The headlines in the aftermath of last week’s EU summit have largely been focused on the UK veto but surely the more important issue is what Germany is unwillingly to do to save the Euro.
Economists generally agree that two actions are needed to strengthen the Euro Zone. Firstly, an agreement by the 17 Euro-Zone members to create a fiscal union where, as in the UK and US, tax revenue from the stronger members can be redistributed to the weaker members who have been disadvantaged by uncompetitiveness and the ECB’s single interest rate. Secondly, the ECB should be allowed to purchase large quantities of government bonds to help finance the weaker Euro-Zone members especially Italy and Spain.
However, Germany favours a fiscal union in which it lays down the rules in the form of a modified Stability and Growth Pact but it still fails to agree to the one thing that would strengthen the Euro Zone structure into being like a tried and tested currency bloc. In this structure, common Euro-Zone bonds would be issued to raise finance for the Euro Zone as a whole and the funds raised would be distributed via a central fiscal authority or Euro-Zone Treasury. This does not mean that there would not be a place for individual member bonds but this market would then work like the muni bond market in the US.
The fiscal regulations laid down at last week’s summit state that countries should keep debt-to-GDP below 60% and budget deficits below 3% of GDP. The below charts show that such a policy would have made no difference to Ireland’s current predicament, for Ireland was the only Euro-Zone member to adhere to these targets until 2008, even Germany broke these limits.
Figure 1: Euro-Zone, German and Irish debt-to-GDP. Source: OECD.
Figure 2: Euro-Zone, German and Irish budget deficit as % of GDP. Source: OECD.
For the Euro Zone to work, a structure is needed that addresses the issues illustrated in Figures 3, 4 and 5 which show how small Euro-Zone economies such as Ireland’s have been ignored by the ECB’s mandate of targeting the Euro-Zone average CPI. Ireland’s CPI was much higher than the Euro Zone’s target of “below, but close to, 2% over the medium term” before 2007.
Figure 3: Euro-Zone, German and Irish CPI rate. Source: Eurostat.
Furthermore, the year-on-year GDP growth was also much higher than both the German and Euro-Zone average.
Figure 4: Euro-Zone, German and Irish year-on-year GDP growth. Source: Eurostat.
Figure 5 shows that Ireland suffers from being subjected to the wrong rate at almost any given time since the inception of the Euro with respect to its CPI and GDP growth. At times when CPI and growth have been high, the real rate in Ireland has been lower than the Euro-Zone average indicating a higher interest rate would have been implemented if Ireland had had its own central bank. While more recently, when CPI and growth have been low, the real interest rate has been above the Euro-Zone average indicating that a lower interest rate and quantitative easing would have been more suitable. This is backed up by a Taylor Rule simulation.
Figure 5: Euro-Zone, German and Irish real rates (ECB rate adjusted for CPI in each country). Source: Eurostat, ECB.
But fiscal restructuring takes time and in the short term only the ECB can bridge the gap by buying the bonds of imperiled countries such as Italy and Spain.
The trouble is, however, that Germany continues to block the ECB from making large purchases of Spanish and Italian government bonds to keep yields at levels where these countries can raise financing in the markets at more affordable levels. The Bank of England and Federal Reserve have both undertaken QE with one of the key targets of the policy being to lower the long-term interest rate i.e. the 10-year government bond yield.
Markets react when they are given a clear signal by policymakers as in the case of the US and UK. When the strength of the central bank is on the bid side, few will attempt to short the market. “Do as the central bank is doing,” was the call from fund managers and gilt traders when QE was announced in the UK in 2009. This is one of the reasons why UK gilt yields are so low and are now seen as a safehaven, together with a flexible currency.
The Euro-Zone leadership is failing to deliver the necessary policies to deal with the crisis and Sarkozy, or any other leader, appears to have very little power to push the Germans off their hardline.
Blaming Britain or any other country for failing to sign up to the “fiscal compact” is a smokescreen and the more serious issue lies in saving the patient.
Moral hazard has been used as the excuse for not implementing credibly large bailout mechanisms. If a bailout fund of EUR3 trillion had been announced in 2010 along with an intent to restructure the monetary union, the market would have been convinced that the the politicians not only understood the problems facing the Euro Zone but that the leaders were willing to do whatever was necessary to fix the problems as well.
If this had happened, it is highly unlikely that anywhere near the full EUR 3 trillion would have been needed because uncertainty would have eased due to a convincingly large commitment by Euro-Zone leaders to keep the Euro in place.
However, this didn’t happen and credibility has been lost. Now Greece, Portugal and Ireland can no longer raise financing in the bond markets while Italy and Spain are precipitously close to joining them. This is a much more costly course of action because the full cost of providing funding for these countries will either be met by a bailout fund or one or more countries will default on their debt.
Either way, concerns over moral hazard have only escalated the crisis and made it more costly to fix.
Commentators and politicians who support the hard-line German stance do not like the following analogy, perhaps, because it rings too true.
When a patient turns up in a hospital emergency room with a heart attack with a history of eating too much fatty food or not taking enough exercise, the first thing the doctor does is to get the heart going again, first CPR then defibrillation. He does not begin by insisting that the patient sticks to a healthy diet before treating him because the patient’s condition would only deteriorate and be much harder to resuscitate.
This is the problem with the “kick-the-can-down-the-road” style of Euro-Zone policy making. Surely, the most important goal is to save the Euro, then when this is guaranteed regulations and long-term policies can be put in place to rebuild the troubled member countries.
The worry now is that it is too late and too costly to save the Euro.