While we were the agents of our own misfortune in Ireland, the continuing attack by the markets on Euro countries, which we are caught up in, has a very rational basis. As many have pointed out, including George Soros, Paul Krugman, and Erik Jones (Prof of European studies at the Bologna centre of Johns Hopkins University) there are significant flaws in the Euro, which may lead it to fail. The 10 most important reasons are as follows:
1.A successful (stable) monetary union requires a full fiscal union. In other words in addition to having a European central bank (“ECB)” you also need one Department of Finance. Absent one Department of Finance for the entire euro area, markets (in other words ourselves, pension investors etc) see the reality that each individual country is actually standing on its own but without sufficient sovereignty on the one hand (i.e. for a currency devaluation to sort out competitive issues etc) to protect itself but also without enough Euro solidarity to stop one country being isolated and attacked by the ubiquitous markets or larger countries/EU institutions taking advantage of smaller/weaker countries. A full fiscal union is not wanted by most euro countries, I believe, for the simple reason that such would not suit many countries and, of course, who would call the shots in the one Department of Finance?
2. A fundamental and underlying completely flawed belief when setting up the Euro in the stability of financial markets. The error of this assumption is widely understood today.
3. Structurally the Euro, via the ECB, is completely focused on minimising inflation (for historic reasons with respect to Germany) but has no clear mandate to mitigate deflation. Many now see deflation as a greater risk, while allowing a certain amount of inflation would certainly be in many peoples interests, including ourselves with our debt burden.
4. The “one size fits all” macro economic policy of the ECB very quickly meant that countries experiencing strong growth, such as Ireland, where allowed to borrow at low rates of interest that reflected German macro economic structures. Imposed upon an interest-rate environment that had been used to significantly higher interest rates, this inevitably led to much speculation and eventually the bubbles in property and credit in this country. This also happened to a number of other countries in the Euro area, who like us had been used to higher interest costs. This inevitably was going to put significant strain on the Euro.
5. The basic structure, as we have seen repeatedly, does not allow for error and was set up with no ironclad enforcement mechanisms , which are necessary in view of the weaknesses set out in 1 above. The enforcement mechanisms that were put in place initially in the Stability and Growth Pact were significantly diluted by France and Germany in November 2003 when those deficit control mechanisms were creating problems for them.
6. Countries were allowed into the Euro who should never have been allowed membership. Only those who could handle price stability should have been allowed to join the euro. Political decisions by the EU overroad this basic fiscal requirement. (We in Ireland were well aware of this fundamental requirement, but through a combination of greed, the herd instinct, and sectoral selfishness, the Social Partners decided to completely ignore the core need for competitiveness in one of the most open economies in the world.)
7. The basic structure of the Euro means that, compared to when you had your own currency, if you break the rules through excessive deficits or borrowing, you do not hit a balance of payments crisis/foreign currency crisis, which would have happened quite quickly the past. This allows the problem to be ignored and therefore build up until it turns into a much bigger and dangerous problem, eventually the fear of default by the relevant country and the Euro itself. This is exactly what has been happening for a good part of this year and into late November and early December 2010.
8. For a whole variety of reasons, some of which are familiar to us in Ireland, many banks in the Euro zone have made large billions of bad loans or investments which need to be provided for. It is not clear that such provision has been properly made in many countries, including Germany. Such loans include significant property lending, loans to banks who got involved in such lending, loans to banks and countries who have got into significant difficulties (including Greece, ourselves, and others), loans to emerging markets, and investments in sub-prime mortgages, derivatives etc.. Because of the extent of such loans and investments proper provisioning for them could have significant impact on the relevant banks and the relevant countries. That contagion effect /banking problem was not considered in the design of the Euro.
9. An underlying implicit assumption in setting up the Euro is that if one country was cutting back to reduce its deficits, other stronger countries would adopt expansionist policies to maximise demand overall in the Euro area. This is not happening at present. Simply put Germany, despite being in a position to adopt expansionist policies to increase demand in the Euro area, is contrary to the advice of Pres Obama and many others, adopting deficit reduction policies, leaving the Euro area facing declining demand. Such will lead to lower growth, lower profitability, a reduced ability to repay debt personally and by countries and banks, leading to a potentially downward spiral in the Euro area. This is not how most thought the game would be played.
10. The possibility of significant imbalances arising between countries with trading surpluses and countries with trading deficits within the Euro area was ignored. While there are significant conceptual issues here, putting it simply if a country needs to reduce its deficit it frequently engages in cutting wages and prices, Greece and ourselves being two good examples, to improve their competitiveness, increase their exports, and therefore “trade out of their difficulties”. To do this existing surplus countries, such as Germany, need to boost their spending, allow their wages and prices to increase, and thereby help Greece and other deficit countries compete with them fairly and trade out of their difficulties. Germany is utterly refusing to do this, potentially leaving deficit countries such as Greece in great difficulty. While known at a conceptual broader level, it proved too difficult to set up a mechanism to manage these imbalances when the Euro was being set up.
It is clear from this analysis of Ireland was a pawn in a battle over these flaws in the Euro, between the markets who eventually worked out implications of these flaws and the Euro institutions trying to paper over the cracks, and redesign the Euro structure itself within the significant political constraints of the 27 member EU. Who do you think will win that race? To paraphrase Keynes, the markets can stay rational (it is rational to identify the implications of these weaknesses) than the EU can stay liquid, and keep coming up with funds to bail out all the banks and countries in the Euro.
Richard Whelan is a commentator on geopolitics. His website is www.richardwhelan.com.
The broader issues with respect to Germany’s role in the Euro weaknesses are set out in the article titled“Germany’s “Beggar Thy Neighbour” Policies Need to Be Seen for What They Are.Time for Ireland, like Germany, to Look after Its Own Interests.”