The euro

Self-serving myths of Europe's neo-Calvinists

Opinion piece (The Daily Telegraph)
Ambrose Evans-Pritchard
21 November 2011

If you have half an hour, read this paper (pdf) by Philip Whyte and Simon Tilford for the Centre for European Reform. It is a forensic look into the deeper causes of Europe's crisis and why the reactionary policies being imposed on two thirds of the eurozone by Germany's Wolfgang Schauble and the northern neo-Calvinists – with input from 1930s liquidationists at the ECB – will lead to certain disaster. 

It has been out for a week, but I have only got round to reading it. Better late than never. The CER is a proEU group with a broadly free-market leaning. Here are a few extracts: 

European policy-makers have been reluctant to concede that the eurozone is institutionally flawed. Even now, many assert that the crisis is not one of the eurozone itself, but of errant behaviour within it. If certain countries had not broken the rules, they argue, the eurozone would never have run into trouble. The way to restore confidence, it follows, is to ensure that rules are rigorously enforced. 

These claims are wrong on almost every count. It is now clear that a monetary union outside a fiscal union is a deeply unstable arrangement; and that efforts to fix this flaw with stricter and more rigid rules are making the eurozone less stable, not more. The reason the eurozone is governed by rules is that few of its member-states – least of all its wealthier North European ones – have any appetite for fiscal union. Crudely, rules (gouvernance) exist because common fiscal institutions (gouvernement) do not. But rules are no substitute for common institutions. And tighter rules do not amount to greater fiscal integration.

The hallmark of fiscal integration is mutualisation – a greater pooling of budgetary resources, joint debt issuance, a common backstop to the banking system, and so on. Tighter rules are not so much a path to mutualisation, as an attempt to prevent it from happening. 

This course of action is more likely to precipitate the euro's disintegration than its survival. 
Why is the eurozone in crisis? 

The short answer is that the introduction of the euro spurred the emergence of enormous macroeconomic imbalances that were unsustainable, and that the eurozone has proved institutionally ill-equipped to tackle. North European policy-makers have been reluctant to accept this interpretation. For them, the crisis is not one of the eurozone itself, but of individual behaviour within it. If the eurozone is in difficulty, it is because of a few ‘bad apples’ in its ranks. In this interpretation, neither the design of the eurozone nor the behaviour of the ‘virtuous’ in the core were at fault. 

Ever since the eurozone crisis broke out, the North European interpretation of it has prevailed. It essentially sees the crisis as a morality tale, pitting those who sinned against those who stuck to the path of virtue. The major sins of the periphery were government profligacy and losses of competitiveness. The way out of the crisis, it follows, is straightforward. It is to emulate the virtuous core by consolidating public finances and improving competitiveness (by raising productivity, reducing wages, or both). If the periphery can achieve this, then the eurozone debt crisis can be resolved without an institutional leap forward to fiscal union. 

The North European interpretation is by no means all wrong (no serious observer disputes that Greece grossly mismanaged its public finances). But it is damagingly partial and self-serving. It skates over the contribution played by the euro’s introduction to the rise of indebtedness in the periphery; it wrongly assigns all the blame for peripheral indebtedness to government profligacy; it makes no mention of the far from innocent role played by creditor countries in the run-up to the crisis; and it does not acknowledge how the it was wasted (perhaps unsurprisingly). 

It is wrong, however, to blame government profligacy for the rise in peripheral indebtedness: Greece is the only country where this holds true. In Ireland and Spain, it was the private sector (particularly banks and households) that was to blame. Indeed, in 2007, the Spanish and Irish governments looked more virtuous than Germany’s: they had never broken the fiscal rules, had lower levels of public debt and ran budget surpluses. 

Creditor countries cannot be absolved of all blame. Not only was export-led growth in countries like Germany and the Netherlands structurally reliant on rising indebtedness abroad. But creditor countries in the core harboured plenty of vice: the conduits for the capital that flowed from core to periphery were banks, and these were more highly leveraged in countries like Germany, the Netherlands and Belgium than they were in the periphery (or the Anglo-Saxon world).

The eurozone crisis is as much a tale of excess bank leverage and poor risk management in the core as of excess consumption and wasteful investment in the periphery. If the eurozone had been a fully-fledged fiscal union, it would not be in its current predicament. Its aggregate public debt and deficit ratios, after all, are no worse than the US’s. But it is not a fiscal union – which is why it faces an existential crisis, and the US does not. 

The current crisis, then, is not simply a tale of fiscal irresponsibility and lost competitiveness in the eurozone’s geographical periphery. It is also about the unsustainable macroeconomic imbalances to which the launch of the euro contributed (in creditor and debtor countries); about the epic misallocation of capital by excessively leveraged absence of fiscal integration has exacerbated financial vulnerabilities and made the crisis harder to resolve.

How did the euro’s introduction contribute to the current crisis? The answer is that the removal of exchange rate risk inside the eurozone encouraged massive sums of capital to flow from thrifty countries in the ‘core’ to countries in the ‘periphery’ (where private investors thought the rates of return were higher). The influx of foreign capital cut borrowing costs in the periphery, encouraging households, firms and governments to spend more than they earned. The result was an explosion of current-account imbalances inside the eurozone. As a share of GDP, these imbalances were far bigger than those between, say, the US and China. 

Ever since the Greek sovereign debt crisis broke out, the thrust of eurozone policy has been to try and turn the region into a less Mediterranean and more Germanic bloc – that is a shared currency held together by increased discipline among its members. The centrepiece of the framework that has emerged is a ‘grand bargain’ between creditor and debtor countries. Creditor countries have assented to the creation of a European Financial Stability Facility (EFSF) to extend bridging loans to countries that are temporarily shut out of the bond markets. In return, debtor countries have agreed to much stricter membership rules. 

The grand bargain (or Plan A) has failed. The reason is that its  underlying philosophy – that of ‘collective responsibility’ – is flawed.

The demands of collective responsibility have been asymmetric: self-defeating medicine has been prescribed to debtor countries, while problems in creditor countries have been allowed to fester. Second, too much virtue has become a collective vice, resulting in excessively tight macroeconomic policy for the region as a whole. 

The European Central Bank (ECB) believes that the faster budget deficits are cut, the faster private consumption and investment will pick up. The reverse has been the case. The ECB, meanwhile, has done too little to offset this synchronised fiscal tightening (in July, it actually raised its key official interest rate, citing "upside risks to price stability"). For a variety of reasons, the ECB has been deeply uncomfortable straying from the narrowest interpretation of its mandate. At times, the ECB has looked to be more concerned about inflation than about the eurozone’s survival.

The ECB’s reluctance to act as lender of last resort to governments, for example, has raised doubts in the financial markets about its commitment to the eurozone, and weakened confidence in solvent countries like Spain and Italy. 

The punishing (and self-defeating) economic adjustments imposed on debtor countries contrasts with the self-righteous complacency shown in the creditor countries. Not only have the latter insisted that debtor countries implement the kind of structural reforms for which they have shown no enthusiasm themselves (like opening services to greater competition). But they have also been reluctant to accept the potential for write-downs among their banks. So the very countries that have insisted on wrenching economic adjustments indebtor countries have often been the ones that have done the most to conceal the fragility of their own banks. 

This asymmetry in treatment has deepened the crisis and increased the cost of resolving it. A year’s worth of punishing austerity and contracting activity has only succeeded in pushing Greece deeper into insolvency. Contagion has spread to Ireland and Portugal (which have been forced to accept bail outs and swallow the same medicine as Greece). And foot-dragging in a number of countries has condemned the region to a series of weak ‘stress tests’ which have given clean bills of health to under-capitalised banks. Eurozone policy has therefore actively contributed to the vicious feed-back loop that has developed between banks and sovereigns. 

Having spent two years denying that many European banks were under-capitalised, eurozone leaders finally relented – but at a terrible time. Fresh capital is much harder to raise from the private sector than it was a year ago, and several eurozone governments (including France) can ill afford to step in with taxpayer funds. 

The eurozone crisis is chronic in character and requires far-reaching reforms. The euro is a currency union without a Treasury or a lender of last resort. The macroeconomic policy framework is ill-suited to a big, largely closed, economy, and the national markets are insufficiently flexible and imperfectly integrated. 

Policy-makers now face a choice. They must either address the eurozone’s institutional underpinnings or risk a disorderly break-up. 

They need to agree on a number of long-term steps. The first is a partial mutualisation of sovereign borrowing costs, via the adoption of a common bond. The second is the adoption of a eurozone-wide backstop for the banking sector. The third is growth-orientated macroeconomic policy: the European Central Bank needs a broader mandate, member-states’ fiscal policy must be co-ordinated, and trade balances narrowed symmetrically. 

On current policy trends, a wave of sovereign defaults and bank failures are unavoidable. Much of the currency union faces depression and deflation. The ECB and EFSF will not keep a lid on bond yields, with the result that countries will face unsustainably high borrowing costs and eventually default. This, in turn, will cripple these countries’ banking sectors, but they will be unable to raise the funds needed to recapitalise them. Stuck in a vicious deflationary circle, unable to borrow on affordable terms, and subject to quixotic and counter-productive fiscal and other rules for what support they do get from the EFSF and ECB, political support for continued membership will drain away. 

Faced with a choice between permanent slump and rising debt burdens (as economic contraction and deflation leads to inexorable increases in debt), countries will elect to quit the currency union. At least that route will allow them to print money, recapitalise their banks and escape deflation. Once Spain or Italy opts for this, an unravelling of the eurozone will be unstoppable. Investors will not believe that France could continue to participate in a core euro: the country has weak public finances and a sizeable external deficit. 

Participation in a core eurozone would imply a potentially huge real currency appreciation and a corresponding collapse in economic activity. Investors will calculate that the wage cuts (to restore competitiveness) and cuts in public spending (to rein in the fiscal deficit) would be politically unsustainable. In short, France will effectively be in the same position as Italy and Spain are at present. While it is impossible to put a timescale on this, the direction of travel is clear. 

Eurozone leaders now face a choice between two unpalatable alternatives. Either they accept that the eurozone is institutionally flawed and do what is necessary to turn it into a more stable arrangement. This will require some of them to go beyond what their voters seem prepared to allow, and to accept that a certain amount of ‘rule-breaking’ is necessary in the short term if the eurozone is to survive intact. Or they can stick to the fiction that confidence can be restored by the adoption (and enforcement) of tougher rules. This option will condemn the eurozone to self-defeating policies that hasten defaults, contagion and eventual break-up. 

Indeed. Read it all.