Archive for June, 2011
Despite Wimbledon week, the main centre court contest that many economists are watching is that between the German government and the ECB. An abbreviated summary of the action so far is as follows. The German Finance Minister, Herr Schäuble, initially appeared to gain the advantage by admitting that the Greek situation is so perilous that they should be allowed in effect to default—the phrase he used was ‘voluntary restructuring’. Monsieur Trichet then fought back hard arguing that a Greek default would be catastrophic and implying that eurozone governments (not the ECB) should continue lending. The ECB even threatened to stop accepting Greek Eurobonds as collateral for its continued lending to the Greek central bank, a move that would effectively pull the plug on the Greek banking system. Who will prevail?
On the face of it, Herr Schäuble has a strong case, albeit rendered more palatable to his critics by such sweeteners as having Greece sell off public assets, voluntarily ‘reprofile’ its sovereign debt and so forth. The real case for default, though, is that the retrenchment medicine is not working and risks killing the patient. Instead of extracting a vengeful levy entirely from ordinary Greeks, German and French banks should be made to pay their fair share—a ‘haircut’ variously estimated as between 35% and 70% of the bonds they hold. Indeed, given the dramatic turn of events in Athens in recent days, default now looks almost certain.
But here is the rub. A default—however sugar-coated—is still a default. The ECB argument is that if Greece is allowed to do so, other highly indebted members will follow suit and, as contagion spreads, the markets will cease buying members’ sovereign debt altogether. The ECB would be left to bail out not just the small peripheral economies, but probably Spain and Italy too. That would spell the end of the euro. That is partly why Jean-Claude Trichet will be replaced in October by another tough conservative, Italy’s Mario Draghi who famously prefaced an interview with the Financial Times by the phrase “The euro is not in question.”
On the face of it, then, the first set of the match will almost certainly end in a nail-biting tie break. But whoever wins, the match will be far from over. To borrow Wolfgang Münchau’s phrase, the existing union is too weak to function properly, but too strong to blow up. Assuming the eurozone does not blow up, how might it be strengthened?
The central pillar of a new economic architecture for the eurozone would be the creation of a Treasury Secretary with a secretariat; ie, an embryonic Eurozone Treasury (Ministry of Finance). Indeed, the idea was floated earlier in June by Monsieur Trichet himself who added that such a Ministry would also carry out “all the typical responsibilities of the executive branches as regards the union’s integrated financial sector, so as to accompany the full integration of financial services, and third, the representation of the union confederation in international financial institutions.”. The key points to retain are, first, that such a Ministry would have real power (ie, it could override national bickering in the Council); and secondly, that the Eurozone would have a single banking system.
Another pillar would be fiscal-financial. Like its US counterpart, a Eurozone Treasury would need to be able to emit E-bonds jointly guaranteed by all members. Not only would this enable the eurozone to supersede the now-discredited system of relying on national Eurobonds, it would greatly strengthen the euro as a reserve currency since euro-assets would be far more desirable (and available) to hold. Additionally, a Euro-Treasury might start by improved ‘co-ordination’ of member-states’ fiscal policy, but it would soon need to raise significant amounts of revenue. A useful mechanism would be to follow up on a suggestion by Spain a decade ago that a tax on member-states (ie, a share of their VAT receipts) be levied progressively in proportion to their per capita income.
The third pillar would be political. The eurozone cannot survive unless its citizens benefit from its existence. And here is where serious political courage is needed—the courage to set up a Eurozone unemployment benefit scheme, and/or for that matter, a Eurozone pension scheme. Initially such schemes would complement the national schemes already in place, but as they grew in size, they would come to play the same macroeconomic stabilisation and redistributive functions as the US Treasury.
How do these proposals relate to the current contest between the Germans and the ECB? The answer is straightforward. Although the Greeks, the Irish and other countries at risk will doubtless be offered further loans, at the end of the day what we are witnessing is a slow-motion default. Why? Because ‘internal devaluation’ and the fiscal straightjacket imposed upon the weakest members means they can never repay. Ultimately, Germany, France et al will have to bail out their own banks. If slow-motion default leads to another major financial crisis, we shall all pay.
In truth, Eurozone member-states already live in a ‘transfer union’, and the sooner members realise it and adopt a common macro-economic framework, the better. The practical details may take a long time, but one thing is certain: the gruelling match on centre-court is far from over.
 See ‘Interview with Mario Draghi: Action on the addicts’ http://www.ft.com/cms/s/0/af24be36-03ca-11e0-8c3f-00144feabdc0.html#ixzz1PAShPhkq
 See Wolfgang Münchau ‘Ingredients of a European political union’ Financial Times, June 5 2011.
Five years ago I wrote a book supporting the euro, but saying inter alia that Eurozone governance was fatally flawed and that a European Treasury was needed. Although not taken very seriously at the time, this view has today gained wide currency. Like it or not, a US-style Treasury is needed to guarantee states’ financial system and to effect fiscal transfers within the Eurozone. Yes, the Eurozone is a ‘transfer union’ and the sooner the rich countries face up to this reality the better. The alternative could be collapse of the euro, followed by financial chaos.
Intra Euro debt: Claims between national central banks (£bn)
source: M Wolf, ‘Intolerable choices for the Eurozone’ FT, 31 May 2011.
In a series of excellent pieces in the Financial Times, Martin Wolf has spelled out a compelling case for fundamental reform. The eurozone, Wolf reminds us, started life as a reincarnation of the gold standard. Eurozone member states were meant to finance a trade deficit by borrowing abroad; ie, by emitting their own central bank bonds. If markets were unwilling to buy these, a member-state would have no option but to find the money internally by means of a squeezing labour costs, or what is euphemistically termed ‘internal devaluation’.
There are two problems here. One is that squeezing wages may have an unacceptably high political cost. While it is true that cutting aggregate demand sufficiently will balance the books at some (very much) lower level of national income, the patient may stop breathing as a result. (For example, Ireland has now experienced four years of recession and the young are emigrating in droves.)
The second problem is the banking system. Since private credit died up after 2008, the ECB (and the Bundesbank) have acted de facto as the Eurozone’s lender of the last resort, both in buying the sovereign debt of the periphery’s Central Banks and helping Europe’s large private banks to do so. Indeed, the accompanying figure illustrates the unnerving symmetry between Germany’s position as chief central bank creditor and the growing indebtedness of the Eurozone periphery—unnerving because the Germans are indirectly financing the periphery through the banking system rather than through explicit fiscal transfers. Although this has helped peripheral states to weather the storm, what happens if peripheral countries default?
Many commentators (including myself) believe that some form of default is now inevitable—but default could have dire consequences too. The insolvency of periphery governments would almost certainly threaten the solvency of debtor country central banks, leading to large losses for creditor country central banks (eg, Germany), which national taxpayers would need to shoulder. Doubtless this is a major reason for Signor Smaghi’s implacable opposition to default. And in the absence of support from the ECB and other creditor central banks, the threat of default by Greece or Ireland would hasten contagion and paralysis. Banks would not want to rink continued lending to any potential defaulter, credit would seize up and, ultimately, the existing financial transfer mechanism would collapse.
The options for the eurozone are narrowing. Either default will result in weaker countries leaving the eurozone—a lengthening list as contagion and financial collapse spreads—or the eurozone must undergo radical reform. This means tearing up the current system under which Greece and its banking system depend on selling sovereign bonds to the market and establishing in its place a Eurozone Treasury which would, like its US counterpart, guarantee the integrity of the Eurozone’s financial system as a whole. Needless to say, other key reforms would be necessary (true e-bonds, smaller trade imbalances) which I shall not dwell on here.
All this boils down to a single basic point: Europe already has a central bank ‘transfer union’, but it is under growing threat. Either Europeans bite the bullet and accept the need for true fiscal union and economic governance, or they can stand aside and watch the Eurozone disintegrate. Just as in the case of climate change, it’s too late to think that we can merely wish for the best and ‘muddle through’.
1 See George Irvin, Regaining Europe; an economic agenda for the 21st century, London: Federal Trust, 2007.
3 See http://ftalphaville.ft.com/blog/2011/05/10/564346/roubinis-guide-to-a-greek-debt-restructuring/.