Martin Wolf
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Governments are playing double or quits in their game with financial markets. The package they announced last weekend is dramatic. But the question is whether it is more than a temporary solution. The answer is: no. As initially designed, the eurozone has failed. It will succeed only if radically reformed.
What is the plan? First, European governments have committed €500bn (€440bn in loan guarantees to eurozone members in difficulties, and a €60bn increase in a balance of payments facility). Second, the International Monetary Fund will, it appears, put up an additional €250bn ($320bn, £215bn). Third, the European Central Bank has, to the chagrin of Axel Weber, president of the Bundesbank, decided to purchase the bonds of members under attack. Finally, the US Federal Reserve has reopened swap lines, to provide foreign banks with access to dollar funding. This is a panic-driven response to market panic. It reminds us of the autumn of 2008.
Will the plan work? On the assumption that it is ratified, the answer should be yes, as markets concluded. It greatly increases the cost of betting against the debt of weak governments. The public debt of the eurozone is slightly lower than that of the US, relative to gross domestic product. If the creditworthy governments decide to support the less creditworthy ones, they can do so, for now.
Why has such radical intervention been found necessary? It is, after all, hardly what the designers had in mind. This is where we need to go back to the beginning of the project for a currency union. It rested on three central assumptions: first, treaty-defined limits would constrain fiscal deficits of members; second, to the extent that this failed, the “no bail-out” clause would constrain them; and, third, member economies would converge over time. Alas, none of this has proved to be true.
First, the treaty-defined limits on deficits proved both ineffective and irrelevant. They proved ineffective, because, when they should have been binding, they were ignored. This was most spectacularly true of Greece, which made its figures up. They proved irrelevant, because some countries that have big deficits today, notably Spain, easily met the fiscal criteria, so long as their bubble economy was inflating: Spain ran a fiscal surplus in 2005, 2006 and 2007.
Second, markets long paid no attention to emerging fiscal frailty, rating all eurozone bonds similarly. As Paul De Grauwe of Leuven university states, in a mordant note for the Centre for European Policy Studies: “The source of the government debt crisis is the past profligacy of large segments of the private sector, and in particular the financial sector.” The financial markets financed the orgy and now, in a panic, are refusing to finance the resulting clean-up. At every stage, they have acted pro-cyclically.
Third, the story of the eurozone economy has, in consequence, been one of divergence, not convergence. The rough external balance masked the emergence of countries with huge current account surpluses and corresponding exports of capital, notably Germany, and of others with the opposite condition, notably Spain. In countries with weak domestic demand and low inflation, real interest rates were high; in countries with strong demand and higher inflation, the reverse was true. The result is not just huge fiscal deficits, now that private-sector spending has collapsed, but a need to regain lost competitiveness. But, inside the eurozone, this is possible only with falling wages, higher productivity growth than in Germany (and so soaring unemployment), or both.
Why has such radical intervention been found necessary? It is, after all, hardly what the designers had in mind. This is where we need to go back to the beginning of the project for a currency union. It rested on three central assumptions: first, treaty-defined limits would constrain fiscal deficits of members; second, to the extent that this failed, the “no bail-out” clause would constrain them; and, third, member economies would converge over time. Alas, none of this has proved to be true.
First, the treaty-defined limits on deficits proved both ineffective and irrelevant. They proved ineffective, because, when they should have been binding, they were ignored. This was most spectacularly true of Greece, which made its figures up. They proved irrelevant, because some countries that have big deficits today, notably Spain, easily met the fiscal criteria, so long as their bubble economy was inflating: Spain ran a fiscal surplus in 2005, 2006 and 2007.
Second, markets long paid no attention to emerging fiscal frailty, rating all eurozone bonds similarly. As Paul De Grauwe of Leuven university states, in a mordant note for the Centre for European Policy Studies: “The source of the government debt crisis is the past profligacy of large segments of the private sector, and in particular the financial sector.” The financial markets financed the orgy and now, in a panic, are refusing to finance the resulting clean-up. At every stage, they have acted pro-cyclically.
Third, the story of the eurozone economy has, in consequence, been one of divergence, not convergence. The rough external balance masked the emergence of countries with huge current account surpluses and corresponding exports of capital, notably Germany, and of others with the opposite condition, notably Spain. In countries with weak domestic demand and low inflation, real interest rates were high; in countries with strong demand and higher inflation, the reverse was true. The result is not just huge fiscal deficits, now that private-sector spending has collapsed, but a need to regain lost competitiveness. But, inside the eurozone, this is possible only with falling wages, higher productivity growth than in Germany (and so soaring unemployment), or both.
Now governments are struggling to cope with the aftermath. But, in insisting that there will be no defaults, they are protecting the financial sector from its stupidity. The people of indebted countries are expected to pay, instead. Is this going to prove an acceptable bargain, in the absence of a return to growth in stricken countries? Hardly.So where do we go from here? We must start by recognising that all we have done is buy a little time. In the eurozone’s first real crisis, governments have been driven to desperate attempts to prevent defaults, as finance has dried up. Now they confront big choices.
The first and most fundamental is whether to go towards greater integration or towards disintegration. The answer has to be the former. Of course, it is possible to imagine a return to national currencies. But this would cause the financial system to implode, since the relations between assets and liabilities now in euros would become so uncertain. There would be massive capital flight into the banks of those countries deemed safe.
The second is how to manage divergence. The eurozone cannot rely on markets alone. It will have to police divergence in upswings and cushion adjustment in downswings. This is why a monetary fund is essential. Any such policing must influence the policies of both demand-deficient and excess-demand economies. Even the former should now understand this: why, after all, accumulate worthless foreign assets?
The third is how to facilitate changes in competitiveness. This means labour market reform. It may also mean legal means for adjusting nominal wages, on a one-off basis.
The fourth is over how to reinforce solidarity. One interesting idea, from the Brussels-based think-tank, Bruegel, is that eurozone countries should pool up to 60 per cent of GDP of their national debts, thereby creating one of the world’s two largest public debt markets.
The last is over how to restructure excess debt. This must be allowed. The alternative creates vast moral hazard, not among politicians, as has been feared, but among financiers.
As my colleague, Wolfgang Münchau, has made plain, this is now a moment of truth, especially for Berlin. The survival of the eurozone is overwhelmingly in Germany’s long-term interests, not just because it is the capstone of a postwar policy of European integration. The currency union has also protected the competitiveness of German industry and so allowed the economy to grow, despite the stagnation of domestic demand.
The German inclination is to believe that everything would be fine if deficit countries were placed under greater discipline. This is false. The answer, instead, is to create a system that recognises and responds to reality. It must be changed, to contain divergence, facilitate debt restructuring and promote economic adjustment. It is either this or failure. What is now needed is the courage to reform wisely
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