unproductive investment boom and a surge in debt.

Do Capital Inflows Cause Speculative Frenzies?

As money poured into German, its current account surplus of course
reversed into deficits, which by definition means that there was a
large and growing excess of investment over savings. Part of this was
caused by rising German consumption, but much of it was caused by
surging investment. Unlike in peripheral Europe 135 years later, the
capital inflows were not mediated through commercial banks into the
pockets of households, businesses, and local governments but rather
ended up wholly in the hands of Berlin. Germany in the 1870s had an
opportunity denied to peripheral Europe in the 2000s, in other words,
to control the use of the massive transfer. I will get back to this
point a little later.

As money poured into Germany the German economy boomed, along with
German consumption, investment (a growing share of which went into
projects at home and abroad that turned out in retrospect to be overly
optimistic), and into the Berlin and Viennese stock markets. By early
1873 more experienced German, Austrian and British bankers were quietly
warning each other of a speculative mania, and they were right. The
stock market frenzy culminated in the 1873 global stock market crisis,
which began in Vienna in May, shortly after the beginning of the 1873
World Fair, and rapidly spread throughout a world brimming with
liquidity (a large part of the first French indemnity payments went
directly to London to pay outstanding German obligations). By September
the crisis reached the United States with the collapse of Jay Cooke and
Company, one of the leading US private banks, and for the first
time in history the New York Stock Exchange was forced to close, for
ten days. The subsequent global "Long Depression", which lasted until
1896, was felt especially severely in Germany, one of whose first
reactions was the collapse of the railway empire of Bethel Henry
Strousberg, a major industrialist at the time whose prehistory included
a stint in jail for absconding from a previous job as financial agent
with other people's money (petty criminals who become industrial
magnates seem to be another characteristic of globalization periods).

Within a few years of the beginning of the crisis attitudes towards the
French indemnity had shifted dramatically, with economists and
politicians throughout Germany and the world blaming it for the
country's economic collapse. In fact so badly was Germany affected by
the indemnity inflows that it was widely believed at the time,
especially in France, that Berlin was seriously contemplating their
full return. The great beneficiary of French "largesse" turned out not
to have benefitted any more than Spain had benefitted from German
largesse 135 years later.

This is interesting. The German economy responded to French capital
inflows in almost the same way that several peripheral European
economies responded to large German capital inflows 135 years later. It
might seem an unfair comparison at first because the 1871-73 transfer
to Germany was huge, but it turns out that the magnitude of the French
transfer into Germany was broadly similar, in fact probably smaller, to
the inflows into peripheral Europe. By the way I should point out that
I use Spain to represent peripheral Europe not just, as I stated
earlier, because I was born and grew up there, and so know it well, but
also because Spanish government polices were in many ways among the
most "responsible" in Europe, and so cannot really be blamed for the
aftereffects. Spain's debt and its fiscal accounts were far stronger
than the European average and stronger than those of Germany in most

It is hard to imagine that the amount of inflows into Germany from 1871
to 1873 could have been comparable to the inflows Spain experienced,
but if anything they were actually smaller. Here is why I think they
were. From 2000-04 Spain ran stable current account deficits of roughly
3-4% of GDP, more or less double the average of the previous decade.
Germany, after a decade of current account deficits of roughly 1% of
GDP, began the century with slightly larger deficits, but this balanced
to zero by 2002, after which Germany ran steady surpluses of 2% for the
next two years.

Everything changed around 2005. Germany's surplus jumped sharply to
nearly 5% of GDP and averaged 6% for the next four years. The opposite
happened to Spain. From 2005 until 2009 Spain's current account deficit
roughly doubled again from its 3-4% average during the previous five
years. The numbers are not directly comparable, of course, but during
those four years Spain effectively ran a cumulative current account
deficit above its previous 3-4% average of roughly 21-22% of GDP. Seen
over a longer time frame, during the decade it ran a cumulative current
account deficit above its earlier average of roughly 31-32% of GDP.

These are huge numbers, and substantially exceed the French indemnity
in relative terms. Of course the current account deficit is the obverse
of the capital account surplus, so this means that Spain absorbed
capital inflows above its "normal" absorption rate equal to an
astonishing 21-22% of GDP from 2005 to 2009, and of 31-32% of GDP from
2000 to 2009. However you look at it, in other words, Spain absorbed an
amount of net capital inflow equal to or substantially larger than
Germany's absorption of French reparations during 1871-73. It is not
just Spain. In the 2005-09 period a number of peripheral European
countries experienced net inflows of similar magnitude, according to an
IMF study, including Portugal, Greece and several smaller east European

By the way in principle it isn't obvious which way causality ran
between capital account inflows and current account deficits (the two
must always balance to zero). In 1871-73 it is obvious that German
capital inflows drove current account deficits. In 2005-09 European
countries might similarly have run large current account deficits
because of the capital inflows imposed upon them, but it is also
possible that they had to import capital by eagerly borrowing German
money in order to finance their large current account deficits. To put
it differently, German money might have been "pushed" into these
countries, as the "blame Germany" crew has it, or it might have been
"pulled" in, by the need to finance their spending orgies, as the
"blame anyone but Germany" crew insist. For those who prefer to think
in more precise terms, Germany either created or accommodated the
collapse in Spanish savings relative to Spanish investment. For those
-- including, distressingly enough, most economists -- who believe a
country's savings rate must be driven only, or mainly, by domestic
household preferences, please refer to "Why a savings glut does
not increase savings".

The structure of the balance of payments itself does not tell us
conclusively which caused which, German outflows or Spanish inflows,
and no one doubts that there was a strong element of self-reinforcement
that was an almost automatic consequence of the payments process, as I
have discussed in the January 21 entry on this blog. If it were
the latter case, however, it would be an astonishing coincidence that
so many countries decided to embark on consumption sprees at exactly
the same time. It would be even more remarkable, had they done so, that
they could have all sucked money out of a reluctant Germany while
driving interest rates down. It is very hard to believe, in other
words, that the enormous shift in the internal European balance of
payments was driven by anything other than a domestic shift in the
German economy that suddenly saw total savings soar relative to total
investment. I have discussed many times before what happened in Germany
that resulted in the savings distortion that convinces me that the
flows originated in Germany, as it has many others.

What is interesting is how similar the consequence of the inflows were
even though Berlin was able to control the disbursement of the inflows
in a way of which Madrid could only dream. And yet from 1871 to 1873
the German economy experienced one of the most dramatic stock market
and real estate booms in German history, and although the flow of funds
into government coffers rather than through banks to businesses and
households ensured that the subsequent rise in German consumption was
not early as extreme as it was in Spain, Germany did engage in a frenzy
of investment at home and abroad in which a substantial share of the
inflows was effectively wasted in foolish investment. Of course unlike
Spain today, there never was any question about Germany's obligation to
repay the transfer. It had come, after all, in the form of reparations
demanded by a victorious army, and not in the form of loans. In fact it
took the massive US lending to Germany in the 1920s for German
investment misallocation to lead to wholesale default on external debt.

Syriza's Challenge

It is useful to remember this history when we confront the consequences
of Greece's recent elections. Syriza's victory in Greece has reignited
the name-calling and moralizing that has characterized much of the
discussion on peripheral Europe's unsustainable debt burden. I think it
is pretty clear, and obvious to almost everyone, that Greece simply
cannot repay its external obligations, and one way or another it is
going to receive substantial debt forgiveness. There isn't even much
pretence at this point. This morning financial advisor Mish
Shedlock, sent me (as a joke? as a sign of despair?) German newspaper
Zeit`s interview with Yanis Varoufakis entitled "I'm the Finance
Minister of a Bankrupt Country".

Even if the question of who is to "blame", Greece or Germany, were an
important one, the answer would not change the debt dynamics. It would
take the equivalent of Ceausescu's brutal austerity policies in
Romania, which were imposed during the 1980s in order for the country
fully to repay its external debt, to resolve the Greek debt burden
without a write-down. Given that Ceausescu's policies led directly to
the 1989 revolution, which culminated in both Ceausescu and his wife
being executed by firing squad, the reluctance in Athens to imitate
Romania in the 1980s is probably not surprising.

But to say Greece simply cannot repay isn't the end of the story. As
Europe moves towards a more rational debt policy with Greece, I would
say that there are three important things to remember:

1. There is an enormous economic cost, not to mention social and
perhaps political, to any delay. I worry about the terrifyingly low
level of sophistication among policymakers and the economists who
advise them when it comes to understanding balance sheet dynamics
and debt restructuring. Greece's debt overhang imposes rising
financial distress costs and increasingly deep distortions in the
institutional structure of the economy over time, and the longer it
takes to resolve, the greater the cost.

I think most analysts understand that costs will rise during the
restructuring process. I am not sure they understand, however, that
delays will impose even heavier costs during the many years of
subsequent adjustment. There is a lot of bad blood and recrimination
among the various parties. I suspect that some of those who oppose
Syriza are probably revolted by the thought that a rapid resolution
of the Greek crisis would rebound to Syriza's credit, but they must
understand that dragging out the restructuring process will impose
far greater long-term costs on the Greek people than they think.

My friend Hans Humes, from Greylock Capital, has been involved in
more sovereign debt restructurings than I can remember, and he once
told me with weary disgust that while it is usually pretty easy to
guess what the ultimate deal will look like within the first few
days of negotiation, it still takes months or even years of
squabbling and bitter arguing before getting there. We cannot forget
however that each month of delay will be far more costly to Greece
and her people than we might at first assume.

2. From what I read, much of the focus of the restructuring will be
aimed at determining an acceptable and manageable debt-servicing
cashflow for Greece. There is a mistaken belief that this is the
only "real" variable that matters, and the rest is cosmetics. I
don't agree. Greece's nominal debt structure will not just affect
the debt-servicing cashflows but will also determine future behavior
of economic agents.

There are at least two important functions of an economic entity's
liability structure. One is to determine the way operating profits
or economic growth is distributed among the various stakeholders,
or, put differently, to determine economic incentive structures. The
other is to determine the way external shocks are absorbed. This is
why the restructuring process is so important and can determine
subsequent economic growth. The face value and structure of
outstanding debt matters, and for more than cosmetic reasons. They
determine to a significant extent how producers, workers,
policymakers, savers and creditors, alter their behavior in ways
that either revive growth sharply or slowly bleed away value.
Incentives must be correctly aligned, in other words, so that it is
in the best interest of stakeholders collectively to maximize value
(this rather obvious point is almost never implemented because
economists have difficulty in conceptualizing and modelling
reflexive behavior in dynamic systems). Rather than let economists
work out the arithmetic of the restructuring based on linear
estimates of highly uncertain future cashfllows, whose values are
themselves affected by the way debt payments are indexed to these
cashflows, Greece and her creditors may want to unleash a couple of
options experts onto the repayment formulas and allow them to
calculate how volatility affects the value of these payments and
what impact this might have on incentives and economic behavior.

3. In fact the overall restructuring must be designed so that the
interests of Greece, the producers who create Greek GDP, and the
creditors are correctly aligned. To date sovereign debt
restructurings have almost never included the instruments that
reflect the instruments in corporate debt restructurings that
accomplish this alignment of interests, largely becausse these
instruments have not been "invented". Among other things the
negotiating committee might want to dust off the GDP warrants that
were included in Argentina's last debt restructuring.

If the restructuring is well designed, within a year of the
restructuring I think we could easily see Greek growth surprise us
with its vigor. I was delighted to see that Greece's new Finance
minister agrees. An article in Monday's Financial Times starts
with the claim that "Greece's radical new government revealed
proposals on Monday for ending the confrontation with its creditors
by swapping outstanding debt for new growth-linked bonds, running a
permanent budget surplus and targeting wealthy tax-evaders." Today's
Financial Times has an article by Martin Wolf that mentions the
benefits of "a growth linked bond". In The Volatility Machine I
spend chapters explaining how to create liability structures that
minimize external shocks, align the interests of creditors and
citizens, and improve the quality of payments for creditors, and I
show why these make a restructuring much more successful for all
parties concerned. This is just basic finance theory. Yanis
Varoufakis should really take the lead in designing an entirely new
form of sovereign debt restructuring, not just for Greece but for
the many countries, in Europe and elsewhere, that will soon follow
it into default.

Enough people seem to hate or fear Syriza that there will be little
attempt to approach Greece's problems with enough imagination to give
either party what it needs, but in fact with the right cooperation,
imagination, and intuitive understanding of how balance sheet
structures change overall value creation, a greek debt restructuring
could leave both sides far better off than either side might imagine.
Of course if done right this matters far more than for just its impact
on the Greek economy. While everyone probably agrees that Greece simply
cannot proceed without debt forgiveness, less widely agreed, but no
less obvious in my opinion, is that there are a number of other
European countries that also need debt forgiveness if they are to grow.
Because I was born and grew up in Spain, and my French mother founded
and ran a successful business there which my family and I still own, I
am confident that I know the country well enough to say that even with
some impressive reforms having been implemented under Mariano Rajoy,
Spain is nonetheless one of these countries. I suspect that many other
countries including Portugal, Italy, and maybe even France are too.

I also know, however, that Spanish debt prospects are an extremely
sensitive and emotional topic, and I will be roundly condemned for
saying this. Today's Financial Times has a very worrying article
explaining why Madrid wants to be seen among the hardliners in opposing
a rational treatment for Greece: "when it comes to helping Greece,
there will be no such thing as southern solidarity or peripheral
patronage." This is the reverse of what it should be doing. In an
article for Politica Exterior in January 2012, I actually proposed,
albeit without much hope, that Spain take the lead and organize the
debtor countries to negotiate a sustainable agreement, but in its fear
of Podemos, the Spanish equivalent of Syriza, and its determination to
be one of the "virtuous" countries, it strikes me that Madrid is
probably moving in the wrong direction economically. Ultimately, by
tying itself even more tightly to the interests of the creditors, Rajoy
and his associates are only making the electoral prospects for Podemos
all the brighter.

As it is, and for reasons that may have to do with recent history,
Francisco Franco, and the psychological scars he left among those of my
generation, any discussion in Spain is likely to be subsumed under
non-economic considerations, especially angry denunciations of moral
virtue and moral turpitude. These non-economic considerations are
irrelevant. In fact some of them are very important and even admirable.
But they must be understood within a more neutral context.

As far as I can tell there are at least four important reasons that
opponents of debt forgiveness, not just in Germany but also in Spain,
have proposed as to why demands for debt forgiveness would be a
long-term disaster for Spain:

1. Spain's economic future depends on its remaining a member of
Europe in good standing. To demand debt forgiveness (let alone a
renegotiation of the currency union) would cause a financial crisis
and relegate Spain to backward country status.

2. If Spain fails to honor its debt commitments it will be
considered forever an unreliable prospect and will be frozen out of
future investment and trade.

3. More importantly, it would be morally wrong. The German people
provided Spain with real, hard-earned resources which Spaniards
misused. It is not fair or honorable that Spain punish the German
people for its generosity.

4. Spain had a real choice, and it chose to spend money wantonly on
consumer frivolities and worthless invest projects. It got itself
into this mess only because of the very poor economic policies a
corrupt Madrid implemented. Had Spaniards acted more like Germans
and refrained from excessive consumption -- the result of a flawed
national character trait -- it would not have suffered from
speculative stock and real estate market bubbles, wasted investment
and, above all, an unsustainable consumption boom and a collapse in
savings. It is unfortunate that ordinary Spaniards must suffer for
the venality of tis leaders, but ultimately they are responsible.

These four arguments, which are the same arguments made about other
highly indebted European countries, have been made not just by the
greedy Germans of caricature, but also, more importantly, by indignant
locals. They genuinely believe that their country behaved stupidly and
must pay the price, and it is hard not to respect their sincerity.

Blaming Nations

The last of the four points is I think the most powerful of the
arguments and among the most confused, and it is the one I hope I have
at least partly addressed with my discussion of the French indemnity,
and that I will discuss more below, but I should briefly address the
first three, and of course while I refer to Spain, in fact much of what
follows is as true of Greece and other heavily indebted European
borrowers as it is of Spain:

1. There is no question that a renegotiation of Spanish debt or of
its status within the currency union would be accompanied by
economic hardship and perhaps even a crisis. But compared to what?
The Spanish economy is already in disastrous shape and there is
compelling historical evidence that countries suffering under
excessive debt burdens can never grow their way out of their
debt no matter how radical and forceful the reforms.

This means that by refusing to negotiate debt forgiveness, not only
must Spain be prepared to live with unbearably high unemployment and
slow growth for many years, which would undermine the social,
political and financial institutions that are the real determinants
of whether a country is economically advanced or economically
backwards, but in the end after many years of suffering Spain would
be forced into debt forgiveness anyway, only now with an
economy in far worse shape. Historical precedents also suggest that
while the real reforms Madrid has implemented seem to have failed,
in fact it is the debt constraint that has prevented their impacts
on productivity from showing up as economic growth. I suspect that
many of these reforms have actually been very positive for Spain's
long-term productivity. In that sense I think Mariano Rajoy and his
government have put in an impressive performance. Unless Madrid
waits too long, they may very well even unleash tremendous growth
once debt is written down, but until the debt is resolved, they will
not seem to have worked. Throughout modern history even "good"
reforms have failed to generate growth in nearly every previous case
of overly indebted countries, unless of course those reforms sharply
reduce outstanding debt.

Some economists argue the facts on the ground already contradict my
pessimism. Last week Madrid announced excitedly that GDP grew by
1.7% last year, its fastest pace in seven years. The Financial Times
pointed out that Spain was well-positioned in 2015 to continue
to take advantage of lower energy costs, a weaker euro, and a cut in
personal and corporate taxes, to which I would add lower metal
prices, massive QE, and stronger than expected consumption. But even
if these tailwinds are permanent, and they clearly are not, nominal
GDP growth is still much lower than the growth in the debt burden.
This is as good as it gets, in other words, and it is not good
enough. As the debt burden continues to climb, and as social and
political frustrations mount, Spain will slide inexorably backwards
into the backward-country status it wants so badly to avoid.

2. There is overwhelming evidence -- the US during the 19th Century
most obviously -- that trade and investment flow to countries with
good future prospects, and not to countries with good track records.
The main investment Spain is likely to see over the next few years
is foreign purchases of existing apartments along the country's
beautiful beaches. Once its growth prospects improve, however, with
among other things a manageable debt burden, foreign businesses and
investors will fall over each other to regain the Spanish market
regardless of its debt repayment history. This is one of those
things about which the historical track record is quite unambiguous.

3. It was not the German people who lent money to the Spanish
people. The policies implemented by Berlin that resulted in the huge
swing in Germany's current account from deficit in the 1990s to
surplus in the 2000s were imposed at a cost to German workers, and
have been at least partly responsible for Germany's extremely low
productivity growth -- most of Germany's growth before the crisis
can be explained by the change in its current account -- rather than
by rising productivity.

Moreover because German capital flows to Spain ensured that Spanish
inflation exceeded German inflation, lending rates that may have
been "reasonable" in Germany were extremely low in Spain, perhaps
even negative in real terms. With German, Spanish, and other banks
offering nearly unlimited amounts of extremely cheap credit to all
takers in Spain, the fact that some of these borrowers were terribly
irresponsible was not a Spanish "choice." I am hesitant to introduce
what may seem like class warfare, but if you separate those who
benefitted the most from European policies before the crisis from
those who befitted the least, and are now expected to pay the bulk
of the adjustment costs, rather than posit a conflict between
Germans and Spaniards, it might be far more accurate to posit a
conflict between the business and financial elite on one side (along
with EU officials) and workers and middle class savers on the other.
This is a conflict among economic groups, in other words, and not a
national conflict, although it is increasingly hard to prevent it
from becoming a national conflict.

But didn't Spain have a choice? After all it seems that Spain could
have refused to accept the cheap credit, and so would not have suffered
from speculative market excesses, poor investment, and the collapse in
the savings rate. This might be true, of course, if there were such a
decision-maker as "Spain". There wasn't. As long as a country has a
large number of individuals, households, and business entities, it does
not require uniform irresponsibility, or even majority
irresponsibility, for the economy to misuse unlimited credit at
excessively low interest rates. Every country under those conditions
has done the same. What is more, even if the decision about the
disbursement of the inflows could have been concentrated in the hands
of a single, responsible entity, the experience of Germany after 1871
suggests that it is nearly impossible to prevent a massive capital
inflow form destabilizing domestic markets. Germany, after all, was
much better placed than Spain later was for two important reasons.
First, unlike Spain today, Germany was not saddled with an enormous
debt obligation which it had to repay. Second, in 1871-73 the transfers
went straight to Berlin, which was able fully to control the
disbursements. In 2005-09, on the other hand, the transfers to Spain
left behind an enormous debt burden and were discrete and widely
dispersed in ways that were almost certainly biased in favor of the
most optimistic or foolish lenders and the most optimistic or foolish

And this is a point that's often missed in the popular debate. Over and
over we hear -- often, ironically, from those most committed to the
idea of a Europe that transcends national boundaries -- that Spain must
bear responsibility for its actions and must repay what it owes to
Germany. But there is no "Spain" and there is no "Germany" in this
story. At the turn of the century Berlin, with the agreement of
businesses and labor unions, put into place agreements to restrain wage
growth relative to GDP growth. By holding back consumption, those
policies forced up German savings rate. Because Germany was unable to
invest these savings domestically, and in fact even lowered its
investment rate, German banks exported the excess of savings over
investment abroad to countries like Spain.

Why didn't Germans, rather than Spaniards, take advantage of the excess
savings to fund a consumption boom. The standard response is to point
to German prudence and Spanish irresponsibility, but it must be
remembered that as German and Spanish interest rates converged (driven
in large part by German capital flows into Spain), because they adopted
a common currency at a time when Spanish inflation had been higher than
German, the real interest rate in Spain was lower than that of Germany.
As German money poured into Spain -- with Spain importing capital equal
to 10% of GDP at its peak -- the massive capital inflows and declining
interest rates ignited asset price bubbles, and even more inflation,
setting off in Spain what Charles Kindleberger called a
"displacement". This locked Spain into a classic self-reinforcing cycle
of rising asset prices and declining interest rates.

What is more, under normal (i.e. pre-euro) conditions the Spanish
peseta would have dropped and Spanish interest rates risen, but the
conditions of the euro prevented both adjustment mechanisms, and to
make things worse this gave Berlin's policies far more traction than
anyone expected, locking Germany into an over-reliance on capital
exports to Spain, the obverse of Germany's current account surplus.
German workers gave up wage growth in order to eke out employment
growth, which itself depended on an ever rising surplus. Throughout it
all there was little productivity growth as German companies reduced
their investment share in the economy.

Meanwhile German banks, flush with the higher savings that low wage
growth, rising surpluses and growing corporate profits all but
guaranteed, continued eagerly to export into Spain the savings they
simply could not invest at home. So why didn't "Spain" step in and put
an end to this process by refusing to borrow German money? Because,
again, there was no "Spain". There were millions of households and
business entities all of whom were offered unlimited amounts of lending
at very low or even negative interest rates, and under the conditions
of euro membership Madrid could not intervene. If German and Spanish
banks blanketed the country with lending proposals, Madrid could do
nothing to stop it (at least not without raising domestic unemployment
and igniting the the ire of Brussels and Berlin). As long as there were
some greedy, overly optimistic or foolish borrowers (and in a country
of 45-50 million people how could there not be?), German and Spanish
banks fell over themselves to make loans. The money had to be absorbed
by Spain and there was no mechanism to ensure the quality of its

Above all this is not a story about nations. Before the crisis German
workers were forced to pay to inflate the Spanish bubble by accepting
very low wage growth, even as the European economy boomed. After the
crisis Spanish workers were forced to absorb the cost of deflating the
bubble in the form of soaring unemployment. But the story doesn't end
there. Before the crisis, German and Spanish lenders eagerly sought out
Spanish borrowers and offered them unlimited amounts of extremely cheap
loans -- somewhere in the fine print I suppose the lenders suggested
that it would be better if these loans were used to fund only highly
productive investments.

But many of them didn't, and because they didn't, German and Spanish
banks -- mainly the German banks who originally exported excess German
savings -- must take very large losses as these foolish investments,
funded by foolish loans, fail to generate the necessary returns. It is
no great secret that banking systems resolve losses with the
cooperation of their governments by passing them on to middle class
savers, either directly, in the form of failed deposits or higher
taxes, or indirectly, in the form of financial repression. Both German
and Spanish banks must be recapitalized in order that they can
eventually recognize the inevitable losses, and this means either many
years of artificially boosted profits on the back of middle class
savers, or the direct transfer of losses onto the government balance
sheets, with German and Spanish household taxpayers covering the debt

Who is Fighting Whom?

I am not rejecting the claim that "Spain" acted irresponsibly, in other
words, only to place the blame on "German" irresponsibility. But it is
absolutely wrong for Volker Kauder, the parliamentary caucus leader of
German Chancellor Angela Merkel's Christian Democrats, to say,
according to an article in last week's Bloomberg, that "Germany
bears no responsibility for what happened in Greece. The new prime
minister must recognize that." There was indeed plenty of irresponsible
behavior on both sides, during which time wealth was transferred from
workers of both countries to create the boom and to absorb the
subsequent bust, and wealth will be transferred again from middle class
households of both countries to clean up the resulting debt debacle.

Put differently, there is no national virtue or national vice here, and
there is no reason for the European crisis to devolve into right-wing,
nationalist extremism. The financial crisis in Europe, like all
financial crises, is ultimately a struggle about how the costs of the
adjustment will be allocated, either to workers and middle class savers
or to bankers, owners of real and financial assets, and the business
elite. Because the major parties have refused to acknowledge the nature
of this allocation process, and have turned it into a fight between a
creditor Germany, on the one hand, and indebted peripheral European
countries on the other, I was able to make in 2010-11 one of the
easiest predictions I have ever made in my career -- whichever
extremist parties, whether of the right or of the left, who first went
on the offensive against Germany, the bankers and the currency
bureaucrats, I predicted, would surge in electoral popularity and would
eventually reformulate the debate.

That is why the question of debt forgiveness must be reformulated by
the centrist parties first. Fundamental to the argument that Spain (or
Greece, or anyone else) has a moral obligation to repay in full its
debt to Germany are two assumptions. The first assumption is that
"Spain" borrowed the money from "Germany", and that there is a
collective obligation on the part of Spain to repay the German
collective. The second assumption is that Spain had a choice in what it
could do with the German money that poured into the country, and so it
must be held responsible for its having mis-used hard-earned german

The first assumption is, I think, easily dismissed. Germany exported
capital because by repressing wage growth, Berlin ensured the high
profits and low consumption that forced up its national savings rates.
Instead of employing these savings to invest in raising the
productivity of German workers (in fact domestic investment actually
declined) it offered them either to fund German consumption at high
real interest rates (and there were few takers), or through German and
Spanish banks this capital was offered to other European households for
consumption or to other European businesses for investment. The offers
were taken up in different ways by different countries. In countries
where the offered interest rates were very low or negative, the loans
were more widely taken up than in countries where real interest rates
were much higher. To ascribe this difference to cultural preferences
rather than to market dynamics doesn't make much sense.

What started slowly quickly accelerated, again for reasons of market
dynamics. As the huge inflow into Spain set off stock market and real
estate booms, some Spanish households, feeling wealthier, borrowed to
increase their consumption, and many Spanish households and businesses
borrowed to buy real estate. In the subsequent frenzy, credit standards
collapsed as Spanish and German banks fought to gain market share, and
as optimism soared, consumption grew to unsustainable levels, until
eventually Spain was so overextended that it collapsed. The same story
can be told elsewhere. In fact this is what happened in Germany after
the French indemnity.

As for the second assumption, that Spain had a choice, this too should
be quickly dismissed. Clearly Spanish households and businesses in the
aggregate behaved, in retrospect, with astonishing abandon. But could
they have done otherwise -- did they have a choice? Almost certainly
not. Germany did not when it received the French indemnity, and I don't
think there are many, if any, cases of countries that were able to
absorb productively such massive inflows. In every case I can think of,
massive capital inflows were accompanied by speculative bubbles and
financial crises. Even the US in 19th century -- urgently needing
foreign capital to finance a massive amount of productive investment
that could not be financed out of domestic savings, making it the best
candidate possible to receive massive foreign inflows -- was not able
to absorb surges in inflows without seeing the creation of bubbles,
investment scandals, and financial crises. Is it reasonable to insist
that Spain's failure to choose a path that no other country in history
seems ever to have chosen indicates greater irresponsibility on the
part of the borrowers than of the lenders? As long as there is a widely
diverse range of views among Spanish individuals and businesses about
prospects for the future, as long as there is a mix of optimists and
pessimists, or as long as there are varying levels of financial
sophistication, I think it would have been historically unprecedented
if at least some Spanish entities did not respond foolishly to
aggressive offers of extremely cheap credit, especially once this cheap
credit had set off a real estate boom.

In summary, I think there are several points that those of us who want
"Europe" to survive should be making.

1. The euro crisis is a crisis of Europe, not of European countries.
It is not a conflict between Germany and Spain (and I use these two
countries to represent every European country on one side or the
other of the boom) about who should be deemed irresponsible, and so
should absorb the enormous costs of nearly a decade of
mismanagement. There was plenty of irresponsible behavior in every
country, and it is absurd to think that if German and Spanish banks
were pouring nearly unlimited amounts of money into countries at
extremely low or even negative real interest rates, especially once
these initial inflows had set off stock market and real estate
booms, that there was any chance that these countries would not
respond in the way every country in history, including Germany in
the 1870s and in the 1920s, had responded under similar conditions.

2. The "losers" in this system have been German and Spanish workers,
until now, and German and Spanish middle class savers and taxpayers
in the future as European banks are directly or indirectly bailed
out. The winners have been banks, owners of assets, and business
owners, mainly in Germany, whose profits were much higher during the
last decade than they could possibly have been otherwise

3. In fact, the current European crisis is boringly similar to
nearly every currency and sovereign debt crisis in modern history,
in that it pits the interests of workers and small producers against
the interests of bankers. The former want higher wages and rapid
economic growth. The latter want to protect the value of the
currency and the sanctity of debt.

4. I am not smart enough to say with any confidence that one side or
the other is right. There have been cases in history in which the
bankers were probably right, and cases in which the workers were
probably right. I can say, however, that the historical precedents
suggest two very obvious things. First, as long as Spain suffers
from its current debt burden, it does not matter how intelligently
and forcefully it implements economic reforms. It will not be able
to grow out of its debt burden and must choose between two paths.
One path involves many, many more years of economic hell, as
ordinary households are slowly forced to absorb the costs of debt --
sometimes explicitly but usually implicitly in the form of financial
repression, unemployment, and debt monetization. The other path is a
swift resolution of the debt as it is restructured and partially
forgiven in a disruptive but short process, after which growth will
return and almost certainly with vigor

5. Second, it is the responsibility of the leading centrist parties
to recognize the options explicitly. If they do not, extremist
parties either of the right or the left will take control of the
debate, and convert what is a conflict between different economic
sectors into a nationalist conflict or a class conflict. If the
former win, it will spell the end of the grand European experiment.


I leave my readers with three questions that I hope we can discuss in
the comments section:

1. If a huge amount of capital, equal say to 10-30% of a country's
annual GDP, is forcibly distributed to an enormous group of entities
within that country in a short time period, and if the only way in
which to distribute this capital is through a wide variety of banks,
with biases such that the more optimistic and irresponsible the
bank, the more it profits, and the more optimistic and irresponsible
the borrower, the more it receives, is it meaningful to refer to
either side as behaving "irresponsibly", and if so, which side? Does
this sound like a loaded question? If it is, can it be rephrased in
a less loaded way?

2. There have been many cases of large capital recycling in history
-- just in the last 100 years I can think of the recycling of the US
trade surplus to Germany and other countries in the 1920s, the
petrodollar recycling to Latin America in the 1970s, and the
recycling to the US of the Japanese trade surplus in the 1980s and
the Chinese trade surplus in the 2000s. These were all accompanied
in the recipient country by stock, bond and real estate bubbles and
by overconsumption and wasted investment. Have there been cases of
large capital recycling that did not end in tears for the
recipients? If so, how were they different?

3. What about the other side of the recycling? In most cases the
recycling country also experienced bubbles and rising debt. Have
there been cases that did not also end in tears and if so, how were
they different?


(1) The imbalances themselves occurred in forms that are widely
understood and for which we have many historical precedents. I
discussed these in my book, The Great Rebalancing: Trade, Conflict, and
the Perilous Road Ahead for the World Economy (Princeton University
Press, 2013). I am far from the only one to have done so. Martin Wolf's
excellent The Shifts and the Shocks: What We've Learned--and Have Still
to Learn--from the Financial Crisis (Penguin Press, 2014) presents a
schematic account of the causes of the crisis, and in The Leaderless
Economy: Why the World Economic System Fell Apart and How to Fix It
(Princeton University Press, 2013) Peter Temin and David Vine set out
with great clarity the framework within which Europe's internal
imbalances had inexorably to lead to the current outcome.

(2) Michael B. Devereux and Gregor W. Smith, "Transfer Problem
Dynamics: Macroeconomics of the Franco-Prussian War Indemnity", August,
2005, Queen's University, Department of Economics Working Papers

(3) Arthur E. Monroe, The French Indemnity of 1871 and its Effect (The
MIT Press, 1919)

(4) Charles Kindleberger, A Financial History of Western Europe,
(Routledge 2006)

(5) Michael Pettis, The Volatility Machine: Emerging Economics and the
Threat of Financial Collapse (Oxford University Press, 2001)

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