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The eurozone and the streetlamp syndrome

The world was looking for a watershed in Europe. There was one at the European summit last week, but not the one expected: Britain’s isolation on treaty reform was a defining event for the future of Europe, but the agreement to rescue the euro fell short of setting the foundations for stability and growth in the euro area.   

Let us begin by acknowledging two positives in the euro decisions. First, there will be significant ammunition at the disposal of the firefighters: the swifter introduction of the European Stability Mechanism (ESM), its temporary coupling with the financial facility (EFSF) already in place, and new resources to the IMF (which are certainly going to be matched by contributions from the emerging world) add up to a serious intervention power. Markets are likely to take notice. Second, there is new emphasis on a more decentralised approach to budgetary responsibility, with national rules and procedures of the ‘golden rule’ kind. If properly designed and seriously implemented, tailor-made provisions for fiscal discipline are likely to be more effective than micromanagement from Brussels. The new set-up may gradually change the role of the EU, from an intrusive yet ineffective watchdog to a guardian of the consistency of national rules. All this is welcome.   

There is a snag, however: the questionable premise that strict enforcement of the disciplines of the Stability Pact is the key remedy to the euro area’s problems.  

No one can argue about the need to correct the faulty implementation of the Pact and to prevent a repetition of what occurred in 2003 when France and Germany combined forces to block the procedure. But these reforms have already been decided and will enter into force in January. Returning once more and underlining the importance of the three-percent limit and automatic sanctions resembles the famous ‘streetlamp syndrome’, whereby one looks for lost house keys in the light of the lamp rather than elsewhere where it is dark. For three reasons.       

The first is that the Stability Pact suffered from design faults as much as faulty implementation. In 2007 Ireland had a balanced budget and Spain had a significant surplus. Four years later, at the end of 2011, Ireland’s debt has risen from 25 percent to 108 percent of GDP, and that of Spain from 40 percent to 70 percent. Tax receipts artificially swollen by the domestic demand boom made the situation appear healthy but they evaporated as soon as the bubble burst. And governments have had to refloat the banks, at a cost estimated at 40 percent of GDP for Ireland. No amount of automaticity will prevent damage such as this in the future. On the contrary, what is needed is a more economic, rather than legal, and a more discretionary approach.     

The second reason is related to the perverse interaction between the sovereign and bank crises. In some case, such as Ireland, it is the collapse of the banks which brought the country to its knees. In others, as in Greece, it is the failure of the state which is threatening the banks. The same vicious circle applies everywhere: sovereigns and banks are weakening each other because the banks’ balance-sheets are loaded with the debt of their own government and the government alone bears the burden of any rescue of financial institutions.  In the US banks hold little government debt, and when they do it is federal debt. And it is also to the federal level, not New York state level, that Wall Street banks would look for rescue.  

In order to put a stop to this interplay which is making the whole of the eurozone fragile, banks must be required to diversify their risk, or be offered paper representing the whole of the euro area (the famous Eurobonds). Responsibility must also be switched to euro-area level for supervising big banks and the burden of cash injections partially mutualised, or the area must be endowed with fiscal powers to this end. However, nothing serious has been done here, other than scaring banks by asking them to mark government bonds to market, in other words to mark down all southern European paper. The upshot is that banks are offloading these bonds in a hurry, which is knocking even more value off them.     

The third reason is that the euro is suffering as much from a balance-of-payments crisis as from a budgetary crisis, as Hans-Werner Sinn and others have emphasised. Since 2007 private capital has gradually stopped financing southern European countries and central banks have had to step in instead. This situation is dangerous. It was believed that the difference in balance of payments would disappear between euro countries, but they still exist because mobility is weak and banks remain national. To resolve this problem at its root calls for deeper economic integration. This is not the path being adopted.            

If the drug works, it will be because the dose is massive. But the leaders’ prescription is no precision medicine, to say the least.

 

Column for Handelsblatt published on November 23, 2011

 

Germany’s hour

A series of events over the last few weeks have created a new situation in Europe.

First, the euro area has failed to turn the tide. Mario Draghi was right to note last week that in spite of numerous ministerial meetings and three summits, implementation of the decision taken in July is still lacking. There are by now growing doubts about the very wisdom of holding them.

Second, and partially as a consequence, the debt of virtually all euro-area countries is trading at a discount to the German Bund. While a more accurate pricing of risk was necessary, it is hard to believe that with a debt ratio nearly twenty percentage points lower, the Netherlands deserves to be assessed more prone to default than Germany. Even the Bund started to suffer from market anxiety last week.

Third, market participants and, increasingly, real businesses are pricing in a break-up scenario. It is still hard to think the unthinkable, let alone to work out the details of it, but any rational player has to consider the possibility of it. If disaster expectations build up and a growing number of players start positioning themselves to protect themselves from it, the consequences could become overwhelming.   

Fourth, Germany has become the undisputed leader of the euro area. Although France continues to play its role in the couple, it has lost weight and initiative. A weaker French economy, weaker public finances and the coming presidential election are all combining to alter the balance in the old couple. Political impetus can defy the laws of gravity, but only up to a point.

In this context Germany finds itself again in a situation akin that of the late 1980s, when the Bundesbank was making monetary policy for the rest of the continent. At that time chancellor Kohl wisely assessed that German economic dominance was not a stable equilibrium and that a better plan for the future was to build on Germany’s weight and influence to create a permanent common monetary order. This is what gave birth to the euro.                 

Today again Germany’s best interest is to ensure lasting stability in Europe. With foreign assets worth 6 trillion euros, most of which consist of claims on euro-area partners, Germany would lose out massively in a fragmentation of the euro area. Claims on entities in partner countries would either be redenominated in weaker currencies or the borrowers would default on them. And, obviously, German exporters would be hurt by substantial currency appreciation.

Chancellor Merkel has sensibly decided to take the lead on reforming the euro area. But many Germans feel deceived by irresponsible euro-area partners. There is therefore the temptation to use Berlin’s current strength to toughen sanctions and coerce weaker partners into adopting constitutional changes, especially in the budgetary field.

This is a risky attitude. For sure, Germany today has far more leverage than it has had at any point in the last twenty years. But to attempt to extract unilateral concessions from partners is a recipe for disappointment. It is one thing is to be sanctioned if you breach the rules, as today with the Stability and Growth Pact, and quite another thing to move to a new system that gives a higher-level authority the power to overrule national parliaments and censor a budget before it is enacted. Partners are unlikely to agree on major reform if Germany does not offer something in exchange. What is likely to emerge from negotiations is, rather, another layer of largely ineffectual sanctions procedures.

The natural quid-pro-quo for ex-ante budgetary control is solidarity through the creation of Eurobonds. Joint and several liability over public bonds is imaginable only if countries offering their guarantee – in effect potential access to their taxpayers – can exercise veto power and prevent a partner country from issuing more debt. So legally binding ex-ante control is a sine-qua-non condition for Eurobonds. Symmetrically, surrender of budgetary sovereignty through the granting of veto power to the partners is acceptable only if it comes in exchange for a guarantee from these partners that they will come to the rescue in case of accident.

Germany therefore should be bold and use its leverage to offer a new contract to its euro-area partners: mutual guarantee over part of public debt in exchange for strict debt limits and a new legal order in the framework of which a euro-area authority could veto a budget passed by a national parliament even before it starts being implemented. Only boldness will deliver.

 

Column for Handelsblatt and Project Syndicate, November 23, 2011

Fiscal consolidation is no indiscriminate belt-tightening

In June it was Greece. In August it was France, Italy, Spain and Portugal. In September it was Greece and, once again, Spain. In November, France again. Now Italy. Soon very likely Belgium. And perhaps France for a third time. In spite of an ever-darker economic outlook, every month European countries put under pressure by the bond markets are announcing new budget restrictions in the hope of limiting their deficits and halting the slippage in their borrowing terms. Only Germany stands out, announcing a tax cut, though a modest one.

In countries under IMF/EU programme, austerity at the very moment the economy is suffering from a severe downturn raises familiar questions about the design of adjustment packages. For them, the dilemma is a difficult one to which they is hardly a good solution: they have lost access to capital markets and need to reach primary balance expeditiously, but fiscal contraction is adding to their woes. For other countries the reason for the move is the widening of interest-rate spreads in the eurozone. While the yield on German ten-year debt remains under two percent, it exceeds three percent for France, is close to six percent for Spain, and Italian yields have burst through the seven-percent barrier. It looks a no-brainer: even if it dopes the risk of recession, accelerated budget cuts are preferable to a lethal surge in rates.  

The first is that a sound budget strategy should not be based on nominal deficit targets. Rather, it should imply setting a target for the outturn (deficit or surplus) under prudent economic hypotheses, establishing a tax and spend profile consistent with this projection, and then sticking to it irrespective of short-term developments. This allows the ‘automatic fiscal stabilisers’ to come into play. This strategy is not a loose one, in fact it may even be very rigorous if targets are ambitious, but it avoids amplifying cycles, especially recessionary ones. The only thing is that it requires credibility and transparent implementation so that markets trust that the government is sticking to its stated goal.         

The second factor is that headlong consolidation is not necessarily the best way to reassure markets. This is particularly clear in the case of Italy, whose deficit (four percent of GDP this year) is much below those of Spain and France. It is not the deficit which finally spooked investors and turned them off Italian bonds but a cocktail of high debt, desperately slow growth and political paralysis. In a situation like this, nibbling at the deficit is at best a sideshow. What the markets expect is the implementation of reforms designed to durably lift the rate of growth and the installing of credible economic governance in the euro zone. As political capital is scarce, governments have to choose where best to invest it – which may well be in reforms rather than additional consolidation.        

The third reason to doubt the benefit of hurried budgetary adjustments is that they generally rely on measures with immediate impact, but that are economically damaging. Governments know this only too well: according to an IMF survey of their intentions, at the end of 2010 they were pencilling in spending cuts in their medium-term programmes while preserving the most productive, such as education and infrastructure. And on the tax side they were planning to broaden the base rather than raise rates. This was very much in accordance with the policy consensus on what a growth-friendly consolidation should be.

But since the start of the summer European government have actually done the opposite. Rather than focus on spending, they have zeroed in on tax measures, for the most part increasing the rates of existing taxes. Expediency explains why they made this choice. But it is a bad choice for growth and ultimately the lasting and effective character of the consolidation. 

So what should be done? No doubt European countries need a budgetary clean-up, but this is a long-term process. Instead of making knee-jerk cuts, governments should first sit down and set precise and detailed targets for the medium term. They should also spell out what they intend to do in consequence about spending and revenue, in the least damaging possible way for growth.

Governments should then invest in the means to reestablish their credibility. Budgetary rules and institutions are a good investment in this respect. Many European countries have recently introduced domestic rules such as the German “debt brake” or the British “fiscal mandate”. Many have also given an independent institution a key role in overseeing the government’s budgetary behavior and in evaluating the consequences of its decision. For example, the UK has created an independent “Office for Budgetary Responsibility” that has no role in setting policy but has an exclusive mandate for establishing economic and budgetary forecasts. This helps strengthen the credibility of government policy.  

Finally, governments should ensure that their budget and fiscal programmes are consistent with the aim of increasing growth potential. This entails on the one hand finding the sweet spot in terms of spending cuts and tax rises and, on the other, identifying on each side of the ledger the least harmful measures over the medium term. This takes time, thought and steel. But again, it is a much better approach than to rush into hasty consolidation.

The question is, will markets be patient? As panic has set in, there is admittedly a risk they won’t wait to see results. But by the same token, they may be frightened if they see growth falter. All considered, the economically sensible strategy is worth a try. 

Column published in Handelsblatt and Century Weekly (Caixin), November 2011

How to stop fragmentation of the Eurozone

The continual rebounding of the Greek crisis is making the headlines. But a less visible yet even more worrying development has appeared in the Eurozone since the summer:  the beginnings of a creeping process of fragmentation.

The first sign is that banks are once again reluctant to lend to each other. Since July the spread between the rate at which they borrow from each other and the zero risk rate has been climbing. Rather than to lend it on the interbank market, financial institutions with liquidity increasingly prefer to deposit their cash with the ECB, which has had to reactivate its direct lending procedures to banks. This is the same situation – though at this stage less acute – than in the 2007-08 crisis. The tension is obvious, and this time it is internal in origin. In London and New York the interbank market is still working. 

The second sign is that one and the same cross-border bank is charging higher interest rates for firms in southern Europe than to similar firms in northern Europe. This cuts to the core of the single market, and it is making the situation for crisis-hit economies worse. Instead of combating this trend, northern European bank supervisors are magnifying it by setting limits to the exposure of their banks to southern Europe.

The third sign is that, in the eyes of international investors, southern European government bonds no longer belong to the same asset class as northern European ones. It is not simply a case of the price of risk, by definition easily reversible. It marks a deeper change in attitude. If it continues to affect lending behaviour to southern countries, it will harm their solvency and economic recovery.  

It is in this light that we must consider the proposed crisis responses which are being discussed in the run-up to a decisive European summit on 23 October and the G20 summit in early November. The heads of state are expected to agree on a higher debt relief for Greece, a boosting of the European financial facility, and the recapitalisation of banks. These would be welcome moves, but the heart of the problem is to determine which set of principles will underpin the construction of a more robust monetary union.     

The main cause of the creeping fragmentation which is observable is the mutual dependence of banks and governments. In the Eurozone banks are vulnerable to sovereign debt because they hold a lot of public paper, frequently issued by their country of origin, and the governments are vulnerable to bank crises because they are individually responsible for rescuing national financial institutions. Every episode in the crisis illustrates how much this interdependence is a source of fragility.  

There are three possible responses to this state of affairs. The first relies on intervention by the central bank in case of a threat to the sovereign debt market. The mutual exposure of banks and the sovereign exists in the UK and the UK’s budget situation is worse than that of Spain, but the certainty that the Bank of England would prevent speculation on the UK’s debt is sufficient to reassure investors. In the Eurozone the ECB has not been equipped with this mandate. It is not meant to be a lender of last resort. It has played this role with Italy and Spain but is up against stiff opposition from within its own ranks, and it may well not continue for much longer. In fact, it does not have the right decision-making structure to take decisions that may end up implying a transfer from one set of countries to another one. The recently created European financial facility is better equipped to take such decisions and may play a similar role but its war-chest is limited. As for changing the mandate and structure of the ECB, this would not be acceptable for Germany, if only for constitutional reasons. 

The second response consists of strengthening the banks through recapitalisation and removing the dividing walls between national banking systems in order to staunch their overexposure to sovereign default. The Eurozone would be healthier with a properly capitalised banking system, holding diversified assets and endowed with common surveillance and deposit insurance. This would sever banks from over exposure to their own sovereigns and sovereigns from exposure to their own banks. However, it is to be feared that European leaders may not be bold enough to fully embrace such a plan as they are reluctant to renounce their national banking champions and access to captive investors. We will soon see how the land lies here when the recapitalisation details become known.   

The third response consists of reducing sovereign risk by means of a system of surveillance and mutual guarantees between the Eurozone countries. This is budgetary union, and the fuller form of this is the issue of bonds jointly guaranteed by all participating states, which are known in Europe as Eurobonds. The principle of them is best summarised if one imagines that each states borrows from a common debt agency that in turn issues debt on behalf of all states and with their joint and several guarantee. Introducing Eurobonds would in fact imply for each state giving its neighbours access to its own taxpayers and this cannot be imagined without ex ante control of the same neighbour’s budgetary decisions. Moving to such a system is a politically very tough choice both for those countries who would perceive themselves as guarantors and those who would benefit from the guarantee. But it probably remains the most practical way forward of the three.     

These three responses are in fact in part complementary, though any durable regime is likely to give priority to one. Even espousing one of them would be a positive sign. It would show that Europe goes beyond mere patches to revisit the fundamental principles upon which monetary union is based. This would be the surest way to regain investors’ confidence.

 

Column published in Handelsblatt, Century Weekly (Caixin) and Project Syndicate, october 2011

The euro: no soft landing on exit

It may appear pointless to switch to summer time each year when it would be simpler for everyone to decide to come into work one hour earlier in the morning. Yet we all change the clocks because it is much easier to put back your watch than to change your habits.

One hears this same rationale increasingly often for arguing that the countries whose competitiveness has nose-dived should leave the euro. Rather than hoping that, by the combined effect of tens of millions of independent decisions, firms and workers would force themselves painfully to absorb past price and wage inflation, it would, according to some, suffice to recoup competitiveness by reducing the exchange rate of the new national currency by the requisite percentage.   

Monetary experience in fact teaches that, for the same final result, an internal devaluation (by a change in prices and wages) is much harder to achieve than a devaluation of the exchange rate. But, even if one disregards the European political stakes of such a decision, this logic sins by omission on several counts.  

The first obstacle is legal. The EU Treaty provides for a voluntary exit clause from the Union, but not from the euro. Thus a state may leave the Union (and thereby forfeit regional aid, considerable for Greece and Portugal, and CAP transfers), but there is no provision for leaving the euro and remaining in the Union.      

The second obstacle is technical. It is straightforward to change currency in a financially underdeveloped country: just order a stock of brand new notes. But it is quite another matter in a modern economy. Years of preparation and adjustment of IT systems went into the switch to the euro, followed by a lengthy test phase. Leaving the euro abruptly would inevitably be costly and disruptive. 

The third obstacle is economic. The proponents of exit claim that a controlled devaluation of the new currency is to be anticipated. This is to overlook that the countries likely to go for this option are labouring under a credibility gap. If there are new national currencies, it is the market which will determine what they are worth. When Argentina severed its fixed link to the US dollar in January 2002, the government announced a new exchange rate of 1.4 pesos to the dollar (instead of one peso). In July, there were four pesos to the dollar: the currency had lost three quarters of its value.     

A drop of three quarters in the exchange rate, surely, guarantees an ultracompetitive economy. But it would imply a quadrupling of the price of imported goods, which would not only impoverish consumers hugely but would prevent firms from acquiring equipment and semi-finished products. This is not the route to kick-starting exports again.

The fourth, and toughest, obstacle is financial. Thinking in terms of competitiveness, inflation and purchasing power is to ignore the lending and borrowing of households, firms and the state, which are today denominated in euros. While commitments between residents of one and the same country could easily be redenominated in the new currency, this would not be the case between residents and non-residents. Bear in mind that, according to Claire Waysand and her colleagues at the IMF, lending and borrowing of the euro countries between each other currently amounts to 200 percent of GDP. Greek sovereign bonds held by French and German banks, the subject of much concern, are but part of a much wider web of potential problems. Firms, banks and insurance companies would see some parts of their balance sheet remaining in euros and others suffering a sharp drop in value. Some would gain from this, others would immediately go bankrupt. It would mean that fortune or ruin would be decided as if by the spin of a wheel.   

Moreover, as exit is not provided for in the treaty, it could not occur overnight. Depositors would have ample time to withdraw their money from banks, and banks would have time to borrow from their central bank in order to invest in countries remaining in the euro. This cautious behaviour would only deepen the disaster.

Given the torment which Greece is facing at the moment, it will become ever more tempting to go for an alternative. But the option of an exit with a soft landing is a fiction. If by any chance this were to happen, there would be chaos. It would be economically destructive, financially ruinous and socially devastating.

 

Column for Handelsblatt, September 13, 2011

Europe: the last taboos

You can always trust the Americans, Churchill said, because in the end they will do the right thing, after they have exhausted all the other possibilities. For the last 18 months, Europe has made of this famous phrase its roadmap: it has taken the necessary decisions, but always as a last resort.

Once again, on 21 July, the euro area's leaders proclaimed that what they previously said was unthinkable was in fact necessary. They gave up the pretence that Greece was solvent, agreed to extend more and longer-term loans to it, admitted that excessive interest rates could only make the problem worse, called for private lenders to bear some of the burden, gave a guarantee of continued funding for Greek banks, recognised the need to support growth, and agreed to broaden the scope of the European financial facility, making it a more flexible tool for intervention.

For Germany, France, the European Central Bank and other players in the European game, these about-faces have a cost in terms of reputation, political capital or legal leeway. Although decisions taken on 21 July were wide-ranging enough for everyone to be able to claim success, the players are going to have to explain why red lines were crossed. All no doubt will claim that this is the last time.

Is this true? Have the last taboos been broken? Or will another crisis summit need to be convened soon with even bolder denials and measures?

In the case of Greece, there is real aggiornamento. In place of an equation without a solution, European leaders have substituted another, which no longer seems unsolvable. In deciding to provide cheaper loans and in agreeing to a debt reduction, they have started reducing the burden – though not enough, as far as private lenders are concerned.

A reduction in public debt will not make companies more competitive or create jobs for the unemployed -- even though it will help. There is a view that for Greece to recover, it will be necessary to break the 'euro taboo' and reintroduce a national currency. The certain outcome of this would be immediate devaluation, much beyond what restoring competitiveness requires. When in 2002 Argentina broke its link to the dollar, the peso lost four-fifths of its value. But financial claims in Greece are denominated in euros. Forced conversion would destroy much of the value of savings and resulting currency mismatches would unleash a wave of bankruptcies (in Greece or the rest of the euro area depending on the exact terms of the conversion). Even before the shock, there would be a bank run as savers would move their assets, resulting in a bank collapse. Furthermore, far from being reinforced the rest of the euro area would be weakened, as speculation on the true value of the German, French or Portuguese euros would start. All this renders adjustment within the euro area preferable, despite all the difficulties it presents.

For the euro area as a whole, the measures announced on 21 July will not dispel the concerns about other countries, in particular Italy and Spain. One of the most striking vulnerabilities revealed during the last few months is the correlation between banking crises and sovereign crises. In Greece, the state of the public finances is a threat to the banks, which have a portfolio of government securities twice the size of their capital. The same fear is present in Italy. In Ireland, it was the banks going off course that brought the government to its knees. Spain has been weakened for the same reasons. The vicious circle sucks in one party or the other, but the logic is the same: a state in difficulty weakens the banks because of the falling value of government securities; banks in difficulty weaken the state because of anticipated bailout costs.

This dangerous vicious circle results from the refusal to diversify and share risks. In the United States, banks incorporated in Delaware feel no obligation to hold bonds from that state. Instead, they hold federal securities. And it is Washington DC, not the state of New York, which is responsible for bailing out Wall Street. This does not eliminate all the risks, but spreads them and means that, in the face of financial hurricanes, calls can be made on the central bank. Europe is not a federal state but the weakness of the euro area would be greatly diminished if deposit insurance was pooled -- which obviously implies relevant changes in banking supervision -- and if the banks diversified their bond holdings so that they are more representative of the euro area as a whole (the famous Eurobonds).

Europe has cautiously started to move in this direction by broadening the scope of its financial facility. But the pooling of risk remains taboo. It is not clear if this taboo will remain unbroken by the end of the crisis.

 

Column for Handelsblatt and Project Syndicate, July 26, 2011

Vergiftete Schulden

Europäische und deutsche Fahnen werden auf den Straßen Athens verbrannt – vor zwei Jahren war das noch der Alptraum eines deutschen Diplomaten, der mir seine Sorge anvertraute. Mit den Straßenschlachten auf dem Syntagma-Platz ist dies bittere Realität geworden. Die EU und ihre großen Mitgliedstaaten haben im vergangenen Frühling die konditionierte Finanzhilfe an EU-Krisenstaaten beschlossen und eine führende Rolle dabei übernommen. Damit haben sie sich auf ein Spiel eingelassen, auf das sie nicht vorbereitet waren und das weitreichende Folgen haben kann.

 
Diese Dimension darf man nicht verkennen, wenn über die Lösung der griechischen Haushaltsnotlage diskutiert wird. Das vorherrschende Denken bei den europäischen Beamten ist: Griechenland soll erst ein Sparprogramm durchlaufen, um das Verhältnis des Schuldenstands zur Wirtschaftsleistung zu stabilisieren. Andere europäische Länder hätten das auch geschafft, beispielsweise Belgien – warum nicht Griechenland?

Den EU-Prognosen zufolge steigt die Relation der Schulden zum Bruttoinlandsprodukt 2012 auf 166 Prozent. Selbst bei umfangreichen Privatisierungen – auf die ich nicht wetten würde – läge sie  bei 150 Prozent.  Will Griechenland seine Schulden so weit abbauen, dass private Investoren ihm wieder vertrauen, müsste es lange Jahre viel mehr Steuern einnehmen, als es – vor Zinszahlungen – ausgibt. Das ist ein Rezept, um die Bürger gegen sich aufzubringen. Angesichts der verbreiteten Steuerflucht und des Gefühls, dass die Lasten sehr ungerecht verteilt sind, reizen die beschlossenen Steuererhöhungen die Griechen schon jetzt bis an die Grenze. Dabei liegen die Einnahmen noch deutlich niedriger als erforderlich.

Belgien kam von seinen Schulden herunter: dank eines effektiven Staates und kräftigen Wachstums. Griechenland kann nicht einmal auf kräftiges Wachstum hoffen. Es muss sein Preisniveau senken, um wieder wettbewerbsfähig zu werden. Das bedeutet ein langsameres Wachstum und ein verschärftes Schuldenproblem. Das Land hat zudem in den vergangenen Jahren von niedrigen Zinsen profitiert. Nun steigen sie. Zu den heutigen Bedingungen kann Griechenland den Kapitalmarkt überhaupt nicht anzapfen. Selbst wenn es vollständig auf die Hilfe seiner Partner und die Verlängerung eines Teils der privaten Kredite zählen kann, wie jetzt von Frankreich vorgeschlagen, steigen im Vergleich zu früheren Jahren die Kreditkosten. 

Was bleibt zu tun? Es gibt nur zwei schlüssige Optionen. Die erste, nennen wir sie Plan A, wäre: Die griechischen Schulden werden sozialisiert. Dafür müssten alle Anleihen von den Partnern garantiert und die Zinsen so weit gesenkt werden, dass Griechenland im Lauf der Zeit wieder zahlungsfähig wird. Wer soll die Kosten tragen? Entweder die Banken, etwa durch eine Sonderabgabe, oder die Steuerzahler – wie es meist geschieht. Die zweite Möglichkeit, Plan B, wäre es, die privaten Gläubiger zahlen zu lassen durch eine geordnete Umschuldung. Das Hindernis ist die Furcht vor einer neuen Finanzkrise. Damit der Plan funktionieren kann, muss er gut vorbereitet werden, nicht zuletzt durch die EZB. Dann könnten die ungewollten Folgen eingedämmt werden.

Beide Pläne missfallen einem Teil der europäischen Entscheider. Aber einen müssen sie wählen. Je mehr Zeit verstreicht, desto näher rückt Plan A – aus dem einfachen Grund, dass die offiziellen Gläubiger nach und nach an die Stelle der privaten rücken. Selbst wenn der französische Vorschlag voll verwirklicht würde, verlängerten die privaten nur die Hälfte ihrer fällig werdenden Anleihen. Die andere Hälfte und alle neuen Schulden müssen der IWF und die EU-Staaten schultern.

Die Europäer müssen sich also entscheiden, ob sie weiter an ein griechisches Wunder glauben wollen oder ob sie akzeptieren, das Land zu subventionieren. Wahrscheinlich werden sie so lange wie möglich weitermachen wie bisher. Irgendwann aber werden die Griechen merken, dass sie einen großen Teil ihres Einkommens in Form von Zinsen an reichere Partnerstaaten überweisen. Dann werden sie das Ganze infrage stellen – wenn nicht schon früher. Die EU-Kommission hat ausgerechnet, dass 2012 bereits siebeneinhalb Prozent der Wirtschaftsleistung für Zinsen fällig werden.

Mit dem Streit über die deutschen Reparationen hat Europa in der Zwischenkriegszeit erlebt, wie spaltend und politisch vergiftend ein Konflikt über Finanzlasten zwischen Staaten sein kann. Falls die Politiker das vergessen haben, sollten sie in ihren Ferien „Lords of Finance“ von Liaquat Ahamed lesen. Das wird ihnen die Augen öffnen.

 

Column for Handelsblatt, July 1, 2011

Belgian lessons for Greece

Two years ago a senior German diplomat told me his fear to see the European and German flags burned on the streets of Athens. The increasingly acrimonious tone of the Greek debate and the riots on Syntagma Square indicate that he was right. When they decided in spring 2010 to take a leading role in conditional financial assistance to countries in crisis the EU, and the major member states within it, entered a game for which they were not prepared and that can have far-reaching consequences.

This dimension should not be ignored when discussing what strategy to adopt to address the Greek budgetary predicament. The current thinking among European officials is that Greece should first adjust to stabilise its debt-to-GDP ratio and then embark on a sustained effort to reduce it. Belgium, it is sometimes said, did it in the 1990s. Why not Greece?   

According to European Commission forecasts, the Greek public debt ratio is set to reach 166 per cent of GDP next year. Even assuming a swift privatisation programme (hardly a safe bet), it will still be of the order of magnitude of 150 per cent of GDP. A frightening number, because to reduce this ratio to a level at which creditors would willingly lend, the country will need for many years to keep non-interest spending way below tax receipts – a recipe for citizen anger. Large-scale tax evasion and a sentiment of unfairness in the distribution of the burden already result in public tolerance to higher taxes reaching its limits, although tax receipts are still below to non-interest spending.     

True, Belgium in 1993 reached a debt ratio of 134 per cent of GDP and was able to bring it down to 84 per cent in 2007. This comparison, however, ignores important differences. To start with, Belgium in 1993 had a reasonably effective state and a reasonably fair tax system. Second, in the ten following years it grew at close to 4 per cent per year in nominal terms: not stellar, but enough to help reduce the load of outstanding debt. Third, over the same period interest rates on the debt declined from the 8 per cent inherited from the inflationary years to some 5-6 per cent. Under these conditions a lasting excess of tax receipts over non-interest spending of about 5 to 6 per cent of GDP – not a trivial achievement by international standards – was enough to bring about steady debt reduction.          

Greece unfortunately cannot hope to grow fast. Official projections envisage reaching four per cent nominal growth from 2015 onwards, but the country starts from a very uncompetitive position and it needs to keep inflation way below euro area average if it wants to restore competitiveness. Success on that front implies slower nominal growth and, for this reason, an aggravated debt problem. Moreover, Greece benefitted over the last ten years from favourable interest rates. Borrowing costs as now set to increase. Obviously it cannot tap the markets under current conditions, but assuming it would entirely rely on official assistance and a maturity extension on part of its outstanding debt claims, as recently proposed by French banks, this would over time result in an increase of debt costs.

So what can be done? There are only two economically consistent options. One, call it Plan A is to socialise the Greek debt. It requires guaranteeing Greek debt and/or lowering the interest rate on official assistance, so that the average debt cost is low enough to make Greece solvent. As some form of subsidy will be inevitable, this plan also implies deciding who will bear the corresponding cost – either the banks, through a special levy or, by default, the ordinary taxpayers. The other strategy, Plan B, is to make private creditors pay through an orderly restructuring. The obstacle here is the fear of consequences for financial stability. To make it a viable option, preparations must be undertaken, not least by the ECB, so that when restructuring takes place its financial fallout can be contained.

Each plan is anathema to some of the European leaders, but one will eventually have to be chosen. The more time goes by, the closer Europe gets to Plan A, for the simple reason that official creditors gradually substitute private creditors. Even if the scheme put forward by French banks was implemented in full, private creditors would only roll over half of outstanding bonds coming due. The other half, and all new debt, would be financed by the IMF and the EU member states.

So the Europeans will eventually have to decide whether to insist, in spite of contrary evidence, that Greece can follow the Belgian route, or to accept subsidising it. The more likely scenario is that they will stick to the current stance for as long as they can. At some point however the Greek citizens will realise that they are transferring a significant fraction of their income to wealthier European sovereigns in the form of interest payments (Commission forecasts indicate that interest on the public debt should already reach 7.5 per cent of GDP in 2012). At this point, if not before, the politically sustainability of the whole scheme will be put into question.      

With the German reparations, Europe in the interwar period experienced ad nauseam how divisive and ultimately poisonous inter-state financial quarrels can be. Perhaps the best advice to the European officials as they prepare for the holidays season is to take to the beaches the excellent Lords of Finance, by Liaquat Ahamed. It is entertaining, illuminating, and sobering.

 

Column for Handelsblatt and El Economista, July 1, 2011

London and Washington, DC: economic policy litmus tests

The threat of a downgrade of the US public debt by the rating agency Standard and Poors a few weeks ago was a bolt from the blue. Only recently confined to a few delinquent countries, the public debt issue is now cutting to the core of the advanced economies. The message given loud and clear to all governments was that if the quality of bonds issued by the supplier of safe assets by excellence can be questioned, no country can consider itself immune from attacks. The question is no longer whether it is time to reduce deficits but how fast, how far and by what means.

In Europe Ms Merkel, the German chancellor, is portrayed as a tough deficit-cutter. But while she is wont to raise her voice, she acts with caution – the German budget adjustment is in fact very gradual. The countries where the budget battle will be won or lost are the UK and the US where deficits exceeded 10 percent of GDP in 2010.

In London, Prime Minister David Cameron is on the offensive. On arriving in power, he first entrusted budgetary forecasting to an independent Office for Budgetary Responsibility (OBR), thus forfeiting any possible sleight-of-hand. He then announced a bold consolidation programme to cut the cyclically-adjusted deficit by one-and-a-half points per year in order to reduce the deficit to three-and-a-half percent of GDP in 2013.

The bet was that this adjustment would not hinder growth and would even stimulate it. Since Ireland and Denmark showed the way twenty-five years ago, numerous governments dream of carrying out successful expansionary budgetary contractions. A closer look at these oxymoronic, semi-miraculous episodes reveals however that for the customary recessionary impact to be eliminated or even reversed, the action on the deficit has to have at least one following three impacts: a reduction of the households’ precautionary savings; a drop in long-term interest rates; or a move by the central bank to a more expansionist monetary policy, with the associated weakening of the exchange rate. Absent these conditions, budgetary adjustments are almost always costly in terms of growth. This was confirmed by a recent detailed and careful IMF study of past consolidation episodes.        

In the UK case, no drop in savings could be counted upon (being heavily in debt, households need to save more, not less), nor any decrease in long-term interest rates (they are already very low). That only left monetary policy to support economic activity. But in part as a result of the surge in commodity prices and in part because of weak productivity gains, inflation is higher than expected: the Bank of England forecasts that it will be around three percent at the start of 2012, almost two points higher than what the Bank foresaw last year. It is suddenly more and more difficult to promote growth although it is stagnant - it has been zero for the two last quarters. The latest Bank of England inflation report makes no mystery that such a context makes interest-rate hikes likely. The least one can say is that David Cameron’s bet is not yet won.    

The US stance has been entirely different. Faced with an unemployment which is still close to the post-war maximum, the Obama administration has delayed adjustment in order not to smother recovery. It even gave the economy a further boost at the end of 2010, in part to offset the highly restrictive policies of the US states, most of which have balanced-budget rules and have as a consequence run very pro-cyclical policies. To keep on stimulating in the short term was a perfectly defensible choice but at the same time it made all more apparent the lack, bof any serious thinking about the speed and the manner of future consolidation. Until very recently the feeling of urgency which pervades European conduct was almost entirely absent on the other side of the Atlantic. There were reports to discuss which way to go, but they visibly lacked traction.

A new phase commenced last month with the last-gasp agreement to avoid a shutdown of the federal government, and the approval by the House of Representatives of the budgetary programme prepared by Republican Congressman Paul Ryan. The budget debate is now in full swing. However the objective remains relatively un-ambitious and, even more importantly, disagreements about the means to achieve it are huge. The Obama administration is advocating a balanced approach, whereby two-thirds of the adjustment comes from spending cuts and one-third from tax increases. The Ryan plan on the other hand provides for a steeper reduction in the budget, in particular cuts in social spending in order to finish off what remains of welfare and to finance a cut in taxes. The gap between the two camps is huge.

The head-to-head between the two sides suggests that a kind of war of attrition is being waged in the US. They both focus on the state of public finances but each camp is seeking to use the deficit to push its own preferences with regard to the future of income and spending and to compel the other camp to back down. Unfortunately, as economists Alberto Alesina and Alan Drazen illustrated in a famous paper twenty years ago, this is exactly the type of political configuration that leads to delay budgetary adjustments.

The battle is intrinsically political. It is also uneven, because those whose ambition it is to shrink the State are by definition more prepared to risk bankrupting it than those who are seeking to preserve it. The Obama administration has already made major concessions on tax reductions and spending cuts.

Once again the UK and the US are acting as political-economy laboratories for the rest of the world. The fate of the UK experiment will critically influence the other countries’ resolve to embark on large-scale adjustments; and the result of the US battle will influence further choices about the relative priority of spending cuts and tax increases. The results of the experiments taking place there before our very eyes will have major consequences for the entire advanced world. 

 

Column for Handelsblatt, Project Syndicate and Century Weekly (Caixin), May 2011