Posts Tagged Federal Europe
François Hollande’s Prime Minister, Jean-Marc Ayrault, claims the new budget (unveiled on 28 September) is ‘fair, economically efficient and allows France to meet its priorities’. In the carefully chosen words of the Guardian’s economics editor, Larry Elliott, the claim is ‘total moonshine’!
It is true that more than half the €37bn in planned budgetary savings is designed to come from increased taxes on rich households and large companies whilst—in contrast to Britain—cuts in government expenditure spare the poor and the elderly. Particularly welcome is the new 75% tax band for those earning over €1nm a year. But whatever gloss one puts on it, the budget is about reducing the deficit from the current 4.5% to 3% new year—and to near zero by 2017. With the French economy stagnating over the past 9 months and persistent unemployment of 10% or more for over a decade, budgetary austerity—however achieved—is most definitely not the answer.
The success of this budget depends on two key assumptions. The first is that greater budget discipline will bring a return to private sector growth, or to use Paul Krugman’s expression, greater discipline will inspire the ‘confidence fairy’. Thus, the growth rate in 2013 is assumed to be 0.8% rising to 2% annually for the period 2014-2017. But elsewhere in Eurozone austerity is resulting in growing unemployment and stagnation. And a stagnating economy causes budget deficits to widen. For France to reach even the above modest growth target and to reduce its deficit, a strongly reflationary budget would be needed, particularly under conditions of generalised austerity throughout Europe.
Secondly, Monsieur Hollande’s Prime Minister claims that reducing the budget deficit will enable France to retain the confidence of financial markets and therefore to enjoy continued access to cheap credit. This too is nonsense. Throughout Europe, young people are increasingly angry about unemployment and growing job insecurity. As the French economy continues to stagnate, scenes now seen in the streets of Athens and Madrid will spread to Paris. Financial markets may be impressed by austerity in the short term, but in the longer term nothing rattles financial markets more than political unrest. An austerity budget today sets France firmly on the road to unrest in the coming years.
Why then has Monsieur Hollande reneged on his election promise to reject austerity? Why indeed is France going to ratify a so-called Budgetary Pact (TSGC: Traite sur la stabilité, la gouvernance et la coordination) which entrenches the Golden Rule of eventually reducing the annual structural deficit to zero. Some economists of the PS (Parti Socialiste) know perfectly well that such a rule is not merely illogical, but adopting it means abandoning discretionary fiscal policy altogether (having already ceded monetary policy to the ECB.) The pact has already created much discord in the PS and its governing allies; eg, Europe-Ecologie-les-Verts (EE-LV) voted against it in late September, resulting in the departure of the MEP Daniel Cohn-Bendit.
The answer is as simple as it is perplexing. François Hollande wishes to please the Germans. He wishes to please not just Frau Merkel—whose coalition will collapse next year—but the German social-democrats (SPD) whose economic beliefs are not so different from those of Merkel’s CDU. Crucially, Hollande’s argument is that if France is to retain its leading role within Europe and the Eurozone, in the short term it cannot afford to anger either the financial markets (and follow Italy and Spain into spiralling borrowing costs and insolvency) or the northern European austerians.
What is perplexing is that the combination of an austerity budget today and the Budgetary Pact (TSGC) tomorrow ultimately condemns France to long-term economic stagnation. This in itself will kill Monsieur Hollande’s European aspirations. Ironically, some of today’s socialist ministers who in 2005 voted against the EU Constitutional Treaty (eg, Bernard Cazeneuve and Laurent Fabius) now support the TSGC. Indeed, Elizabeth Guigou (Minister in the 2003 Jospin government), who is on record as strongly opposing the Pact, is now willing to vote for it. The so-called ‘sovereignty problem’, much discussed by both the left and right in France, is in reality a red herring.
The fundamental issue is about economics. Unless the left of the French socialists forces a change of course, the PS and the centre-left in France will ultimately suffer grave damage. What is need is not austerity, but a massive stimulus to get France—and more generally the EZ—moving again.
Sadly, throughout Europe, the timidity of the social-democratic response to the economic crisis is resulting in unemployment and disillusion of a scale which threatens to destroy social democracy within a generation.
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/.
Let me make it clear that I strongly support the euro; I’m a Brit who believes in European integration and who has little time for Euro-sceptics. But I can also see the writing on the wall. The euro—and with it the whole EU integration project—is in grave danger. It is entirely possible that in five years’ time, travelling from Paris to Berlin and thence to Madrid or Rome will entail queuing to change money and struggling through customs posts once again.
Why should the euro be in danger? After all, the Eurozone taken together is in quite good shape, considering the fact that we’ve been though the worst recession since the 1930s. The 16 euro-states’ budget deficit in 2010 as a percentage of GDP is 6.9% (versus 10.2% for the USA); the ratio of public debt to GDP is 84%, far lower than the US figure of 94%. So what’s the problem?
The problem is the peculiar architecture of economic governance. Since tax receipts fall and spending rises in a recession, government deficits necessarily swell and must be financed by borrowing. Because the Eurozone has no federal treasury and cannot emit federal bonds, smaller member states whose domestic bond markets are too narrow must go to the international market to sell their own Eurobonds.
In normal times, member-states’ government bonds are considered a safe bet by the market. But as past financial crises show clearly, bond markets tend to be driven by the herd instinct; ie, once the rumour circulates that one country’s bonds are at risk, everyone joins in. This is commonly known as ‘contagion’, and there’s lots of it about today. Witness the fact that not just Greece, Ireland, Portugal and Spain are under threat, but in the past week Belgium and Italy have been added to the list.
The joint European/IMF bailout plan agreed earlier this year provided some €750bn (€860bn if Greece is included) in potential relief to afflicted countries—with plenty of nasty strings attached, one must add. The plan covers the period 2010-14, but the combined borrowing requirement over 2011-14 of Italy, Spain, Portugal, Greece and Ireland totals nearly €650bn and is growing. Add to this Belgium’s public debt of about €350bn, and the total is €1tr, far larger than the bailout package. The size of the package is unlikely to increase because of political resistance and possible required changes to the Lisbon treaty; per contra, what is likely to increase is the troubled states’ borrowing requirements. The financial markets have already done their sums, the main reason they are betting against the longer-term success of the rescue.
What are the options? First, Chancellor Merkel and President Sarkozy recently agreed on a sovereign debt default mechanism for troubled Eurozone countries thus forcing bondholders to share the bailout pain. Doubtless such a scheme will appeal to taxpayers and sacked public-sector workers alike, but as Paul De Grauwe has noted forcefully, legitimating sovereign debt restructuring makes speculative runs more likely, not less so; ie, the new mechanism increases potential turbulence.
Of course, it is not just the troubled states that are being rescued; it is the major banks holding troubled Eurobonds that are in danger. Everybody knows—except apparently the German electorate—that when Germany ‘bails out’ Greece, the main beneficiaries are German banks (just as the main beneficiary of the recent UK ‘bailout’ for Ireland will be RBS). As ever, these are deemed to be ‘too big to fail’. To ensure their solvency, the European Central Bank (ECB) has been lending them money at a typical rate of 1 percent, money which is then on-lent to Greece or whomever in the form of bond purchases yielding 5 percent or more.
The problem here (quite apart from the big commercial banks making huge profits) is that the resources of the ECB are finite. It simply cannot conjure up another trillion euros if required. Of course it could do so by engaging in Quantitative Easing (QE)—a form of monetisation—but politicians think this will lead to inflation.
And here lies another trap. Although core inflation in the Eurozone remains very low, once energy and food are added back into the measure the rate goes up. In the next few years, food and energy inflation (both largely imported) are likely to accelerate. And if the ECB prints money, politicians—most of whom still believe in the simple ‘quantity theory of money’—will take the blame.
Finally, there is the fundamentalist solution preached by the deficit hawks: make all the ClubMed countries (including those not bordering the Mediterranean) cut their spending and balance their budgets! But there are two problems here. First, budget balancing might be feasible for one country when the world economy is buoyant, but in a world where the OECD economies are stagnating, asking many countries to balance their budget is not feasible. As a recent IMF study shows, ‘expansionary fiscal contraction’ is not the answer.
So what is the answer? The answer is twofold: first, the ECB, not member states, should be able to issue Eurobonds, an idea which has recently gained limited traction. Secondly and more important, in the long term there must be a Eurozone Federal Treasury, akin to the US Federal Treasury. As the President of the ECB, Jean-Claude Trichet, said in the summer “Nous sommes une fédération monetaire. Nous avons maintenant besoin l’équivalent d’une fédération budgetaire” (Le Monde, June 1st). He repeated this warning to a European Parliamentary Committee on 30 November.
To date, Europe’s political class has been unwilling to listen. They argue, inter alia, that Germany’ constitutional court would never cede fiscal sovereignty. Indeed, the tradeoff between monetary and fiscal sovereignty was at the heart of the Maastricht Compromise of 1992. It is most certainly not in Germany’s interest to allow the euro to flounder. Let’s hope Europhiles wake up before it’s too late.
 See FT Alphaville 23 Nov 2010; http://optionalpha.com/european-national-debt-2010-as-a-percentage-of-gdp-9001.html
 See P De Grauwe ‘A mechanism of self-destruction in the Eurozone’ 9 November 21010; http://www.ceps.eu/book/mechanism-self-destruction-eurozone
 See http://www.social-europe.eu/2010/11/expansionary-fiscal-contraction-and-the-emperor%E2%80%99s-clothes/
 See G. Montani, ‘European Economic Governance and fiscal sovereignty’; http://www.thenewfederalist.eu/European-Economic-Government-and-Fiscal-Sovereignty
I’ve had a number of posts on my blog about my piece on Merkelomics. I shall ignore the one which says ‘all debt is bad’: has the person in question has ever had a mortgage?
Let me take the more serious point made by one commentator (Commentator ‘A’) who clearly wants to Eurozone to succeed—a sentiment I share fully. ‘A’ says: ‘I believe the fault in your analysis is that you don’t see the Eurozone as a national economy in the making. If you were, you would’ve realised that it doesn’t matter whether Eurozone exports originate in Germany or some other Eurozone country.’
My reply? I do indeed wish that the Eurozone were a national economy in the making and that I could praise the Germans for their export-led growth model. That German industry is admirably efficient I have no doubt (far more so than the UK). But perhaps I can best explain the case for Eurozone reform in the following manner. Below is a short ‘thought experiment’.
Let us assume—you can tell I’m an economist—that the contemporary USA were like the Eurozone, that there was little labour mobility, no Federal Treasury, that Congress was weak and that power lay almost entirely with the individual states (as indeed it did in the late 18th century). Let us further assume that because there was no Treasury but only a Central Bank, there was no federal borrowing and that individual states had to finance themselves through taxation and state bond issues.
In such a world, the ‘rating agencies’ would look at the trade statistics of the various US states. Suppose that most US state-level trade was with other states (which it is) and that Michigan and Ohio (which produced mainly manufactures) had enormous trade surpluses while the relatively poor states of Louisiana and Mississippi (which produced mainly fish) ran persistent trade deficits. (Remember, this story is allegorical.)
Ohio and Louisiana might initially both have AAA+ ratings, but because Louisiana was dirt poor and suddenly was struck by a hurricane causing coastal devastation, its economy became a basket case and its tax receipts collapsed. In consequence, the rating agencies downgraded Louisiana’s dollar bonds, making it nearly impossible for the state to borrow. Nor could Louisiana export its way out of trouble because, as part of the dollar zone, it could not devalue. Drastic cuts (internal depreciation) would make it even poorer and more likely to default.
So Louisiana—-together with Alabama and Mississippi— needed help from richer states like Ohio and Michigan. But Ohio, Michigan and various other ‘northern states’ were not without internal problems, and their citizens were reluctant to help the ‘lazy and feckless southerners’. Nor would they let the Central Bank buy the bonds issued by these poorer states … until a major crisis occurred.
I leave the reader to finish the story. Needless to say, the crucial point is that the USA is not in the above situation because it has the economic institutions necessary for operating a federal economy.
At least the USA had Alexander Hamilton and James Madison to shape its structure—today, Europe has Angela Merkel and Nicolas Sarkozy. I’m not optimistic.