‘Eurozone on the brink’ screams the latest headline. And indeed, as the Eurozone (EZ) lurches from one crisis to the next, the whole structure seems increasingly imperilled by its lack of political cohesion. British Tories may wring their hands in glee, but the demise of the euro cannot but lead to the unravelling of the whole integration project, with disastrous consequences for a unified approach to jobs, growth and the environment.
Let the same British euro-sceptics reflect on two simple facts: first, there is little respect in Europe for the imperious and arrogant British—the image of Nigel Farage’s antics in the European Parliament are not easily effaced.2 Secondly, as much as Britain may criticise the euro’s construction, our own economy is not exactly thriving. Not only is Britain stagnating, but its social infrastructure is crumbling while its wealth and income inequalities are the largest in the region.
But back to Europe—which uniquely for Brits means ‘continental’ Europe. The single most worrisome manifestation of the EZ’s predicament is the near-total marginalisation of the Commission and the Parliament in the context of the crisis. Instead, it is the national politicians—Merkel, Sakozy et al.—who have made all the running. What could be more indicative of a ‘democratic deficit’ than the fact that Europe’s elected MEPs have become invisible!
There is a paradox here. Europe cannot go back to what it was before the crisis, nor can it tread water. But neither can a large EZ economy run by squabbling small-minded politicians from 17 countries thrive. Even George Osborne admits that full fiscal integration is the way forward—‘un gouvernement économique européen’ to use the jargon.
Such a form of governance would need far more powerful political institutions including quite possibly a directly elected President. Equally, the legitimacy of a far more centralised EZ would depend on its delivering—nay, on being seen to deliver—secure jobs, higher incomes and common social services. Take pensions: although a strengthened EZ cannot take over the entire pension system given current productivity differentials, it could deliver a basic citizen’s pension, a payment which would guarantee a subsistence minimum for all its retired citizens financed by an FTT (Robin Hood tax).
The principle is clear: if the EZ is to prosper politically, it must deliver tangible benefits. The young French and Dutch voters who voted against the Constitutional Treaty in 2005 were not generally anti-European; they merely wanted a more social Europe.
Whatever the free-market fundamentalists may say, greater social cohesion/social justice lies at the very heart of the European project. To deliver a genuinely social Europe, a new social contract is needed. Democratic governance is not about national politicians fighting for their narrow interests by drawing red lines, still less about 17 national Parliaments agreeing to each line of some new regulation. It is about a genuinely European political debate over our common interests. Only when this lesson becomes clear to all can we overcome the sort of gridlock we see today.
As the Euro Area (EA) dithers about bailing out Greece in the short term and continues to argue about how to expand the European Financial Stability Facility (EFSF), the sovereign debt crisis is turning into a full-blown banking crisis. Shares in Dexia, the Franco-Belgian banking group, are down 72% on their 52-week high—closely followed by other pillars of western finance such as Bank of America (-66%), RBS (-57%) and Deutsche Bank (-50%).  In effect, financial markets have seen the wiring on the wall and have been pulling out of bank shares—both banks that hold euro sovereign debt assets and those that hold shares in other banks that do. This means that the asset side of banks’ balance sheets are contracting and that insolvency looms.
True, the gloom lightened briefly when both Angela Merkel and EU President J-M Barroso announced they favoured a pan-European recapitalisation programme—causing EU bank shares to rally for a time. Governments are trying to pour cash into the banks—in the UK, Mervin King has announced an extra £75bn of quantitative easing (QE), allegedly to help industry get more and cheaper credit, but in reality to ward off a new credit crunch along the lines of what happened after Lehman’s collapsed in 2008. In his words, we face the ‘worst financial crisis ever’.
However, the recapitalisation of Europe’s banks faces a serious credibility gap. First, Dexia was one of the banks to pass the European Banking Authority’s (EBA) ‘stress tests’ with flying colours. Secondly, one result of these tests was a serious underestimation of the degree of recapitalisation required. In consequence, a new round of tests will be required adding further to delays. Perhaps more importantly, there is growing pressure from investors to make banks ‘mark to market’; ie, report the current market value of their assets. Adoption of such a rule combined with current market volatility would doubtless lead to a large number of banks failing the stress tests.
And of course, the prospect of a Greek default looms larger by the day. The problem is not so much that a Greek default is unaffordable; doubtless, were the country to default on its own, it would take some banks down—starting with its own banks. The real danger is that of contagion. We know that Spain and Italy are ‘too big to fail’, and the markets have already begun to mark down commercial banks with exposure to them, not just in Spain and Italy but in France and even the UK. Whatever one may think about financial markets, their analysts are not fools; what they are telling us is that a Greek default will trigger widespread contagion.
Meanwhile, EA Parliaments dither about just how the EFSF’s limited capital can be stretched to meet the bill. Since the €440bn available cannot be miraculously turned into the €2tn required for ‘shock and awe’ to be sure of succeeding, the latest twist involves turning the EFSF from a lending institution into a insurance company, in effect selling credit default swaps (CDSs) to those most in need of insurance. These would be structured into equity, mezzanine and senior layers just like their Wall Street cousins, thus enabling €440bn to be hugely leveraged.
But as more than one commentator has pointed out, there are several problems here. First, one is using over-leveraged instruments to deal with the problem of over-leverage. Second, there is no ‘lender of the last resort’—if the scheme goes wrong, governments cannot bailout the losers since it is governments who hold the equity tranches. In principle, the ECB could perform this role—but the Germans are resolute in their opposition to the ECB acting as a Central Bank for governments.  For that matter, tiny Slovakia is threatening to upset the EFSF applecart unless collateral is provided for its pledged assistance.
An obvious way out of this nightmare would be to forgive Greece at least half its debt (which the markets believe is in any case unpayable) while further reducing the interest on its loan, lengthening its debt maturity profile and aiding the country to become more competitive. Cynics might say this has been obvious from the start, and that it is now too late. If a European financial crisis does not happen next week, it will occur as part of a disorderly default in December when the pain finally becomes too much for Greeks to bear. It is then that we shall all feel the pain of a full-blown financial crisis, most probably followed by more years of economic recession.
 See D Blanchflower ‘As bankshares tumble ..’ New Statesman, 10 Oct 2011.
 See http://on.ft.com/qi7ZIw
Angela Merkel and Nicholas Sarkozy spent part of Tuesday (16 August) mapping the future of the Euro Area (EA) and apparently came away pleased with their work. The good news is that they want to move towards serious EA economic governance and seemed to have agreed on a Tobin tax as part of the deal. The bad news is that they want all members of the EA-17 to write a ‘balanced budget’ rule into their constitution; ie, to replicate the German ‘debt brake’ (Schuldenbremse) law across the EA. It won’t work.
The reason a generalised balanced budget rule won’t work is simple; it follows from the basic national accounting savings balances. Because (over the business cycle as a whole) the private sector normally runs a savings surplus, a government balance of zero logically entails a current account surplus. While this may hold true for Germany, it cannot be true for all EA countries taken together.
For the EA as a whole, one country’s exports are another’s imports—for some countries (like Germany) to run a surplus, others must run a deficit. This is not an empirical matter but follows logically from national accounting definitions; Merkel and Sarkozy are guilty of a basic fallacy of composition.
There is only one way a ‘balanced budget rule’ might work for the EA as a whole—each EA deficit country would have to run a countervailing surplus with the non-EA world. But there are two problems here. The first, shown in a paper by Whyte, is that there is not enough excess demand in the rest of the world to absorb the extra EA exports. Even if there were, the resulting global trade imbalance would result over time in the EA accumulating excess reserves, much as China today.
Crucially, Mrs Merkel and Mr Sarkozy made no mention of strengthening the ‘bailout fund’ or issuing E-bonds. The latter is vital if short-term crisis is to be avoided.
In a sane world, the German Chancellor and the French President would sack their economic advisors who clearly lack an understanding of basic economics or national accounting principles. Sadly, the world is growing less sane by the day. The financial markets will know this and soon enough return to speculating against member states’ sovereign debt.
 The ‘savings balance’ identity is normally written (I-S) + (T-G) = (X-M) where (I-S) is the ‘private sector balance, (T-G) is the public balance and (X-M) is the current account of the Balance of Payments.
 See Whyte, P (2010) ‘Why Germany is not a model for the Eurozone’ London: Centre for European Reform.
The least one can say is that the EU Ministers meeting in Brussels yesterday (21 July 11) at last took decisions to avert immediate crisis as the Vox EU letter from 13 economists asked. Although it is early days yet, the package seems to have been accepted by the markets. The aim of the exercise was only in part to bail out Greece—chiefly it was meant to halt an attack on Italy and Spain. And it appears to have worked since yields on 10-year bonds in both countries have fallen and the euro has strengthened against the dollar. 
As for the decisions, let’s look at them in turn. The most striking, of course, was the approval of the €109bn Greek bailout subject to the condition that the private banks ‘share the pain’. The Germans have insisted—having brushed aside the objections of the ECB and a variety of (mainly French) counter-proposals—that private banks are to be offered a ‘voluntary’ choice of bond exchanges, buybacks and rollovers. Without going into precise details, because banks don’t generally value their bond assets by ‘marking to market’, this means taking a haircut of 10-15%. The catch is that Greek banks hold the bulk of the bonds—far more than France and Germany combined—so their banks will suffer most. 
The gamble is that even if the credit rating agencies mark down Greek bonds to selective default grade, either the ECB will ‘make an exception’ and continue accepting these bonds as collateral, or else the agencies will immediately rescind their markdown as soon as Greek debt in re-profiled. The meeting did add that there would be no haircuts on any non-Greek bond. Mrs Merkel and her team wanted a warning shot fired across the private banks’ bows about ‘moral hazard’, but the conditions are such that Greece’s selective default seems unlikely to provoke another Lehman moment. 
Will Greece now prosper? Cutting the interest rate on the EU/IMF package to 3.5% and extending the loan, as well as many of the short-maturing term bonds, to 15 years certainly makes the debt more manageable, as does the promise of more structural funds from the budget and the EIB to help kick-start growth. But claiming that this constitutes a ‘Marshall Plan’ is decidedly over-the-top, especially since the country is currently plunged into economic contraction worse than it experienced after the 2008 shock. In the absence of nominal exchange rate adjustment, Greece must continue to apply the wage-cutting ‘internal devaluation’ medicine, a cure which could still kill the patient. Moreover, if the country’s debt-to-GDP ratio is to fall in future, it must grow fast enough to generate a primary budget surplus.
Turning to the wider picture, while the strengthening of the European Financial Stability Facility (EFSF) is to be welcomed—its size will be doubled to €800bn, it will be able to lend pre-emptively anywhere in the Euro Area (EA) and some have even suggested that it will be a European mini-IMF—questions still remain. The most obvious question concerns size. The ESFS needs far more capital to be truly credible, a total of €1.5-2.0tn. It will not get all this from the member-states, implying that sooner or later it will have to borrow on international markets; ie, it will need to issue some form of European euro-bond.
But the most worrying feature of the package is its conditionality. The centre-right German, Dutch and other governments are revising the zombified Stability and Growth Pact (SGP) by passing legislation forcing all other EA countries to return to a 3% general budget ceiling by 2013. As Paul Krugman promptly tweeted—comparing the EU to the US in 1937—budgetary austerity is the last thing Europe needs at the moment.  To add to the pain, the ECB has raised its key interest rate again. Business confidence in the EA has ebbed, with the eurozone PMI falling to its lowest level since 2009. Like Britain, the EA needs reflation, growth and jobs—not prolonged fiscal austerity.
In sum, there is a short term gain—assuming the ‘haircut’ strategy works, a major euro crisis has been averted and a strengthened EFSF (to be made permanent and rechristened the European Stability Mechanism after 2013) is emerging, an embryonic institution strengthening EA economic governance. But if it is to withstand bad weather in countries such as Spain and Italy, it will need far more capital. Europe is still without a central bank that can trade genuinely European bonds and engage in Open Market Operations; it is without a Treasury or a long-term macro vision of how to overcome its trade imbalances. In the medium-to-long term, bigger decisions need to be made to avoid even more serious pain.
 See http://www.voxeu.org/index.php?q=node/6778
 See http://online.wsj.com/article/BT-CO-20110713-705779.html
 See http://www.cnbc.com/id/43850798
 See http://bit.ly/ntPCyX
 The Dutch Central Bank says at least €1.5tn will be needed; see In Traynor, The Guardian 22 Jul 2011; http://bit.ly/qbfvrT
 See http://krugman.blogs.nytimes.com/2011/07/21/1937-1937-1937/
 See Irvin and Izurieta, ‘Fundamental flaws in the European project’ Economic and Political Weekly, http://epw.in/uploads/articles/16386.pdf
It should now be obvious to all that the Greek bailout is not about saving Greece. It is about squeezing the country enough to make sure a number of large EU banks who hold Greek debt (and an even larger number of banks that have lent money to them) don’t go broke.
Until recently, many northern Europeans appeared to believe that Greece had been living beyond its means and therefore needed to tighten their belts—just as most Brits appear still to believe that Britain faces such a fate. But has austerity helped Greece pay its way? Not at all; austerity has only made things worse. Before the crash of 2007-08, Greek GDP was growing at 4.5% per annum. Mainly as a result of the draconian programme of cuts imposed by the EU/IMF last year, Greek GDP has fallen 8.5% since early 2010. Moreover the burden of the cuts has fallen not on the rich (who don’t pay their taxes) but on the poor (who can’t avoid them).
As Martin Wolf recently reported, when last year’s cuts were announced, the spread between German and Greek bonds was about 460 basis points (4.6%). It is now 1460 basic points. In effect, Greece has been locked out of the world’s private financial market. The country’s debt-to-GDP ratio is now 160% and rising.
The Greek Parliament has now effectively approved the latest €28bn austerity package demanded by the EU/IMF in order for them to disburse an extra €12bn in funding which Greece needs to get through the next month without defaulting. But this package is so deeply unpopular that it seems unlikely to be fully implemented. As protesters are now chanting on the streets: “First they robbed us, now they have sold us.” Even if it were fully implemented, the package would merely deepen the Greek recession making it even less likely that the debt-to-GDP ratio will fall.
Nor does the latest French ‘Brady-bond’ proposal really fit the bill? While lengthening the maturity on Greek debt to 20-30 years and establishing a fund to guarantee its repayment may be a good idea in principle, there are several problems with the plan. First, it covers only a relatively small proportion of Greek sovereign debt; secondly, it is unlikely to satisfy the private banks (Deutsche Bank has already criticised it) and, most important, even if accepted ‘voluntarily by the banks, the rating agencies may still consider Greece to be in default.
Is there any way out? Basically, there are two possible paths.
The first scenario is for the EU/IMF to keep pouring money into Greece, in essence buying time for private banks to reduce and write off their debts. Once this is done—and assuming ordinary Greeks will accept being squeezed for several more years—Greece will be allowed to default. The problem here is twofold. First, will the speed with which the ECB, the IMF and the ESF (European Stability Facility, which starts working in 2013) buy up debt be enough to prevent a Greek political meltdown. Remember that if the Papandreou government falls, the opposition leader Mr Samaras has said he will reject EU/IMF conditionality. The second problem is that outright default might lead to Greece leaving the euro. A return to a (rapidly falling) drachma would leave the country facing high inflation, falling real wages, and an even higher debt mountain.
There is another possible outcome—although it would require an astonishing U-turn on the part of the EU/IMF. The alternative is for all or most of Greek sovereign debt to be ‘forgiven’ (it is unpayable anyway); for the German, French (and Greek) banks to be recapitalised; and for Greece to receive enough assistance to bring its social and economic infrastructure up to a level which would help ‘crowd in’ private investment and restore its economy to health. This is the ‘Marshall Plan’ scenario, if you will. Such a plan could be financed by E-bond emission (Mr Juncker’s proposal), by ECB quantitative easing or by a Tobin tax (or some combination of the three); thus, the ‘cost to the European taxpayer’ could be negligible.
I can hear the reader object that pigs are more likely to fly supersonically. But the longer the EU/IMF continues along its current foolish path, the greater the chance of a second major financial catastrophe engulfing not just Greece but much of Europe.
 See Martin Wolf ‘Time for common sense on Greece’ Financial Times, 21 June 2011.
 See P Jenkins and R Milne ‘EU “Brady bonds” plan for Greece’ Financial Times, 27 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/.
Suppose that my rich neighbour down the road mortgaged his mansion up to the hilt to bet on the horses, ran up millions in debt and asked me, an ordinary punter, to pay off his debts plus interest. Suppose that foolishly I accepted, and while I struggled to pay it off while barely able to feed my family and pay off the mortgage, my super-rich neighbour acquired an even bigger mansion. To make matters worse, he used all sorts of clever dodges in the Caymans to pay negligible taxes, while if I failed to pay mine I knew I’d be sent to prison.
It may sound like total madness, but that’s pretty well what’s happening to a growing number of Europeans (including Brits) today.
How did we get here? In Britain, the 2008 credit crunch produced a massive recession which played havoc with government finances. In Ireland the government took over the entire debt of its banking system, while in Greece, the rich paid minimal taxes and successive governments, unwilling to challenge them, indulged in creative accounting. That’s somewhat simplified, but it’s the essence of the story.
Everywhere in Europe, voters are being told that decent pensions and universal welfare provision are no longer affordable and that we must all tighten our belts. Governments can no longer borrow because the credit rating agencies might downgrade their bonds. First it was Greece and Ireland, today it is Portugal, and tomorrow perhaps Spain, then Italy, and then … who knows?
But ordinary punters are starting to wake up. Instead of enduring years of economic depression, the Greeks and the Irish will probably have to default, as will the Portuguese if their economy reacts the same way to belt-tightening. And what if Spain has to be bailed out, still less defaults? That would spell a major hit for banks in Germany, France, the UK (and elsewhere), all of which could easily add up to another major financial crisis.
Are we really so vulnerable? The answer is indeed yes—-because so little has been done to address the underlying causes of the 2008 crisis.
While the recent Basle Three agreement requires banks to carry a slightly higher cash cushion, nothing has been done to re-establish the division between investment banking and commercial high-street banking, a division which disappeared with the repeal in the US of Glass–Steagall in 1999. Except for a temporary ban on naked short sales in Germany, the derivatives trade remains mainly unregulated. Credit default swaps (a form of insurance on risky financial products) are still sold over-the-counter rather than through an official market, the US President having failed to follow up his 2009 promise to re-regulate these.
Meanwhile, the trillions poured into the big banks since 2008, instead of going to cash-starved small business or being used to build infrastructure and to create jobs, have largely helped fuel a new stock market bubble. The extraordinary rise in the value of companies such as Facebook and Zynga provides a worrying parallel with the dotcom bubble of 2000.
Tax dodging is now a major growth industry—witness the latest GE scandal. As for making the bankers pay by introducing some form of Tobin tax, there’s been much talk but little action.
Perhaps most galling of all is the injustice of using Keynesian economics to justify the need for state intervention in banking bailouts while claiming today that the profligate state caused the problem, as politicians now argue in London, Brussels and Frankfurt. How long will sensible people go on accepting this nonsense before venting their anger on our ruling classes?
(An earlier version of this piece first appeared at http://www.social-europe.eu/2011/04/the-big-bailout-scam)
5 See Ha-Joon Chang, ‘The revival—and the retreat—of the state?’ Red Pepper, Apr/May 2011.
The question mark in the title is not there for Orwellian irony, but simply to express my own genuine confusion about this contradictory war. After all, had Gaddafi’s army had a free hand in Benghazi, who doubts that it would have slaughtered thousands? Does anybody think this ‘leader’ is anything other than a rogue, in Robert Fisk’s words ‘completely bonkers, flaky, a crackpot on the level of Ahmadinejad of Iran and Lieberman of Israel’.
Nevertheless, however crackpot and dangerous Gaddafi may be, there are some compelling reasons for opposing this war—or at least for treating the ‘coalition’s’ stated aims with the utmost scepticism. First, there is the sheer hypocrisy of the US, Britain and France (plus a few hangers-on) speaking of ‘protecting civilians’. In the past two decades, hundreds of thousands and possibly a million civilians have died as a result of the imposition of no-fly zones and/or outright invasion to secure western interests, Iraq and Afghanistan being the most obvious examples. Did anybody call for a no-fly zone in Gaza when the Israelis were using white phosphorous bombs against the Palestinians? At the moment, civilians are dying daily in Yemen and Bahrain, in the latter using military equipment from the Saudi monarchy supplied by the coalition. That any Westrern politician could publicly back the war without pointing out this contradiction is itself an assault on the humanitarian values we purport to uphold.
Next are the practical arguments, already amply covered in the press. What exactly is the aim of this operation? Clearly it cannot be merely to ‘protect civilians’ since, as long as Gaddafi remains in power, opposition civilians will remain at risk. So either the country must be permanently divided—which nobody either in Libya or the West wants—or else Gaddafi must be taken out. Despite repeated denials, that was obviously the US intent in hitting his bunker.  But it is doubtful that the Libyan leader, having gathered a human shield to protect it, was anywhere near when the Americans struck.
Given the size of the country, even the most sophisticated aerial intelligence cannot be sure of his whereabouts. Large numbers of ‘boots of the ground’ are necessary for this kind of work. As much as the coalition would like to see it happen, it seems unlikely that the Libyan opposition can quickly capture Tripoli to achieve this end given that, even in the wake of the French air strike, they have been unable to push loyalist forces fully out of nearby Adjabiya. With the exception of some defecting units of Gaddafi’s army, the opposition has little military training. In sum, one can expect the dirty work to be done by a battalion or two of coalition ‘special forces’ operating under a suitable PR guise.
Let’s assume for convenience that Gaddafi is killed quickly (which would be advantageous for all concerned). As Patrick Cockburn argues, what then? In the absence of a politically coherent opposition with a wide popular base—which in a largely tribal country is difficult to form even under the most favourable conditions—-the coalition will end up occupying Libya to ‘maintain stability’, just as has been the case in Iraq and Afghanistan. Don’t expect the coalition to allow the country to spiral downwards into Somali-style anarchy, not where oil and a strategic geographical position are at stake.
To paraphrase Cockburn, Yasmin Alibhia-Brown, Robert Fisk and other journalists who know the region, it will not take long for the coalition’s Libyan operation to be seen across the Middle East as hypocritical and self-serving, and resisted as such.
However circumspect Mervyn King may have been about raising interest rates in the Bank of England’s (BoE) quarterly inflation report issued in February, it is clear that the City wants him to do so. Indeed, judging from the fact that 12-month interest rate futures are now 1.4%, it is generally thought that there will be three to four quarter-point hikes over the next twelve months, while over the coming two years the rise may be twice that figure. One must ask, first of all, is such a rise justified by inflation; and secondly, if not, what damage will raising UK interest rates do?
The proximate cause of the problem is that the Retail Price Index (RPI) has jumped to just over 5% in the UK, mainly reflecting rising world food and energy prices, but also the effect of a sterling devaluation of over 20% in 2008 working its way through the economy as well as January’s VAT rise. Even the Consumer Price Index (CPI), which strips out housing costs, is rising at a rate of 4%, twice the BoE’s 2% target.
Of course, stripping out food and energy, core inflation is well below the BoE’s target, but inflation hawks would argue that several other factors must be taken into consideration. First, inflation is rising not just in the UK but in the US and the core Eurozone countries such as Germany and France, in part reflecting strong inflationary pressures in countries such as China and Brazil. Secondly, UK firms may be raising prices to recoup the profits lost during the credit squeeze, or even in anticipation of lower future profits. Finally, the fact that the recession has pulled down UK trend growth means that the weight of the structural deficit is all the greater; ie, a return to (lower) trend growth would leave a larger proportional gap between public spending and receipts than would have been the case before the recession. On this view, the larger the structural deficit, the higher are domestic inflationary expectations.
The counter-argument goes roughly as follows. First of all, the main domestic culprits—devaluation and the VAT rise—are once-and-for-all events, so their inflationary impact can be expected to decline over time. Secondly, with regard to the key imported components, mainly food and energy, it is not so much a case of gradual price inflation; rather, these prices have exhibited strong fluctuations. Energy prices peaked in 2008, then fell and have now risen again; there is every reason to believe that they will fall again. And even if imported inflation continues to rise, raising domestic interest rates will not seriously arrest this rise. Thirdly, there is no sign of wage inflation in the UK economy—indeed, with unemployment at 2.5 million and rising, real wages are falling. Moreover, with the bulk of government spending cuts still in the pipeline, unemployment will rise (and real wages fall) further. This being the case, ‘inflationary expectations’ are groundless. As one academic colleague put it, ‘there has been no Phillips curve [expectations augmented or otherwise] in the UK for a generation’.
Little wonder then that Mervyn King is being circumspect about raising interest rates when the prospects for UK growth are so poor and their impact on inflation is likely to be negligible. Nevertheless, it is equally clear that George Osborne wants higher rates and that the MPC, which has been dovish on the matter, is now split and edging towards hawkishness. Such hawkishness will come at a cost. In the words of one commentator:
‘charts in the Inflation Report suggest the Bank now believes the UK economy must grow by about 0.25 percentage points less than it thought in November to avoid sparking inflation. That is a loss to economic output which accumulates by roughly an additional £4bn every year, making fiscal consolidation even more difficult.’
Indeed, such a loss would come on top of the cuts. A recent report by the IMF suggests that, even if interest rates remain near zero, public sector cuts equivalent to 1.5% of GDP per annum over the next four years will subtract an equivalent amount from growth, or about £20bn every year.
According to the IFS ‘green budget’, between 2010 and 2015, the UK is forecast to have the third largest reduction (behind Ireland and Iceland) in the share of government borrowing in national income among 29 high-income countries. As Martin Wolf has noted, using the OBR’s latest figures, the implicit (compound) rate of growth of GDP between 2007 and 2015 is just 1.2% per annum. And if interest rates rise in response to a perceived inflationary threat, the growth rate will be even less.
In a word, Britain under the Tory-led government faces years of not merely stagnation, but quite possibly of something worse: stagflation. Perhaps Monsieur Trichet at the ECB should be pondering the lesson for the Eurozone.
*diagram source: N Cohen, ‘King denies interest rate rise certainty’ FT, 16 Feb. 2011
1 In private correspondence with Martin Hoskins.
2 David Blanchflower is more optimistic and believes the MPC will remain dovish; see http://www.newstatesman.com/blogs/david-blanchflower/2011/02/mervyn-king-growth-inflation
3 See C Giles, ‘Slower growth seen as inflation buster’, FT, 16 Feb 2011; http://www.ft.com/cms/s/0/3279a6ee-3a0c-11e0-a441-00144feabdc0.html#axzz1EDbJnmWK
4 See Duncan Weldon ‘The danger of spending cuts: some advice from the IMF’; http://duncanseconomicblog.wordpress.com/2011/02/15/the-dangers-of-spending-cuts-some-advice-from-the-imf/
5 See http://www.ifs.org.uk/publications/5460.
6 See M Wolf, ‘Britain’s experiment in austerity’ FT, 8 Feb 2011; http://www.ft.com/cms/s/0/5e5a6d1e-33c9-11e0b1ed-00144feabdc0.html#axzz1EDbJnmWK