Richard Whelan takes issue with an inaccurate account of fiscal imbalances and of Ireland’s role in the economic crisis.
The Opinion Piece in the Irish Times on 12 November 2011 by Thomas Klau headlined Deepening crisis calls for further integration in Europe, is a good summary of what could be called The Official Version of why the eurozone crisis occurred and how to solve it.
Klau, a senior political analyst with the European Council of Foreign Relations, attributes the crisis to a “dangerous combination of poor regulation, too much debt and weak leadership”. To him the choices are stark. Either we “yield to the power of the markets, accepting an economically violent disruption of monetary union and thereby reopening the door to the dynamics of nationalism” or “initiating a bold jump forward into a federated euro zone power, involving as its main feature some shared assumption of the euro zone’s fiscal past and therefore a shared management of its fiscal future.”
Both this analysis of why the crisis occurred and the need for a stronger federal Europe based on a strengthened fiscal union, now almost accepted as gospel, are flawed.
The crisis occurred because of a crisis in banking (a word not mentioned in Klau’s opinion piece) in Europe and only the full achievement of a currently incomplete and inadequate monetary union in the eurozone will prevent its recurrence.
Fiscal issues, in particular budget deficits, did not cause the crisis – Ireland has a better fiscal position in the years leading up to the crisis than Germany, with both it and Spain running budget surpluses in those years. To quote the special report by the Economist on “Europe and its Currency”, 12 November 2011: “Both meticulously kept within the limits for deficits and debts set down by the Stability and Growth Pact – unlike Germany, which flouted the rules for four years from 2003 (and avoided punishment). Nor did Italy lurch into extravagance.” The problem in Greece was actually caused by debt flows. It is this understanding that led to the following conclusion in a recent independent analysis of what happened and what should be done: “It was deliberate rule breaking by governments and their rigging of the market in favour of government bonds [explained below], not the lack of a fiscal union, that led to the current crisis.” [Can Europe’s Divided House Stand? Separating Fiscal and Monetary Union, by Hugo Dixon, Foreign Affairs, November/December 2011.]
The continuing weaknesses in Europe’s banks are at the core of the current crisis. As the New York Timesexplained: “Europe’s banks tower over the economies in which they operate, much more so than in the United States. That gives them not only significant political influence but also explains why European governments have been so reluctant to push for a write-down on bank debt holdings.” [Europe looks for Hope in Bank Test Results, 14 July 2011.] To put this in context, in December 2010, bank assets for US banks were approximately 82% of US GDP. At the same date bank assets as a percentage of their national GDP, were 246% for Germany, 338% for France, 380% for Belgium, and 389% for the UK.
In addition over 50% of the investment in US sub-prime mortgages was made by European (and especially German) banks. These banks also made significant investments in bank and sovereign assets in Iceland, Greece, Portugal, Spain, Ireland, other peripheral European states and in Eastern Europe. When the sub-prime crisis exploded this destroyed the balance sheets of these banks due to their extensive holdings directly in sub-prime investments, and indirectly through investments in other banks with similar holdings. Europe’s regulators then added to the problem by demanding that banks hold supposedly safer assets, such as European sovereign debt. This sovereign debt was supposedly risk-free. This was because of the widespread view that European nations, particularly members of the eurozone could not default. This was reinforced by the way banks are regulated under the Basel rules. These say that government bonds are risk-free assets and the banks do not have to hold any capital when they invest in them. So, banks piled in, which also happened to suit European governments who were provided with significant funding.
Data from the Bank for International Settlements shows that such investment to the sovereigns in Italy, Greece, Spain, Portugal, and Ireland rose by 24.2% to $827 billion between the second quarter of 2007 when the sub-prime crisis hit and the third quarter of 2009, when the crisis in Greece started to taint European sovereign debt.
What turned these supposed risk-free assets into distressed debt?
There are many factors – the key background ones being governments that borrowed beyond their means, regulators who permitted banks to treat these bonds as risk-free, and investors who for years did not make the distinction between the bonds of weaker economies like Italy and Greece and those of stronger economies like Germany, and therefore earned higher returns on the former. However these background factors only became obvious in October 2008 and subsequently when Germany changed the rules of the game and, as noted by the Peterson Institute for International Economics, signalled that defaults of sovereign debt could happen and that investors would have to bear a share of the losses.
George Soros agrees: “The decisive moment came after Lehman Bros collapsed, and authorities had to guarantee that no other systematically important financial institution would be allowed to fail. German Chancellor Angela Merkel insisted that there should be no joint EU guarantee; each country would have to take care of its own institutions. This was the root cause of today’s Euro crisis”. (My emphasis).
“The financial crisis forced sovereign states to substitute their own credit for the credit that had collapsed, and in Europe each state had to do so on its own, calling into question the creditworthiness of European government bonds. Risk premiums widened, and the euro zone was divided into creditor and debtor countries”. [Europe Needs a Plan B, George Soros, Financial Times, 11 July 2011.] This action turned what could have been a manageable banking problem, to the “life-threatening” sovereign, banking, and recessionary problems we face today. Standing together the euro-zone was untouchable, standing alone in a modern game of “17 little Indians”, each country gets picked off one by one, as their individual weaknesses get highlighted and exaggerated.
Commentator Wolfgang Munchau explains why this happened: “Some European elites simply don’t grasp the nature of the problem: the traditional European solution to banking crisis is to sit them out – to do nothing and wait for the next economic recovery. Indeed, that’s what Germany did to overcome the costs of unification…”
“The close ties between banks and the respective governments are also making it difficult to achieve clarity. In Germany, the six regional banks (landesbanken) that are most in need of recapitalisation have cosy ties with local government … Indeed, the presence of a highly-politicised banking sector was the main reason why the euro zone leaders, back in October 2008, decided to provide large safety nets to the banking system on a nation-by-nation basis; no country wanted to expose its banks to the embarrassments and competitive disadvantages of an objective assessment. The then German finance minister, Peer Steinbruck, was explicit in acknowledging this stating that his country was against transferring regulatory powers to the EU because it would have deprived Germany of political control of its banks.” [Original Sin, Wolfgang Munchau, Foreign Policy, 7 April 2011.]
This analysis clarifies the approach necessary to solve the crisis.
If the game of 17 little Indians is not ended, disaster will ensue. Peter Bofinger, a German economist who advises the finance ministry in Berlin is clear: “Europe either stands united and survives, or stays divided and falls.” The independent IMF has been clear for some time about what is needed. A successful currency union needs and a normal monetary union requires centralised euro-zone bank supervision, centralised bank resolution mechanisms for troubled banks (and a mechanism for insulating them from their respective sovereigns), and a centralised system for bank liability insurance. In addition the ECB must be in a position to act as a lender of last resort, otherwise you in essence have a currency/monetary union uniquely with no backstop.
These structural changes, together with a serious euro zone bank recapitalisation plan that is actioned immediately for the IMF recommended level of €200 billion, and a realistic (50% – 60%) write-down of Greek debt (the current planned write-down is actually a voluntary 30% write-down) would finally stop the crisis.
Absent these developments, the targeting of Italy will continue, then Spain, France, and then Germany itself. Closer fiscal union, which is unobjectionable (assuming appropriate safeguards for peripheral and other euro zone states) will not address the banking issues set out above. Only the completion of a proper monetary union will do so. The issue is whether Germany is ready to accept deeper monetary integration.
Chancellor Angela Merkel is frequently criticised for indecision and not pushing forward with the dramatic moves the eurozone needs. A more nuanced interpretation of her actions and her inactions is that she is an accurate reflection of Germany today. Leaving behind the post-World War II era, proud of its economic strength, but wary of entanglements that might impinge on it, and with some, much- hidden, resentment against the West, Germany today is a country in a transition to an unclear future. A recent interview with Helmut Kohl, former chancellor of Germany, in the leading German foreign affairs journal Internationale Politik is a good indicator of a Germany that is adrift from its three core moorings of the past (multilateralism, the EU, and the relationship with the US) and in search of a new identity/role in the world. The same magazine, in the September/October edition, published a survey showing that although 33% of those surveyed think Germany should maintain its political co-operation with the West, 31% think it should favour relations with Russia, China and India over the West.
Until Germany has clarified its role in the world, and therefore in Europe, solutions to the eurozone crisis will continue to be piecemeal and inadequate. Only a full commitment to standing together and to full monetary union will solve the current crises. Let us hope that Germany is in a position to commit to such sooner rather than later. The timing of that decision will determine whether the impacts of these crises on Europe are serious or terminal.
Unfortunately the damage to date has been extensive. Many do not realise that the sovereign bond market has already been seriously damaged by the actions and inactions of Germany, their allies, and the ECB. As theEconomist explains: “German orthodoxy ignores the possibility that rising bond yields are being driven by a self-fulfilling panic in financial markets. Investors who once regarded Italian bonds as a safe asset now worry about everything from the integrity of the credit-default-swap market to a possible break-up of the single currency. The result is a stampede for the exit, which cannot be stopped by Italian policy reforms alone. So by adding to the pressure on the governments of countries in crisis, the Germans and their allies succeed in forcing reform, but at the cost of making it far harder to rescue the Euro.”
“Emerging economies which borrow in a foreign currency have long been vulnerable to these kinds of self-fulfilling crises of confidence. As the pool of euro assets deemed ‘safe’ dwindles, more countries may face such runs. Judging by this week’s leap in yields, France looks to be next in line. The big difference, however, is that average emerging-market debt is less than 40% of GDP. Italy’s debt ratio is more than three times higher; France’s twice as high.” [The Euro crisis – the German problem, 19 November 2011].
What the failed policies to date in this area have done is cast doubts on the credit worthiness of Western European governments for the first time in 60 years. That damage will not be easily undone.
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