The other day, the cost of filling up our family car rose to €109, and the price of oil is going up and up every month. Looking out on the huge reclamation work going on in front of me at Abu Dhabi’s Corniche region (where I am speaking at a conference), I pondered on the vast wealth of this place, where money for public works is no issue because of oil dollars.

Out beyond the white beaches, to the north lies Iran and, to the west, about 100 miles or so away, are the strategic Straits of Hormuz.

All the talk here is about Iran and the fear that America and Israel are on a collision course with the Islamic Republic. Iran’s closeness to the Shia Muslims in Syria worries these Sunni Muslims, who see a Shia Muslim arc running from Iran through Iraq and Syria and into South Lebanon.

Last night, an Arab friend suggested that “all Abu Dhabi has to do is stay out of trouble”, then he quipped: “That is easier said than done.”
But the price of oil isn’t rising just because, geopolitically, this region is once again jittery. The blame for the rise in the oil price can equally be placed closer to home.

I was speaking on a platform on the future of the euro with the former president of the Bundesbank, Axel Weber. Weber, the monetary hawk, was discussing the ECB’s giant ‘cash for trash’ scheme which has seen the ECB lend close to €1,000,000,000,000 to Europe’s banks since December.

One trillion is a very big number. It is followed by 12 zeros. And just to put that into context, if you were to spend a million euros a day, it would take you 2,740 years to spend a trillion euro.

Although Weber was talking about the euro, the ‘cash for trash’ scam explains the price rises in oil at least as much as the tensions down the road from here.
With all this excess money sloshing around, it is not surprising that the price of everything is rising. The banks are borrowing at 1 per cent from the ECB and buying into the oil rally and exacerbated the initial upward movement in prices. Ultimately we, the people, pay for this at the petrol pumps.

The ‘cash for trash’ scheme also explains why the fiscal compact will not make the euro more stable, despite the German and French suggestions that it will. In fact, their fiscal compact obsession simply reinforces the fact that they have totally misdiagnosed the eurozone’s affliction to suit themselves.

After all, if the problem for the eurozone was fiscal in nature, why the ‘cash for trash’ initiative?
The €1 trillion bank subsidy tells us that the problem in Europe is not excessive government borrowing, but excessive bank lending which has destroyed the balance sheets of the banks. This is forcing the ECB to break all its own rules and give the banks anything they want to stay afloat.

Why are they in trouble?
Because they destroyed their own wealth in the boom by lending too much money to dodgy investments – many of which have gone sour.
The crisis is not the cause of the euro’s problems but theconsequence of the euro’s problems.

Weber gave an insight into German thinking. The Germans want German-style federalism as soon as possible and the fiscal compact is another step to that. But the problem in Europe is not government deficits. In fact, government deficits are the consequence of excessive bank lending and excessive current account imbalances.

The problem in Europe is that the rest of Europe can’t keep up with the industrial might of Germany. This causes countries to run trade deficits with Germany. To pay for these German imports, the countries need to borrow money. They borrow this money from Germany and what we see then are huge current account imbalances and huge accumulated debts on the periphery.

Sitting in the middle doing all this lending are the German and French banks – as well as the major banks in all countries. However, because the other countries are borrowing German savings to pay for the German goods that Germany makes but chooses not to buy, German banks are significant lenders.
When this borrowed cash flows into the peripheral countries, the price of everything goes up, including the price of labour. This propels the costs on the periphery upwards, making them less competitive – exacerbating the original competitive imbalance with Germany.

Because the banks see only the very short term, they see a demand for more loans from the periphery and a supply of new savings from the Germans. One side-effect of all this is that governments’ tax revenues expand in the boom. They increase expenditure and then, when the bust happens, the tax revenue collapses and you have a fiscal problem.

But the fiscal problem is the consequence of trade and current account imbalances, not the other way around.
So what the peripheral countries need to do is pay themselves less; the Germans need to pay themselves more.

If we had our own currencies, we would devalue against the Deutschmark and the Deutschmark would revalue against everyone else. This can’t happen now, so actual wages need to fall. But aggregate wages in Ireland have not actually fallen since the bust. Take-home pay has fallen because of increased tax, but wages haven’t generally fallen by much. Obviously trade unions fight against wage cuts for their members, as do constructs like the Croke Park agreement.

Real wages in Ireland – wages adjusted for inflation – haven’t fallen, whereas, for example, real wages in Iceland expressed in euro have fallen because it could devalue. Even in Latvia, where the economy has shrunk, real wages haven’t budged. This shows that wages don’t fall in a recession. The fabled ‘flexibility’ of the Irish labour market is just a horrible expression for unemployment and emigration. Yes, the market adjusts all right; but it adjusts with more people on the dole. Now, with more on the dole, government spending goes up, not down, resulting in a higher deficit.

In the US, when this happens, as it did to the Boston region in the late 1980s, fiscal transfers from the core ease the burden. Bostonians, when they are weak, pay less tax and get more help. That is how a real fiscal union works.
The German fiscal union envisages penalising the weak country precisely at the moment it is weakest. So the weakest must raise taxes in the face of a slump. This is obviously unworkable.

It is all the more unworkable if the ‘cash for trash’ scheme, which is designed to save reckless bankers, is pushing up the cost of living for essentials like oil. Equally, how does reducing individual wages make the individual debt overhang – which is the human face of the current account imbalances – any easier?

So the fiscal contract is not going to make Ireland any more stable. In fact, the ECB’s current policy of monetary incontinence on a monumental scale simply underlines that the euro’s problem is capital flows through the banks, not fiscal deficits. Egregiously, the German and French are wilfully misdiagnosing the illness to suit their own ends, and people like Axel Weber know this.

Fighting current account imbalances with a fiscal compact is like fighting heart disease with chemotherapy.

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