Episode 8: European Bumblebees
Jim Grenn: Hans Christensen is a financial consultant living in Denmark. Years ago, he refinanced his home with a floating rate mortgage. In January 2016, Christensen opened his mortgage statement to find a strange surprise. The interest rate on his home had floated to a negative 0.0562 percent. Christensen still had to make principal payments, but the bank was actually crediting him the equivalent of thirty-eight dollars each month for the privilege of having his mortgage. In other words, the bank was actually paying Christensen to borrow money.
The Wall Street Journal did a story on Hans. “My parents said I should frame it, to prove to coming generations that this ever happened,” Hans is quoted in the article.
Even before the bank began paying him, Christensen was already taking full advantage of the ridiculously low rates in his country. Two years earlier, Hans and a small group of investors had purchased ten apartment units for $1.5 million, borrowing roughly the majority of the purchase price. The low interest rates were rekindling a fire in the Danish housing market.
What happens when interest rates become negative. The world will soon find out.
This is Domino, and examination of a historical event that a had a ripple effect on the global economy.
I’m Jim Grenn, the host of Domino. Today, we are examining Europe’s response to the Great Recession of 2008, but as usual, let’s back up and start from the beginning.
Kent Oliver: Every year in early May, countries in the European Union celebrate Europe Day, a day that highlights the peace and unity throughout Europe by memorializing a singular event.
Jim Grenn: That’s Kent Oliver, our big picture guy.
Kent Oliver: In 1950, an agreement was reached between West Germany and France to pool their coal and steel production. The agreement was viewed as the first step back on the road to promote peace and unity throughout Europe following World War II. The agreement morphed into something of a free trade deal between the two countries. Eventually this morphed into the European Union – in which free trade and economic growth became the backbone of reconciliation for the Continent.
Jim Grenn: Lets help our listeners understand a little more about Europe. You mentioned the European Union – can you explain a little about what it?
Kent Oliver: It’s kinda like NAFTA on steroids.
Jim Grenn: Ok…
Kent Oliver: It’s a standardized system of laws and policies to ensure the free movement of people, goods, services and capital. The European Union includes 28 countries and 500 million people. And interestingly, it’s all relatively new – the EU was formed in 1992.
Jim Grenn: Ok, and from this agreement of countries, these countries eventually decide to use a common currency.
Kent Oliver: Well, 19 of the 28 countries are using a single currency – the others still have their own.
Brady Raanes: Yes, so, the same agreement that set up the EU also called for a common currency, now known as the euro, but that didn’t go into effect until 1999.
Jim Grenn: That’s Brady Raanes, our detail guy. A common currency seems like a good idea after what we learned with Mexico’s currency problems following the passage of NAFTA.
Brady Raanes: A single-currency system offers numerous economic benefits to participating countries: no need to change currencies in each different country; less currency risk for importing and exporting, leading to increased trade; and an increased likelihood of continued peace throughout the region.
Jim Grenn: Sure. I can see that.
Brady Raanes: Really, though, the adoption of the euro was designed to be the final step in bringing long-term peace and prosperity to a continent fraught with centuries of conflict. I mean, let’s not forget two world wars effectively began because Europeans couldn’t get along.
Jim Grenn: Right.
Brady Raanes: Ultimately, the idea of peace and unity trumped the details behind the economic complexities of using a common currency for nineteen different countries with vastly differing economies.
Jim Grenn: Gotcha – and what economic complexities might arise from Europe having a shared currency like the Euro?
Kent Oliver: Well, by sharing a common currency, each country was relinquishing control of their own monetary policy - which meant that each country was giving up some control over their own monetary system – such as how much money was printed, what interest rates would be etc.
Jim Grenn: Ok – I see that, each country is ceding some control – but isn’t that basically the same as the 50 states in the USA. They give up some control to a central government.
Kent Oliver: Right. It’s similar. But… there is no central government in Europe. No one pays into a singular European bucket. There is no president of Europe. Each country is still very much on their own when it comes to taxation, social programs, etc. the only common thread is currency – and their policies are controlled by the European Central Bank.
Jim Grenn: Kind of like the Federal Reserve.
Brady Raanes: Right, and I don’t want to get too deep in the weeds, but an important and complicated byproduct of a single-currency system involves interest rate normalization. In the United States, for instance, the interest rate you pay when buying a car in Mississippi is basically the same as the interest rate you’d pay in New Mexico. But that wasn’t the case in Europe prior to the euro. Borrowing costs in Greece were different from borrowing costs in Germany because each country set their own rates prior to the Euro. As such, the government of each respective country held different borrowing costs when issuing bonds.
Jim Grenn: And after the Euro gets adopted, the interest rates in each country begin to converge.
Brady Raanes: Right, because the ECB sets interest rates and investors began to view each country as one region. The advent of the euro normalized rates and made it possible (in theory) for countries like Greece and Spain to borrow and lend in the same manner as larger countries like Germany.
Jim Grenn: And why is this a bad thing.
Kent Oliver: Well, I don’t know if I would say it’s bad – it seemed great at the time. But it had some unforeseen consequences. The lower interest rates led to a boom in economic activity in countries like Greece, Spain, and Ireland but soon a housing bubble developed in southern Europe as banks in Portugal, Ireland, Greece, and Spain experienced credit growth increases of more 20 percent per year from 2004 to 2008. In hindsight, it was bad, but at the time it was great.
Brady Raanes: Yeah, home prices in Ireland and Spain rose more than 150 percent in the decade before the crisis erupted. The interest rates convergence basically led to a housing bubble much like what we had in the US.
Jim Grenn: And this boom was set off just because interest rates fell?
Kent Oliver: Essentially, yes. Some countries – specifically in southern Europe generally had higher interest rates prior to the Euro.
Jim Grenn: And why is that? Why would countries in Southern Europe purposefully have higher interest rates prior to the Euro?
Brady Raanes: Probably because they were trying to strengthen the value of their currency, and certain countries command a higher yield because they are perceived as riskier. I mean, if you were going to invest in government bonds in Argentina, you’d certainly demand a higher yield than investing in bonds from Canada.
Jim Grenn: Yeah, I see that.
Jim Grenn: Ok – so back to Europe. They region agrees on a trade deal and a common currency. Once they adopt the currency, interest rates converge… which means the countries in southern Europe experience lower interest rates than usual. And that essentially sets off a housing bubble at the same time that the US was creating a housing bubble.
Brady Raanes: Yep. And I’m not sure that the two were extremely related, but it was rather coincidental.
Jim Grenn: Right.
Kent Oliver: So, then 2008 happens in the US. And the housing market in the US tanks. And… the housing market in Europe tanks right along with it.
Jim Grenn: Which probably would have happened either way
Brady Raanes: Yeah, probably. European banks would have eventually seen a day of reckoning from overleverage and a housing bubble but the US real estate debacle merely sped up the process made it much worse. By 2009, the major US banks had locations in every corner of the developed world and had done a marvelous job spreading the subprime mortgages and derivatives into banking systems throughout Europe. Analysts at the International Monetary Fund reported that European banks may have even had a higher overall allocation of the toxic mortgages than US banks.
Kent Oliver: The US slowdown quickly became a global slowdown. Banks stopped lending and construction jobs vanished and the unemployment rate in southern Europe soared. As the economy slowed, tax revenue fell.
Brady Raanes: Which meant that government ran short of funds and had to start running deficits and borrowing more money.
Kent Oliver: Government borrowing surged in Greece, Spain, Portugal, Italy, and other European countries as they tried to cope with a slumping economy. The mortgage crisis that began in America had exposed deep structural issues in Europe.
Jim Grenn: And are the problems isolated to southern Europe? where those countries you named the specific problem areas?
Brady Raanes: No, not entirely, but a fun acronym was developed to describe the countries with the biggest issues: PIGS (Portugal, Italy, Greece, and Spain). Occasionally, France was thrown into the mix. Making it the F’n PIGS.
Jim Grenn: Ah, I see what you did there. A little European financial crisis humor – I like it.
Brady Raanes: That truly was the acronym.
Kent Oliver: So – there was another strange secondary issue making Europe’s situation extremely unique. In the United States, prolonged economic slumps in one state could be overcome by workers simply moving to another state to find new opportunity. But in Europe, the mobility of labor is less viable. Moving from one country to another for employment generally meant losing government benefits and starting over in a new country.
Brady Raanes: Right, US citizens, on the other hand, are assured that the government will continue to offer the same social security and Medicare coverage regardless of which state they reside in. In Europe, no such safety net exists. Taxes are paid directly into one country rather than Europe as a region. So, if you move from one country to another you start all over with government benefits.
Jim Grenn: Let’s take a quick break. Domino will be right back.
Jim Grenn: So, last week we talked about the US response to the crisis. What was the Europe response?
Brady Raanes: Britain announced a £200 billion program. The French government announced that it would be taking equity positions in France’s distressed banks, much like the US government had done for so many US banks. France also pledged 100 billion euros to plug the holes in its financial system.
Kent Oliver: The Norwegian central bank agreed to provide the equivalent of $58 billion in additional liquidity to its banking system.
Jim Grenn: Tiny little Norway. Brady aren’t you of Norwegian blood?
Brady Raanes: Arrr. A Viking we are.
Jim Grenn: Was that… Yoda?
Kent Oliver: But Greece became the poster child of the Europe’s problem.
Jim Grenn: Tiny little Greece?
Kent Oliver: Greece had promised really lucrative social programs to their citizens. They enjoyed much more generous pensions than other European countries despite having a younger average retirement age and much worse tax collection.
Brady Raanes: Greek citizens seem to pride themselves on tax avoidance. An IMF report found that the tax collected in the country routinely hovered around 50 percent of the tax revenue actually owed. Most small companies knew that they would never be audited so they don’t bother to pay taxes. A Greek senior government official said “The Greek economy would collapse if the government were to force these people to pay taxes.”
Jim Grenn: That’s wild!
Kent Oliver: At the onset of the creation of the euro in 1999, it was expected that all Europeans would behave similar; the Italians would behave like the Germans. Greece would have the same tax collection as the French, etc. but they didn’t.
Jim Grenn: It’s interesting that the different countries have such different attitudes towards money in Europe.
Brady Raanes: True, we’ve all heard the old saying that Italians love debt and Portuguese people can’t budget.
Jim Grenn: No… Brady. We haven’t.
Kent Oliver: Anyway, as tax collection fell and pensions rose, the federal deficit in Greece ballooned. Soon Greece was primarily funding its liabilities with borrowed money. Still, banks and investors reassured themselves that countries don’t go broke.
Brady Raanes: Government budget deficits in Greece were four times larger than the highest threshold allowed under the European Union agreement governing the appropriate finances for each country.
Kent Oliver: Greece imposed spending cuts and government layoffs and attempted to increase taxes but it only made matters worse.
Jim Grenn: Do I smell another IMF bailout?
Brady Raanes: I’m afraid that you do.
Kent Oliver: Yep, Greece couldn’t utilize the traditional means of improving their economy with lower interest rates and currency devaluation, so they accepted a joint bailout from the European Central Bank, the International Monetary Fund, and the European Commission of $143 billion in 2010 and another bailout of $170 billion in 2012.
Jim Grenn: And… I suspect, that as in Latin America three decades earlier, the loans kept the country afloat, but the austerity measures caused great suffering to the people.
Kent Oliver: Unemployment hit 25 percent, and more than 60 percent of Greek children lived in poverty. Greek stocks fell 90 percent from the peak. At its low point, the entire stock market was worth less than the American discount retailer Costco.
Jim Grenn: Ok, so, we touched on this a little, but let’s go back to monetary policy in Europe. Who is pulling the strings on interest rates at the European Central Bank.
Kent Oliver: Draghi was tasked with heading the European Central Bank in 2011. He was well spoken, well connected, and well respected. Draghi, however, had an extra level of stress. The European Central Bank was the link holding the European region together. With no central European government to rely on for fiscal policy and uniform spending policies, there was no concerted government response within the region. As head of the ECB, Draghi was the closest thing to a unifying player in all of Europe.
Brady Raanes: And shortly after Draghi took over at the ECB, he had a crisis of confidence on his hands. It wasn’t just Greece. Each of the PIGS were in trouble. The 2008 meltdown had forced countries to borrow so much that their government debts were getting out of control.
Kent Oliver: Yeah, and the Greece bailout had been pretty tiny. But the European Union and European Central bank was concerned that they may be looking at bigger problems than just Greece.
Brady Raanes: To put in perspective. Greece’s economy is roughly the same size as Alabama. Italy is the size of Texas. France is the size of California. It’s a lot easier to bailout an economy that’s the size of Alabama rather than one the size of California. If those larger European countries needed bailout money it would be really big deal. And it would likely fall on the wealthier countries like Germany to step up and help.
Jim Grenn: Which I’m sure they weren’t crazy about doing.
Brady Raanes: Pressure grew throughout the Eurozone that the region might need to abandon the single currency. Rumors surfaced that the Germans wanted out too. Many questioned how long the richer countries would continue funding and bailing out poorer countries with weak fiscal restraint like Greece.
Kent Oliver: The situation was worsening in Europe. Despite the common currency, some countries in the Eurozone were having to pay investors far more than neighboring countries to borrow money. It began to look like the system was breaking down. In Portugal, short-term interest rates on government bonds approached 20 percent. In Greece, the rate eclipsed 40 percent on short-term bonds.
Brady Raanes: Meanwhile, Mario Draghi had tried all sorts of things to reassure the world that the European Central Bank would continue to be accommodative with monetary policy. In the summer of 2012, Draghi tried a new tack. He stepped to the podium at a conference in London and began talking about bumblebees.
Jim Grenn: Bumblebees?
Brady Raanes: Draghi didn’t elaborate on the science behind his statement—that bumblebees’ bodies are too large relative to their wing size or that bumblebees seem to defy the laws of physics—but his message was clear. Draghi didn’t elaborate on how he planned to the keep the bumblebee in the air, but he did emphasize one point: the bumblebee would remain in flight.
Jim Grenn: Ok?
Brady Raanes: It’s known now as the “whatever it takes” speech.
Brady Raanes: Within weeks, interest rates in the southern countries of Europe began to fall back to more normal levels by the end of 2012. Draghi hadn’t actually done anything in regards to policy, but his confidence and assurance had calmed investors. In time, the speech would become famous.
Jim Grenn: Wait what? that’s it? He gave a speech about a butterfly and said he would do whatever it takes and it calmed everyone so much that the speech became famous?
Kent Oliver: Europeans are simple people, Jim. They like to drink wine and be told it’s going to be ok.
Jim Grenn: And the Portuguese are bad at budgeting.
Brady Raanes: that’s a fact
Jim Grenn: Speaking of Wine.
Brady Raanes: C3 is really good by the way – I personally love the 2012 Cab.
Jim Grenn: Ok, so the panic subsides a bit after the speech for some reason. A strange solution to a falling domino.
Kent Oliver: Right, the fear subsided a bit, but debt levels continued to grow as each country tried to stimulate growth but the impact had been disappointing. If they couldn’t grow, they would just be looking at another debt crisis in a few years.
Jim Grenn: so??
Brady Raanes: So, about a couple years after the speech, the European Central Bank decides to throw an economic Hail-Mary and reduce interest rates into negative territory.
Jim Grenn: Negative interest rates. The concept is so foreign to most people. In other words – rather than earning interest on a savings account, people in Europe would be losing money each year on their savings.
Brady Raanes: Right. The main fear throughout Europe was the same that the United States had held in 2008: deflation would take hold the way it did in Japan throughout the 1990s and 2000s. To fight deflation, the European Central Bank had to encourage consumer spending. Draghi hoped that imposing negative interest rates would incentivize spending and borrowing by punishing savers.
Jim Grenn: And did it work?
Kent Oliver: Not really. I mean, the interest rates on bonds went negative as Draghi wanted. Government bonds yields fell into negative territory across Europe, which helped each government keep borrowing costs low, and I suppose it may have helped avoid a deeper crisis, but it didn’t exactly cause the economy to boom.
Jim Grenn: Was that not the plan?
Brady Raanes: I mean, the real plan was to lower interest rates enough to stimulate borrowing and spending so much that the economies begin to grow again… with the idea that they can grow their way out of the debt crisis.
Jim Grenn: This always seems counterintuitive – that a country could lower interest rates enough to borrow and spend their way out of a debt crisis. Has that ever happened before?
Brady Raanes: There is only one recent example where you can argue that an economy successfully grew its way out of a heavy debt burden. Ireland. Irish national debt hit £23 billion in 1986, more than the size of all economic output that year.
Jim Grenn: Ah, the old Ireland 1986 example. A classic tale.
Brady Raanes: Ireland lowered tax rates to attract foreign investment, deregulated industries that had been under government control, and began focusing investment into science, engineering, and tech.
Jim Grenn: Ok
Brady Raanes: And it worked for a while. Foreign businesses came into the country to take advantage of low taxes and skilled labor. The economy began to expand. Tax revenue increased and the national debt began to fall. By 2000, Ireland had a significant surplus and began an infrastructure expansion. By 2002, national debt was less than half the size of the economy.
Jim Grenn: Well isn’t that a fun little story
Kent Oliver: It would be if it ended there but the Great Recession of 2008 hit Ireland particularly hard. Much of the foreign business it attracted with the lower corporate tax rates and lax regulation was centered in the financial industry, making Ireland something of a financial hub for the Eurozone.
Jim Grenn: Uh oh
Brady Raanes: Ultimately, Ireland decided to nationalize part of the banking system, which increased their national debt dramatically. By the end of 2010, the national debt was again larger than the total size of the economy. Interest rates spiked as international lenders were unwilling to make further loans to Ireland at reasonable rates. Eventually, Ireland accepted an €85 billion bailout loan from the IMF and European Union.
Jim Grenn: Well, that’s disappointing. So – coming back to modern day Europe – what’s the landscape look like? What has the impact of negative rates been?
Kent Oliver: Well we are only a couple years removed from the negative rates and it sometimes takes years for the real impact of policy changes to be felt. But government debt in Europe is super high, and several countries still have extremely low borrowing costs. At some point, interest rates are bound to rise, and that’s when we will see how the ECB responds.
Jim Grenn: And where are the PIGS countries today? Has their debt returned to normal levels?
Brady Raanes: No. they are roughly in the same place as they were in 2012. As of the end of last year 2017 Portugal, Italy, Greece, Spain, and France all had government debt that was roughly the size of their entire economy. Greece’s debt is 170% the size of their economy.
Jim Grenn: So, nothing is really different than it was when the crisis hit?
Kent Oliver: Right.
Brady Raanes: Europe is basically one huge economic experiment from the central currency to the negative rates – and there is really no way to have any idea how this Domino falls.
Jim Grenn: Fascinating.
Jim Grenn: Next week will be Domino’s final episode of the season where we will examine China’s strange response to the great recession of 2008. Spoiler. They decided to create their own real estate bubble and debt crisis. Join us next week for the finale.