Posts Tagged Germany
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.
Nouriel Roubini famously described the long decline of the euro as a ‘slow motion train wreck’. Mind you, economists disagree on exactly when the wreck will happen. Professor Vincente Nabarro has argued that the euro will survive for as long as it serves the purposes of the German (and European) elite while, in the Financial Times, Wolfgang Münchau mischievously suggests the crisis could last another 20 years given Germany’s proclivity for muddling through. By contrast, Megan Green at RGE sees the confluence of crises in Greece, Spain, and Italy during September and October, 2012, as potentially lethal. But all agree that—sooner or later—it will happen.
In Greece, the coalition government will have to agree a package of measures with the troika to secure the latest tranche of bailout money. The problem is twofold: first, Mr Samaras has asked for an extra two years to impose further austerity measures required by the troika, a request which the Germans have already rejected. Secondly, the Greek Parliament must approve the measures, failing which another general election would almost certainly need to be called.
Even if one assumes that Greeks can be paper over their differences once again (or else that Greek default does not produce catastrophic contagion), Portugal is likely to remain locked out of the financial markets and thus forced into a second round of difficult negotiations with the troika. Because the ESM comes into existence in September—assuming the Germans Constitutional Court rules in its favour—Spain too will require negotiations with the new body both on bailing out its private banks and on sovereign bond purchases.
Elsewhere, the campaign in Italy for the April 2013 general election will begin in earnest and Mr Berlusconi can be expected to launch his political comeback on an anti-euro platform, having said quite plainly earlier this year that either Italy gets bailed out or it leaves the EZ. However one views Berlusconi, there should be no doubt about the seriousness of this threat. In September too, France’s President Hollande will advance a budget which is bound to be controversial, while at the same time the Dutch will hold a general election likely to lead to a euro-sceptic coalition.
The situation might not be so dangerous were it not for growing euro-scepticism in Germany. While a majority of Germans may still favour remaining in the euro, over a third of those questioned favour a return to the old currency, the highest percentage in the large EZ countries. Public opinion, moreover, is strongly against what is perceived as further German ‘aid’ to the Club-Med countries (which is reality is ‘aid’ to their own banking system). Spurred by such neo-liberal economists as Hans-Werner Sinn, centre-right German politicians continue to insist that: (a) neither commonly backed Eurobonds nor bank insurance are an option; (b) further ECB sovereign bond purchases are dangerous, and (c) there can be no bank recapitalisation without EZ banking union, and such banking union must be preceded by political union.
But the strong EZ banking union required is not what the German centre-right has in mind, and even were it to accede on this point, German actions (and inactions) to date mean that the chance of achieving political union is growing ever more remote. Nor can we expect much to change were the SPD to enter into a new grand coalition in late 2013. After all, it was the previous SPD-CDU coalition which embedded austerity into the German constitution in the form of the debt-brake law, and the then SPD Finance Minister Peer Steinbrük—now a strong candidate to lead the party into the 2013 election—famously dismissed the Keynesian notion of a pan-European economic stimulus package. Moreover, the ex-central banker, Thilo Sarazzin , whose 2012 book Europa braucht den Euro nicht (Europe doesn’t need the euro) has been a best-seller, is a well-known SPD member.
Without a fundamental shift in the German position—not just on the above issues but on domestic demand reflation and trade imbalances–the euro seems doomed. Since there is no sign of such a shift, Europe sits on its hands awaiting the inevitable economic shock. One source has put the cost to Germany in the first year alone as a 10 per cent collapse in GDP. Perhaps this is the sort of price which, sooner or later, all of us will pay as a result of accepting the deep flaws in the initial structure of the common currency.
While the punters speculate on the outcome of the Greek election on 17 June, in truth ‘Grexit’ is already happening. Because of massive withdrawals from the Greek banking system, the country is on emergency life support from the ECB. First, following the inconclusive May elections, the ‘troika’ decided that it would postpone the €48bn recapitalisation payment until after the June election. Then, a fortnight ago, the ECB stopped accepting collateral from the Central Bank of Greece (BoG) for several of Greece’s major banks. This collateral is required for weekly refinance operations required to keep the country’s private banks liquid.
In consequence, the central bank has had to seek €100bn from the ECB’s Emergency Liquidity Assistance (ELA), whih is slowly being chanelled to four major private banks. The difference between money received through the ‘normal’ ECB refinancing channel and the ELA is that, in the former case, the loan from the BoG to the private Greek banks is guaranteed by all ECB members while in the latter case it is guaranteed by the Greek state. In the words of one commentator, ‘think of what this means about keeping your money in your local bank?’ Or in the words of another:
“Essentially, ELA represents the ECB passing the risk back to the sovereign. That could be the trigger for potential default … ”
Some think that Greece’s departure may be a good thing. The arguments are familiar enough: first, Merkel and her allies want Greece out ‘pour encourager les autres’. Secondly, a numbrer of prominent economists (eg, Nouriel Roubini) believe Greece will benefit from leaving now rather than later. With Greece gone, a deal can probably be done between Merkel and Hollande over Eurobonds or (minimally at least) ‘project bonds’. The latter would be construed as a victory for the anti-austerity camp. Until recently, that is certainly what I had thought.
As Martin Wolf and others have noted, Greece’s disorderly departure will in all likelihood shatter faith in the Eurozone forever. Given the slow motion bank run in Spain, a Greek bank run will almost certainly trigger massive flight from the single currency. We shall not return to the comfortable prosperity of post-war Europe soon or even later—in all probability, that world has now died.
At the moment, the Euro Area is stagnating, unemployment is rising and the entire banking system is dangerously fragile—in Nouriel Roubini’s phrase, we are watching a slow motion train wreck. But if the opinion polls are right, François Hollande will very soon be President of the French Republic and economic policy in the Euro Area (EA) could become decisively more progressive. ‘Austerity’ could be ditched and Europe could go for growth and jobs.
Hollande can talk the talk, but can he ‘walk the walk’? Whether genuine change is possible depends on a number of factors difficult to evaluate; eg, how markets will react, how Hollande manages the relationship with Germany in the coming months, whether the German SPD can form a government after the 2013 general election and, crucially, whether social-democrats in the EU scrap the current economic orthodoxy. Let us consider each in turn, bearing in mind the speculative nature of any such discussion.
How will markets react to a progressive government in France? The knee-jerk reaction is to invoke Mitterrand’s experience in 1981-3 when financial turbulence forced the social-democratic left to change course within two years and into ‘cohabitation’ within five. And, yes, it must be added that financial markets are far more powerful today. Nevertheless, there are important differences. First, the once-powerful French Communist party (PCF) is no longer of any significance, so there is no red revolution to fear. It is easily forgotten, too, that Mitterrand’s policy failed largely because of rising inflation which rocketed in 1983; inflation is no longer a serious threat today.
An even more important difference is that, with every passing day, politicians and financial ‘experts’ are becoming aware that fiscal austerity leads to a dead end. Far from leading to budget balance, deep expenditure cuts leads back to recession which makes things worse—as we see in Greece, Portugal and Ireland and will soon see in Spain too. Hollande’s message is simple: in a recession, fiscal rectitude is achieved through state-led growth—it is higher national income that generates higher savings, not the other way ‘round. Even the IMF appears to agree.
Doubtless there will be capital flight from France as a result of higher taxes on the rich, but it is unlikely to be massive. Young middle-class French people migrate not because of high taxes but because there are too few jobs, and the extra income from higher taxes on the rich—and from clamping down on tax dodges—can be used to create jobs. Unlike the early 1980s, the French today are far more aware of the inequities of neoliberalism and the time-bomb of unemployment. But if Hollande wants jobs and growth, his proposed ‘stimulus’ will need to be far more than 1% of French GDP.
Hollande’s most difficult task upon coming to power will be calming the Germans while renegotiating the so-called Stability Treaty. There are two issues here. First, Angela Merkel, by openly backing Sarkozy, has declared war on the Hollande camp, presumably because she believes that by so doing she can preserve her own brittle CDU-FDP coalition government. But even assuming she can remain in power until the German general election deadline of September 2013, her popularity is on the wane and numerous polls suggest the most likely electoral outcome to be either an SPD-Green coalition or else a ‘grand coalition’ without Merkel.
The second—and crucial— issue is that of the Stability Treaty. This Treaty requires countries wishing to borrow from the European Stability Mechanism (ESM) to adopt a German-style ‘debt brake’ law limiting their structural fiscal deficit to 0.5% of GDP. As shown in detail elsewhere , the debt brake law is only possible in Germany because of the country’s current account surplus—it is economic nonsense to think such a law can resolve the problem of deficit countries. (This is not a matter of Keynesian economics but follows from simple National Accounting identities.)
Although many EA governments are in the process of ratifying it, the Treaty is deeply unpopular—-and not just in Greece, Portugal and Ireland. In Italy, Signor Monti has made it clear that he thinks it foolish and that jointly-backed Eurobonds constitute a better solution. Belgium’s Guy Verhofstatd agrees and even Sr Barroso appears to support this position. In demanding that the Treaty be changed, François Hollande would have the support not just of the EA periphery but of some of its major players and many of its economic experts. One should bear in mind that the poll indications for Italian Parliamentary elections to be held next spring suggest a centre-left coalition will emerge. Whether the Germans and their Dutch and Austrian allies could long hold out against a majority of the larger EA economies is doubtful.
In short, the victory of François Hollande on the 6th of May might well mark a turning point for the economic future not just of France, but of the EU and of Europe as a whole. While the chain of events outlined above is necessarily speculative, what is certain is that the coming 15 months will see fascinating changes take place. After all, two centuries ago France’s revolution embedded the Enlightenment values of liberté, égalité, fraternité which inform the European centre-left today, values which today’s Europe disregards at its peril. Without a growth strategy, the euro—and the European project—is doomed.
Does the Greek Parliament’s latest vote in favour of further cuts—despite the 40 deputies who defied the whips and were forced to resign—mean that the Greek crisis is resolved? Of course it doesn’t. For one thing, the troika (ECB, IMF and EU) will not approve the €130bn ‘bailout package’ next Wednesday unless Antonis Samaras, leader of the New Democrats, agrees to sign. Samaras has made it clear he will not do so until after the April elections because he knows that if he signs now, his party is toast.
For another, even with Parliamentary endorsement of nearly €4bn in cuts for 2012, it is hard to see how the government of Mr Papademos—or whoever succeeds him after the elections—can deliver. And of course, there must be a serious question about whether Ms Merkel and her Eurozone (EZ) allies want Greece to stay in the euro. As the Dutch PM, Marc Rutte, is reported to have said last week, the EZ is now strong enough to weather Greece’s departure—eurospeak for ‘get out’.
Recall what the troika is demanding for 2012 alone:
- a 22 per cent cut in the monthly minimum wage to €586;
- layoffs for 15,000 of civil servants;
- an end to dozens of job guarantee provisions;
- a 20 per cent cut in its government work force by 2015;
- spending cuts of more than €3 billion;
- further cuts to retiree pension benefits.
These demands come as the country faces its fifth consecutive year of recession, and recent OECD figures showing GDP to have fallen by nearly 15% since January 2009 with unemployment standing at 18.7%. As Helena Smith reports in The Guardian, ‘Greece can’t take any more’. Even with the latest cuts and bailout, it is optimistic to forecast that the country’s debt/GDP ratio will be 120% in 2020. According to the FT’s Wolfgang Münchau: “[a] 120% debt-to-GDP ratio by 2020? That’s 9 years of strikes in Greece,” and that is not sustainable.
Is Greece’s problem high labour costs? Nouriel Roubini’s influential think-tank RGE estimates that as far as labour costs are concerned, the view that Greek wages rose too much during the good years is pure myth. In fact, over the period 2005/08, Greek wages rose less quickly than the average for the EZ.
Further cuts mean further recession, and it should be perfectly obvious by now that Greece cannot pay down its sovereign debt as long as the economy is shrinking. As I (and many others) have explained elsewhere, the debt/GDP ratio can only fall where the rate of interest on the debt is less than the rate of GDP growth. Just as Osborne’s cuts are jeopardising the future of the UK economy, so Merkel’s cuts are sinking a (far weaker) Greece.
Unlike some of my colleagues on the left, I have always been pro-euro. But the suffering imposed on Greece now makes me ashamed of being European.
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
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/.
Last year, in defiance of all macroeconomic reasoning, Germany’s ‘grand coalition’ government (CDU/SDP) enshrined a budget balancing law in the Federal Constitution requiring the Federal budget to balance annually from 2016. Angela Merkel, currently in coalition with the centre-right FDP, trumpets the virtues of Schwabian thrift and apparently wants the whole Eurozone to follow Germany in adopting the same type of ‘debt brake’ economics. The rules of the SPG are to be tightened, probably involving new sanctions on members who violate the 60% public debt-to-GDP ratio such as imposing cash penalties and/or possibly withdrawing their voting rights. But Mrs Merkel apparently wants to go further, expelling deficit members altogether.
By contrast, most professional economists believe that deficit spending during and after recession is a good thing, and that government’s budget should only ‘balance’ over the 7-8 year business cycle at best. Why then does Germany reject this view? Can it be that by balancing the budget annually, Germany will have abolished the business cycle forever? Dream on!
Some put Germany’s debt-obsession down to the folk memory of the disastrous inflation of 1922-23. But that was nearly a century ago, when Germany was saddled with reparations from the Versailles Treaty which could only be met by printing money. Besides, debt finance is not inflationary; public borrowing financed by the non-bank public increases both public liabilities and private assets, so overall, the country’s books remain balanced.
Others point to the political fallout from the Greek sovereign debt crisis; unless Germany reduces its debt /GDP ratio from 75 to 60% as Maastricht requires, Germany’s credit rating risks being downgraded, they argue. This argument totally ignores that Germany is running an export surplus, that most of its debt is domestically held, that demand for German bunds has grown and that debt insurance rates for bunds have been rock steady.
Still others—in Germany, typically politicians and the Springer-dominated popular press—point to a rising national debt burden, an ageing population and the likelihood of higher interest rates (and thus high debt servicing costs). But the debt is rising because the deficit has grown faster than GDP—true by definition in a recession. And as Paul Krugman has noted, even allowing for higher future German debt servicing costs, the annual interest charge on debt would be less than 1% of GDP. Moreover, since the debt is mostly domestically contracted, servicing debt is simply a public-private transfer: a positive earnings stream for German bondholders.
In truth, there is overwhelming evidence for the twin propositions that (a) growth reduces the budget deficit; and (b) during and after a recession, deficit spending provides part of the necessary stimulus to reawaken growth. Just as these propositions were true in during the Great Depression, they held true in Europe’s 30 year post-war wirtschaftswunder, in the US under Clinton in the 1990s and again since the 2008 credit crunch and accompanying stimulus packages (not to be confused with bank bailouts).
The IMF, in its July revision of its own April 2010 growth projections, shows that countries which applied a stimulus are doing better in growth terms than those that did not. It has raised its growth projections for countries that applied a vigorous stimulus package (eg, US, Japan) and its lowered growth projections for those where the stimulus was small or negligible (eg, UK, Germany).
If there is any discernible logic to Germany’s position, it emerges using the simple ‘savings’ balance model taught in Economics 101. Assuming no change in the private sector’s savings surplus (eg, steady wage repression), reduced public spending by adopting a balanced budget must lead by definition to a larger current account surplus—if it does not, national income must fall. Suddenly, the ‘debt brake law’ seems to make sense. The object of the exercise in the long term is to boost Germany’s export-led growth model, not just outside the Eurozone but within it where 2/3rds of its exports go.
The German-based correspondent of the Financial Times, Wolfgang Muenchau, has summed up the situation admirably. Balancing the budget forever by entrenching it in the Constitution will either plunge Germany into the vicious circle of falling tax revenue, expenditure cutting and negative growth, resulting in the eventual collapse of the Eurozone. Or else it will bring a virtuous circle of export-led growth, reinforcing Germany’s trade dominance of the Eurozone. The latter option may seem preferable. But in reality, because not all Eurozone countries can run a surplus with each other (one country’s exports are another’s imports), the latter option is equally unpalatable and will result in failure of the euro by a different route.
So there’s an underlying logic for the Eurozone in Merkelomics after all: heads you lose—tails you lose again!