The Moral Hazard of the Euro

by Jesus Huerta de Soto

Mises Daily
March 28, 2011

[Foreword to The Tragedy of the Euro, by Philipp Bagus (2010)]

It is a great pleasure for me to present this book by my colleague Philipp Bagus, one of my most brilliant and promising students. The book is extremely timely and shows how the interventionist setup of the European monetary system has led to disaster.

The current sovereign-debt crisis is the direct result of credit expansion by the European banking system. In the early 2000s, credit was expanded especially in the periphery of the European Monetary Union such as in Ireland, Greece, Portugal, and Spain. Interest rates were reduced substantially by credit expansion coupled with a fall both in inflationary expectations and risk premiums. The sharp fall in inflationary expectations was caused by the prestige of the newly created European Central Bank as a copy of the Bundesbank. Risk premiums were reduced artificially due to the expected support by stronger nations. The result was an artificial boom. Asset-price bubbles such as a housing bubble in Spain developed. The newly created money was primarily injected in the countries of the periphery where it financed overconsumption and malinvestments, mainly in overextended automobile and construction sectors. At the same time, the credit expansion also helped to finance and expand unsustainable welfare states.

In 2007, the microeconomic effects that reverse any artificial boom financed by credit expansion and not by genuine real savings started to show up. Prices of means of production such as commodities and wages rose. Interest rates also climbed due to inflationary pressure that made central banks reduce their expansionary stands. Finally, consumer-goods prices started to rise relative to the prices offered to the originary factors of production. It became more and more obvious that many investments were not sustainable due to a lack of real savings. Many of these investments occurred in the construction sector. The financial sector came under pressure as mortgages had been securitized, ending up directly or indirectly on balance sheets of financial institutions. The pressures culminated in the collapse of the investment bank Lehman Brothers, which led to a full-fledged panic in financial markets.

Instead of letting market forces run their course, governments unfortunately intervened with the necessary adjustment process. It is this unfortunate intervention that not only prevented a faster and more thorough recovery but also produced, as a side effect, the sovereign-debt crisis of spring 2010. Governments tried to prop up the overextended sectors, increasing their spending. They paid subsidies for new car purchases to support the automobile industry and started public works to support the construction sector as well as the sector that had lent to these industries, the banking sector.

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