Wednesday, 6 June 2012

Calling International Rescue

I've been arguing for quite some time now that the Eurozone crisis is a sovereign debt crisis and a banking crisis, a balance of payments crisis, a currency crisis and above all a political crisis. Most people now agree with me on the first two and maybe the third, but they still aren't seeing the crucial importance of the last two. So let me explain how I think this ghastly situation came to be and how I believe it will play out.

The creation of the single currency in 1999 created a market expectation that the debt of all Eurozone countries would be backed by the full faith of the whole Eurozone, irrespective of the strength of the issuer's economy. Because of this, smaller and weaker countries in the Eurozone were able to borrow at similar rates to stronger countries. Their debt was too highly priced and they paid too low a rate - so many of them borrowed far too much. And banks, for whom sovereign debt represented an unbeatable risk-free investment because (at the time) it required no capital to support it (as George Soros points out), bought far too much of their debt.

If the single currency had been a full monetary, fiscal and political union FROM THE START, the expectation that weaker countries would effectively be backed by stronger ones would have been reasonable. This, after all, is how other currency unions such as the United States and the United Kingdom operate. These two countries have very different models for their currency unions: the United States operates on a federal model, whereas the United Kingdom works on a shared sovereignty basis. But the effect is the same. There is common tax raising and sharing at the federal or sovereign level, nationwide spending on essential services and common issuance of debt (although US states can issue their own debt as well, unlike UK regions). Much is often made of the fact that US states can and do go bankrupt - but in practice, services to the population are always maintained through Federal intervention and support. And in the UK, regions at present have no independent tax-raising powers: although there are local taxes, the tax take from these is reallocated by central government to level the playing field between richer and poorer areas. All of this makes common monetary policy and a single currency not only workable but desirable.

But the Eurozone is not a full union. The member states share a currency and operate a single monetary policy. But fiscal policy - taxation, spending and debt issuance - is the responsibility of the individual states. And I would argue that even the monetary union is half-baked. The ECB is explicitly prevented from acting as a lender of last resort, so is unusually limited (for a central bank) in the support it can give to distressed banks. It is also limited in how it can intervene in secondary markets: unlike the Bank of England and the Fed, which can buy as much of their own governments' debt as they see fit, the ECB is severely limited in the use it can make of its Securites Market Programme and has had to resort to all manner of fudge to maintain market access for distressed Eurozone sovereigns.

The events of the last two years have proved beyond a doubt that the Eurozone does not wish to guarantee the debt of its weaker members. Because of that, the prices of sovereign debt in the Eurozone are undergoing a severe market correction. This is unbelievably painful, both for the sovereigns who are seeing their borrowing costs rise to unsustainable levels, and the banks who are seeing the value of their assets drop to unsustainable levels. It is this market correction that is causing the near-bankruptcy of sovereigns and in my view the ACTUAL bankruptcy of many Eurozone banks. (I should point out that the Spanish cajas and Irish banks are bankrupt due to collapse of a property construction bubble, not because of their sovereigns' debt problems: it is in my view particularly the large French and German banks that are unsustainably exposed to Eurozone sovereign debt).

Since the underlying cause of both the sovereign debt crisis and the banking crisis is the lack of a full union, the obvious solution would be to create one. This, in one form or another, is what most commentors have suggested. Pooled debt issuance (Eurobonds), a common banking system, Eurozone-wide deposit insurance - all of these are ways of recreating the implicit guarantee. If they worked, they would restore both sovereign borrowing costs and bank asset values to pre-crisis levels.

But none of them solve the real problem. I've already mentioned it, but here it is again: The Eurozone does not wish to guarantee the debt of its weaker members.  The stronger members do not wish to accept the liabilities of the weaker ones: the weaker members do not want to put in place the financial discipline that would force them to balance their budgets and live within their means (as, for example, US states have to do). All of them want to keep the Euro, but only on their own terms. All of them want the benefits of a single currency, but not the risks: all of them want to keep the gains, but palm the losses off on someone else. And above all, all of them resist relinquishing their sovereignty and their right to self-determination for the sake of a greater union.

For this reason, I do not believe that a full fiscal, monetary and political union is remotely possible in the limited time that is left before the whole edifice collapses under the weight of unsustainable debt and impossible expectations. The adjustment of sovereign debt prices to the reality of every-country-for-itself will continue unchecked until one or more country is forced to default and a whole raft of banks fails. It is time that the world stopped hoping and praying that the currency union can be made to work. The political will to make it do so simply does not exist.

The best hope for the Eurozone now is a planned and managed breakup. Exactly what form this should take is a matter of debate: some people think Germany should leave, because of the distorting effect its giant economy has on monetary policy: others think the weaker states should leave, leaving Germany as the centre of a small group of similar states. I don't think it much matters which way it is done - the important thing is that it is planned and managed in a way that causes the least disruption to the lives and finances of ordinary people and businesses. The present situation, where the Eurozone leadership appears to be completely in denial, is the worst possible scenario.

Spain's distress call today rebounded around the world. The Eurozone is heading for a brick wall at top speed, and the world economy is already beginning to anticipate the impact.  Things are moving too fast now for Eurozone leaders to deal with this alone: world leaders must act before it is too late. Eurozone breakup is now inevitable. But it's not yet too late to prevent it being a total disaster.


  1. I think the problem with a full fiscal union is a matter of it not being possible within the necessary time-frame not necessarily that the politicians don't want to either accept the debt of the weaker members or give up national sovereignty.

    The whole european project has involved politicians slowly but surely ceding sovereignty to Europe.

    I hear a lot of hype from politicians about acting in the national interest but when the chips are down the evidence to-date suggests that politicians of all stripes will sell their country down the drain and get sucked further into Europe against popular wishes.

    I'll believe "less Europe" when I see it.

  2. I can remember when Europe last fell apart in 1945 and a few days ago in my post "The Day It All Began To Go Wrong" on Wednesday May 30 tried to explain why. It is all going in end in tears, yet again.

  3. Sorry Frances, this subject is off-topic, although related and I realise this not a request show, however, I hope you may consider writing a blog on this sometime – I believe you write an honest, clear appraisal delving into the real nitty-gritty of your subjects...

    The Silk Commission report part 1, on devolving tax and borrowing powers to the Welsh Government was published recently. The basic recommendation as I understand it was that the Welsh Govt should be given some specified areas of control over taxation along with some limited borrowing powers.

    The WG is currently funded by a block grant that is greater than the tax raised in Wales and the Silk Report recommends that the WG should be able to borrow extra funds for specific capital projects. This includes from the Treasury ( I assume at a favourable interest rate) and also from the money markets ( at a less favourable rate? ).

    Leaving taxation aside and as devolution itself is a politically contentious subject, let’s stick to the actual mechanics of a regional government borrowing for investment and it’s side effects. It is my instinctive belief ( I am new to economics) that this halfway house would put a regional govt. at a disadvantage compared to either remaining in the current grant system or full independence issuing a sovereign currency. This middle way I guess would place the regional govt. in a similar position to the Euro zone countries, effectively utilising and subject to, the restrictions of a foreign currency.

    Question is, could this be a transitional arrangement towards greater independence or would it have the opposite consequence of making the departure from the Union more difficult. I believe the latter.