By Satyajit Das, the author of Extreme Money: The Masters of the Universe and the Cult of Risk (published in August/ September 2011)
In the Long Term We’re All Dead
The European Union’s attempts to resolve the continent’s sovereign debt problems do not deal with issues of growth, intra-European financial imbalances and competitiveness. The only “initiative” was the vague plan for a massive public investment program, although no details of how it is to be financed were provided.
The call for greater public investment was accompanied by a familiar but contradictory insistence that all Euro-zone states adhere to agreed fiscal targets. Euro-zone countries except Greece, Ireland and Portugal must bring their budget deficit down to less than 3% of GDP by 2013. The need for many European countries to improve public finances is clear. But how greater belt-tightening and austerity would restore growth is not.
As EU targets are honoured in the breach rather than observance, they probably don’t matter anyway. Jens Weidmann. Bundesbank President and ECB council member, also identified the lack of incentive to correct public finances: “By transferring sizeable additional risks to aid-granting countries and their taxpayers, the euro area made a large step toward a collectivization of risks in case of unsolid public finances and economic mistakes. That’s weakening the foundations of a monetary union founded on fiscal self-responsibility. In the future, it will be even more difficult to maintain incentives for solid fiscal policies.”
The European model where Northern nations’ savings finance Southern spending providing a market for exports for countries like Germany was not questioned.
Given current productivity levels and cost structures, countries like Greece, Spain, Portugal and Italy are not internationally competitive at the current value of the euro. The competitiveness of these economies has also been eroded by the rise of other emerging market economies with lower costs. This has boosted demand for exports from Germany and other core EU countries and driven up the value of the Euro, further disadvantaging weaker members.
The common currency means that these nations cannot regain competitiveness through a significant devaluation. In his 1953 book, “Essays in Positive Economics”, Milton Friedman argued that adjustments were easier in a floating currency system because: “It is far simpler to allow one price to change, namely the price of foreign exchange, than to rely upon changes in the multitude of prices that together constitute the internal price structure.”
In the absence of flexibility in the currency, these countries are heavily reliant on structural changes, massive cuts in costs and increased productivity to enhance competitiveness. These measures will only work in the long run, if they work at all. In the meantime, the economy becomes mired in recession or low growth, high unemployment, falling incomes and deteriorating public finances. This is precisely at the heart of the current problems facing these economies.
The longer term options are clear. Europe must move to greater financial and economic union or restructure its monetary and currency arrangements. Greater integration will require sacrifice of national sovereignty, as fiscal policy, taxation and other national decisions are centralised. It will require financial “transfers” and support from the stronger Euro-zone economies to the weaker members.
The political, economic and social problems of such a strategy are formidable. German Chancellor Merkel has stated that she would not allow a union of automatic transfers from richer to poorer states: “This shall not happen according to my conviction.”
The alternative is a radical restructure of the Euro and Euro-zone itself. While the common currency will survive, weaker countries would leave the Euro, reintroducing their own currency – a considerable logistical challenge. The lower value of the new currencies, in combination with other measures, would help these countries regain competitiveness through the reduced domestic cost structures. The countries would gain added economic flexibility without the monetary and fiscal strictures of the Euro. Debt restructuring and a lower currency would potentially restore competitiveness and growth more effectively than successive rounds of ever more astringent austerity – the favoured and to date unsuccessful treatment.
The Panic Room
The EU’s reaffirmation of their commitment to do whatever is needed to ensure the financial stability of the Euro-zone, was initially greeted with relief. Similar “shock and awe” declarations a year earlier bought a few months of respite. This time celebrations lasted for less than a week as investors realised that the deal had not reduced the risk of financial contagion in the Euro-zone.
By Tuesday 26 July 2011, markets had become more circumspect and interest rates on Spanish and Italian bonds rose to levels seen before the bailout was announced. By early August, the pressure on European sovereign increased even further, compounded by the downgrade of the US sovereign debt ceiling.
Given the EU package still needed ratification by national governments, market panic forced the ECB reluctantly to re-commence it program to purchase European sovereign bonds to support the market.
In the background, arguments between the ECB and EU about who would guarantee these purchases continued. The ECB with capital of Euro 5 billion (being increased to Euro 10 billion) and individual Euro-zone central banks with capital of Euro 80 billion do not have the resources to stop the contagion.
There is also the question of how the ECB will finance the purchases. Should it choose to “monetise” its purchase (that is print money), the ramifications, both economic and political, would be profound. In essence, it is unlikely that the ECB can not resolve the crisis by its actions.
The Long Goodbye
The EU’s July attempts to resolve the European debt crisis was the latest in a series of missed opportunities. At best, the proposals buy time – a few months for banks to build a capital and loss reserves and beleaguered countries to undertake necessary reforms. On the most optimistic view, this will reduce the losses in any subsequent major debt restructuring. At worst, its sets up an even more dangerous crisis.
Continued uncertainty and volatility are likely. One market focus will be the periodic tests, which Greece and other countries need to meet, to receive funding. There is likely to be focus on the IMF’s ongoing participation, especially amongst emerging market nations who see the institution as having been exceeding soft on Europe when compared to the treatment of Asian and Latin American nations in previous crises. Disputes between the EU and the ECB, trying desperately to salvage its tarnished reputation, are inevitable.
Spain and Italy will be another focus of attention. The loss of access by the sovereign or banks to commercial funding at acceptable rates would intensify the problems. Unverified media reports already suggest that Italy may not participate in the next round of Greek funding because of its own financial positions.
Pressure on the credit rating or funding costs – initially affecting Spain and Italy but potentially extending wider to the European paymasters Germany, France and other stronger Euro-zone members – will exacerbate instability.
The continued acquiescence of the domestic voters and taxpayers cannot be taken for granted. In the indebted nations, protest against the harsh austerity and the financial egotists is likely to intensify. Resentment towards external interference and control of their economy will increase. Suggestions that the Finns sought the Parthenon and Aegean islands as collateral for a new bailout would not have engendered Greek gratitude for their saviours.
In the nations providing the bailout funds, taxpayers will become increasingly reluctant to finance their neighbours and more resentful towards the financial institutions successfully socialising their losses. Elections and changes in leadership will feed this uncertainty.
The game is all but over for the weaker countries – Greece, Ireland and Portugal. Vulnerable countries – Spain and Italy – are now being relentlessly hunted down. The stronger countries – France and Germany – no longer look secure, immune from the problems. It is time to admit that the “lifeboat” isn’t big enough for everybody and throw Greece, Ireland and Portugal out (read debt restructuring), concentrating efforts on salvaging Spain and Italy. Whether the EU have the stomach for this is difficult to tell, although self-preservation is a powerful motivator, especially for politicians. Whatever happens, the European debt crisis remains a key risk to the global economy.